(EBA, Public domain)
More than stressful conditions
After the financial crisis, the Basel Committee on Banking Supervision developed new capital requirements that have been implemented by the European Union and many other developed nations.
The banks were obliged to raise their capital ratios, create additional buffers enabling them to withstand an economic downturn or possibly even a cyclical recession. They were subjected to stricter controls. The European Banking Authority (EBA) and the United States Federal Reserve (Fed) carried out stress tests on a regular basis, examining how individual banks would cope in a scenario where unemployment rises beyond a certain point, GDP falls by X per cent, stock markets drop by more than X per cent, interest rates rise above a certain level, many instruments in their portfolio are terminated, the prices of oil increase dramatically, etc.
Most of the banks passed the stress tests by a wide margin. However, these tests did not take into account a scenario of a pandemic which includes a long-term shutdown of the economy, double-digit quarterly declines in GDP, an increase in unemployment in the US from 4 per cent at the beginning of March to more than 20 per cent in May, an increase in government debt of more than 10 percentage points, and the associated flooding of the market with government bonds, which forces the central banks to purchase them.
No banking crisis in sight as yet
The European economy relies more closely on the operation of banks than the US economy. European firms obtain more than two-thirds of external financing in the form of bank loans, as opposed to US companies, where bank loans account for less than a third of their external financing and the remaining funds are obtained from sale of shares or corporate bonds.
At the moment there are no signs of a possible collapse of banks, which is partly because the European Central Bank (ECB) promptly flooded the financial system with money, vastly expanding its purchases of government bonds. The ECB plans to buy bonds worth at least EUR1.1 trillion this year. In early April, the ECB also launched a commercial sector bond purchase program. These activities increase the liquidity of banks. The ECB also eased some of its regulatory requirements, allowing banks to draw on the capital buffers which were created in order to deal with such crisis situations. The stress test that was scheduled at the end of July, and which would be a big administrative burden for the banks, was postponed. Andrea Enria, the Chairman of the Supervisory Board of the ECB, has urged banks not to pay out dividends and to limit bonuses for managers in order to protect their capital.
According to Professor Richard Portes, the Chairman of a Committee which advises the ECB and European regulators on financial risk, no large European banks are currently at risk. However, Mr. Portes warned that it was not possible to determine what the future would bring.
In recent years, in several European countries, the banks have been cleaning up their balance sheets, getting rid of some of the non-performing assets. However, according to financial experts the banking system in Europe is less resilient than in the US, and if the crisis drags on, the European banks will be weakened.
Many of them are struggling with low profitability, as reflected in the prices of their stock. While the prices of shares in American banks rose after the financial crisis, the Stoxx Europe Banks index has decreased by 45 per cent over the last ten years. Low profitability, resulting among other things from low interest rates, has forced a wave of restructuring. Two biggest German banks, Deutsche Bank and Commerzbank, which had conducted unsuccessful merger talks, found themselves in a difficult situation.
One thing that may turn into a problem is investment funds owned by banks. If the ratings of the financial instruments held in the portfolios are lowered to junk, then the funds will have to sell them at low prices. This is because they cannot hold instruments that do not have an investment-grade rating.
Some banks have significant exposures in sectors particularly vulnerable to the current crisis. The French bank Natixis, whose assets exceed EUR500bn, has exposures to the oil and gas sector worth EUR10.1bn. In March 2020, the exposure to the airline industry amounted to EUR4.5bn, and to tourism and leisure amounted to EUR1.7bn. In the Q1’20, the bank reported a loss of EUR204m, but the total impact of the crisis caused by the pandemic, which forced the bank to create loss provisions, amounted to EUR290m.
The Dutch ING Group had granted loans in the amount of EUR38bn to the oil industry. According to analysts at JPMorgan, other institutions heavily involved in the financing of the oil and gas industry include the French banks Credit Agricole and Société Générale, the Norwegian DNB, the German Commerzbank, the Swedish SEB and the English Barclays Plc. Banks’ involvement in the oil and gas industry turned out to be more dangerous than the involvement in airlines. Because of the sharp decline in oil prices banks had to create provisions for potential losses. Meanwhile, airlines are among the beneficiaries of public assistance programs in every country.
Banks are creating provisions
The largest global banks have thus far created provisions in the amount of USD78.8bn for the expected increase of non-performing loans. The American banks allocated USD32.5bn for that purpose, while the European banks set aside USD17.9bn, and the Chinese banks created provisions in the amount of USD28.4bn.
These high, perhaps even excessive provisions are not a problem for the American banks, as they have generated substantial profits in recent years. Some are taking into account the possibility of losses associated with unpaid credit cards and loans given to the industries affected by the crisis.
In 2016, the Financial Accounting Standards Board (FASB) issued a recommendation for banks to take into account the Current Expected Credit Losses (CECL) and to make provisions for these potential losses. The CECL credit loss accounting model focuses on the estimation of expected losses throughout the lending period, while the previously applied standard was based on the already incurred losses.
The CECL standard entered into force in January 2020. The banks had developed models enabling them to estimate their potential profits and losses on loans, depending on the rate of economic growth, the changes in the components of the GDP, the unemployment rate, and other macroeconomic parameters. While in “normal times” the forecasts concerning the individual variables are quite reliable, during the pandemic they are fraught with considerable uncertainty.
The ECB encouraged the Eurozone banks to apply the accounting standards in a flexible manner and not to go overboard with loan-loss provisioning in order to avoid any negative effects on lending.
As part of the assistance programs for the economies affected by the pandemic the European governments launched guarantees for corporate and consumer loans, thereby reducing the banks’ risk levels. This is why Deutsche Bank, which is in a difficult situation, has only recorded limited losses thus far. Its clients are mostly small and medium-sized German companies, which are benefiting from an extensive assistance package. After the Q1’20, Deutsche Bank created provisions for NPLs in the amount of a mere EUR500m. In the Q1’19 such provisions amounted to EUR140m.
The HSBC, which is the largest bank in Europe in terms of assets, created provisions in the amount of USD3bn in the Q1 and warned in an official statement that their amount could reach USD11bn by the end of the year. HSBC was the biggest lender to the Singapore-based company Hin Leong, which incurred losses of USD3.85bn and filed for court protection from creditors. Hin Leong owes USD600m to HSBC, whose main area of activity is Hong Kong. Other banks with significant exposures to Hin Leong include ABN Amro (USD300m), Société Générale (USD240m), Standard Chartered (USD240m) and Rabobank (USD230m).
UniCredit, the largest bank in Italy, which is the most unstable banking market in the Eurozone, has announced that it would allocate an additional EUR900m in provisions for potential credit losses. The European rating agency Cerved Rating estimates that 10 to 20 per cent of Italian companies will not survive the crisis caused by the pandemic, with small and medium-sized companies being most at risk. In December 2019, the value of NPLs in the Italian banks amounted to EUR183bn. If such a percentage of companies ultimately end up going bankrupt, then the total amount of NPLs will increase by EUR8.5-17bn.
Credit Suisse has increased the provisions for bad loans and asset write-offs by more than USD1bn, while another Swiss bank UBS increased such provisions by USD268m.
Almost all the big banks recorded significant profit declines in the first quarter of 2020. However, no banks experienced significant losses or liquidity problems, as was the case in 2007-2008. All the bankers emphasize that the further development of the situation in the financial sector is uncertain and will depend on the rate at which normal economic activity is restored.
The problems of Chinese banks
In China, the regulatory bodies allowed banks to adopt a gentler approach to the classification of bad debt. The authorities permitted small and micro-enterprises, which were supposed to make principal and/or interest repayments between January and June, to file for deferment until the end of the Q2. The regulatory authorities asked lenders not to reduce the level of loans with delayed payments and not to report the payment arrears to the centralized credit scoring system. According to the supervisory authorities, non-performing assets only represent 2.04 per cent of all banking assets, which seems hard to believe. Large Chinese banks granted 3.5 per cent of their loans to enterprises in the Hubei Province, where the pandemic originated. This province was completely cut off from the rest of the country for several months, and the local companies weren’t operating, which means that they were also unable to service their loans. Regional banks, and especially those operating mainly in Hubei, are at particular risk. According to the China Banking Association, this includes institutions ranked are among the top 100 banks in China: the Wuhan Rural Commercial Bank (ranked the 54th), Hubei Bank (the 57th), and Hankou Bank (the 60th). The collapse of Baoshang Bank in May 2019 proved that the crisis of a single regional lender could send shockwaves through the entire domestic banking system. The takeover of Baoshang Bank by the supervisory authorities weaken clients’ confidence in banks and increased the cost of capital for other lenders. The effects of this shock were ultimately transmitted to the corporate customers.
So far, Polish banks are doing well
According to the reports published thus far, the situation of the largest banks in Poland has deteriorated, but there is no serious risk. The banks had profits, although they were clearly lower than in the previous year. The relatively low levels of allowances for potential losses caused by the crisis may be a source of concern. In the Q1’20, the banks did not yet experience a significant increase in loan defaults, but the second quarter will likely be worse.
In April, the largest Poland’s bank, PKO BP bank informed about the impact that the pandemic will have on the group’s activities. The bank stated that in the consolidated financial statements for the Q1’20 it included allowances for asset impairment on account of COVID-19 in the amount of no less than PLN215m (approx. EUR47m).
Pekao SA – which his the second biggest Polish bank in terms of assets – informed that its net profit in the Q1’20 amounted to PLN187.5m (EUR41m) and was 23 per cent lower than in the Q1’19 and about 73 per cent lower than in the Q4’19. This bank also set aside greater allowances for impaired financial assets associated with COVID-19, reaching about PLN200m (EUR43m).
Santander Bank Polska Group had a profit of PLN171m (EUR37m), which was 46.9 per cent lower than the year before. The allowances for loan loss provisions amounted to PLN466m (EUR102m), of which only PLN119m (EUR26m) relates to expected losses caused by the coronavirus.
The consolidated net profit of ING Bank Śląski Group amounted to PLN267.3m (EUR58m), compared with PLN324.5m (EUR71m) in 2019, which represents a decrease of 17.6 per cent. The result was reduced by PLN147m (EUR32m) in provisions created after the publication of revised macroeconomic forecasts taking into account the impact of the pandemic.
The net profit of mBank was PLN90.9m (EUR20m) compared with PLN163.2m (EUR35m) a year ago, with the decrease reaching 44.3 per cent. In the Q1’20 the bank created an additional provision for loan losses due to the pandemic in the amount of PLN141m (EUR30m).
BNP Paribas had a net profit of PLN115.1m (EUR25m) compared with PLN161.1m (EUR35m) a year earlier (a decrease of 29 per cent). In the Q1’20 the loan impairment write-offs amounted to PLN198.3m (EUR43m) and were 113 per cent higher than in 2019.
Bank Millennium had a net profit of PLN18m (EUR3.8m) compared with PLN160m (EUR35m) in the same period of 2019 (a decrease of 88.7 per cent). These results are not fully comparable, however, because they include the results of Euro Bank, which was acquired by Bank Millennium in the Q2’19. The results were burdened with a number of special items, including a provision for the expected impact of the coronavirus in the amount of PLN60m (EUR13m).
The net profit of Alior Bank amounted to PLN73.2m (EUR16m) compared with PLN103.5m (EUR22m) in the previous year (a decline of 29.3 per cent). The allowances for expected losses, as well as write-offs for asset impairment and provisions amounted to PLN294.8m (EUR64m) compared with PLN274.6m (EUR60m) in 2019.
Citi Bank Handlowy achieved a net profit of PLN26.4m (EUR5.6m) compared with PLN59.5m (EUR13m) a year earlier (a decrease of 56 per cent). The balance of provisions for expected loan losses and provisions for contingent liabilities amounted to PLN93.5m (EUR20m), which means an increase of 231 per cent year-over-year. This surge was mainly due to the creation of additional allowances in the amount of PLN42m (EUR9m) due to the economic developments in Poland resulting from the pandemic.
The banks may therefore survive an economic shutdown that lasts a few months without too much trouble. However, if the biggest borrowers do not return to normal business activities in the autumn of 2020 and would not able to repay their debts, then the situation will become serious.