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Deep global recession set to take its toll on banks

As the coronavirus pandemic pushes the world into an almost unprecedented economic decline estimated by the International Monetary Fund (IMF) at 3% this year – “much worse than during the 2008 financial crisis”, according to the IMF’s World Economic Outlook – how badly should investors expect banks to suffer? With our focus on evaluated pricing and shifting market sentiment in our recent whitepaper, transparency and access to significant information in times of distress is key to provide guidance through this challenge.

  1. HSBC has recently put US$3 billion aside as a provision against potential losses due to the coronavirus.
  2. Despite the increased risk in a downturn in the economy, the European Banking Authority (EBA) has reported (using the striking phrase ‘banks sail through the Corona crisis’) that EU lenders’ capital strength rose in Q4 2019, with CET1 at almost 15%.
  3. Discover how Refinitiv brings clarity to highly uncertain situations like the current pandemic-challenged economies in our new fair valuations whitepaper.

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Unlike in 2008, banks aren’t the focus of the current crisis. Indeed, a decade on the banking sector is in notably better shape thanks to the Basel III regime’s far more stringent liquidity and capital requirements, as well as the switch to creditor liability through bail-in mechanisms.

For example, by Q3 2019 UK banks were more than three times stronger (on the key common equity tier 1 (CET1) measure) than at the start of the global financial crisis, according to the Bank of England.

Even so, banks are inevitably at increased risk in a downturn in the economy. Major lenders in Europe, the U.S. and elsewhere are bracing for damaging hits from their counterparty exposures – the risk that households and businesses will fail to service their debt in full and on time.

Debt defaults on the rise

Despite huge interventions by governments and central banks affirming their willingness to do ‘whatever it takes’ to shield their economies from the pandemic’s impact, the likelihood of debt defaults is rising rapidly. The International Monetary Fund says ‘the Great Lockdown’ will cause a potential US$9 trillion cumulative loss to global GDP this year and next – greater than the combined economies of Germany and Japan.

Industries with limited scope to reshape for an era of social distancing, such as airlines, hospitality and high street retail may be at the severest risk. The energy sector, already battling the collapse in oil prices, is also in peril.

The cost of insurance against almost all types of corporate borrowers is soaring, with both investment-grade and high-yield credit default swap indices trading at their highest levels in nearly a decade.

Soaring unemployment rates, which some experts forecast will reach 25% in the U.S. (above Great Depression levels), put individual borrowers at risk too – while lenders must already manage government-imposed repayment holidays.

Provisioning push, downgrades growing

Against this background, banks are already taking substantial provisions against potential losses. Note that the IFRS 9 accounting rule under which they now operate – part of the sector’s ‘de-risking’ after the global financial crisis – requires quicker action. We explore how regulation – in particular the introduction of IFRS 13 – has impacted the valuations landscape in our new white paper.

Take HSBC. The London-headquartered megabank recently put US$3 billion aside. An increase of more than 400% from its Q1 2019 charge, this measure halved Q1 earnings and led HSBC to anticipate a total provisioning bill of as much as US$11 billion this year.

Similarly, the top six U.S. banks ramped up loan loss reserves by a combined US$25 billion.

Meanwhile, ratings agencies are signaling that they see higher risk in banks. Standard & Poor’s recently downgraded or lowered its ratings outlook on lenders in Belgium, France, Germany (including the titans Commerzbank and Deutsche Bank), the Netherlands and the UK “in response to the deteriorating economic implications from the COVID-19 pandemic”. Fitch’s outlook on all but 5% of western European banks is now negative, while downgrading entities in eight countries including Italy, Spain and Sweden as well.

These changes aren’t confined to Europe. Moody’s turned negative on the outlook for US banks and now holds this stance on as many as 14 Asian banking markets and eight in Latin America too.

Testing suspended, capital relief

So how bad will it get for banks – and investors exposed to them? The answer clearly depends on the speed and strength of the eventual turnaround, which remains highly uncertain.

But equity and bond holders aren’t waiting to see, and any are already selling out. The Dow Jones US Banks Index is down as much as 33% this year, for example.

Assessing banks’ strength in the current environment is also blurred by the decision by regulators including the European Banking Authority (EBA) and the Bank of England to suspend stress testing due this year. The Federal Reserve in the US also decided in 2019 to require medium-sized banks to only undergo tests every other year.

But the EBA has reported (using the striking phrase ‘banks sail through the Corona crisis’) that EU lenders’ capital strength rose in Q4 2019, with CET1 at almost 15%. Regulators and the European Commission have also provided temporary capital relief, softening IFRS 9’s impact.

Nonetheless, risk/reward in the sector is also clouded by guidance from regulators like the EBA that banks should be retaining capital and not paying out dividends or buying shares back.

Bringing clarity

Discover how Refinitiv brings clarity to highly uncertain situations like the current pandemic-challenged economies in our new fair valuations whitepaper. The Evaluated Pricing Service draws on a network of high-quality data sources, proprietary models as well as regular engagements with market participants. Moreover, our global team of experts share insights from their detailed analyses across various asset classes in Fixed Income and Derivatives.

The global set-up of Refinitiv’s Evaluated Pricing Service allows for consistency and continuous review of new market sentiments which proves to be extremely relevant during today’s volatile and distressed market conditions.

Download our new fair valuations whitepaper. Explore the key valuation measurement challenges facing capital markets firms

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