Can banks withstand the impact of Covid-19?

Illustration: Justin Metz

When regulators were drawing up plans to prevent a repeat of the global financial crisis of 2008, they rightly hit upon the idea that banks should hold substantial buffers in terms of capital and liquidity that would see them survive through another dramatic downturn. 

As banks built up these buffers, regulators insisted that each bank would be subject to an annual stress test to see if they would be able to survive a worst-case economic scenario. That worst-case scenario was one most bankers thought was not just unduly harsh, but unimaginable – a decline in global GDP of 5% to 7%.

Today, as the coronavirus – and governments’ responses to its chilling consequences – infects the global economy to the point of virtual shutdown, daily predictions of GDP decline in the second quarter are getting worse by the day. 

Predictions that the world’s output could decline by at least 25% might be optimistic. 

Buffers were designed to help banks withstand an unprecedented downturn. As it turns out, the scale of what was coming was far beyond the imagination of even the most hawkish regulator. 

Yet, as Euromoney talked to many senior bankers over the course of recent weeks, they seemed relatively comfortable with their ability to cope with even a long-term slowdown. And they were becoming increasingly aware that the role of banks, alongside a level of state intervention the world hasn’t seen even in wartime, would be a crucial part of the reaction to, and eventual recovery from, the sharpest economic downturn in history.

We suddenly live in a world of very big numbers. Think back to the early part of this crisis: Sunday March 15. That was when the Federal Reserve announced a $700 billion quantitative easing programme to invest in US treasury bonds and agency mortgage-backed securities (MBS). 

Reasoning that these underpin the credit markets, which in turn channel financing to corporations and households, the Fed argued that supporting them would promote its policy goals of maximum employment and price stability as the coronavirus panic spread.

It’s the kind of number that used to command attention. Remember Hank Paulson and his $700 billion troubled asset relief programme in 2008? That, and a slew of bank nationalizations, stopped the global financial crisis spiralling into an all-consuming 1930s style depression.

But this time the algorithms driving market prices paused for a few minutes and then just carried on selling. A week later, the Fed gave up trying to impress computers with big numbers and said that its commitment to buying treasuries and agency MBS was simply unlimited. 

It may have to be.

By now, James Bullard, president of the St Louis Federal Reserve, was touting another large number. On its own, 30% doesn’t sound so daunting, certainly not in terms of stock market declines. We got there in just four weeks, after all. As Euromoney was going to press, world stock markets were still volatile at 35% down from their mid February 2020 highs. 

Putting that 30% number out there had one salutary effect. It drew attention to the fact that the world faces no conventional recession, one brought about by unsustainable macro-imbalances, over-production of goods for which there is no demand or leveraged mal-investment and financial excess obscured by structured products.

This is a planned temporary shutdown of leading economies: something that has never been seen before.

The world does not, for now, need new spending to stimulate recovery and expansion. Rather, it wants production to stop while people stay at home, work there as best they can and hide from the pandemic. 

Bullard argues that, for now, traditional ways of thinking about economies and finance are turned upside down and that 30% unemployment would be a sign of success in this extraordinary project.

Bullard spelled out the economic consequences of a partial shutdown to avoid a catastrophic public health outcome in a speech on Monday: “My rough initial estimate of the level of US real GDP (and hence national income) that meets this public health objective is up to 50% of normal production. In other words, we need to throttle back the US economy to produce at only half its normal pace.”

Big monetary sums are needed to bridge families through this siege when breadwinners are laid off and to keep businesses solvent so that in the third quarter of the year, when hopefully people can open their doors and walk outside again, there is still an economy to go back to.

And this is where the banks come in. 

Back on March 11, president Donald Trump held one of those toe-curling gatherings of corporate chief executives in the cabinet room at the White House with the heads of all the largest US banks plus a couple of billionaire hedge-fund types. 

In the absence of JPMorgan’s Jamie Dimon, Brian Moynihan, chief executive and chairman of Bank of America, had the misfortune to be up first to tell Trump what he wanted to hear. 

“The chief executives of the large banks here want you to know that because of all the work done on capital, liquidity, and all the things,” he said, “as we look forward to uncertainty due to the virus and oil price changes, we’re very strongly capitalized. We are in a great position, in terms of liquidity, capital and strength.”

Ask any banker how capable the industry is of weathering this economic shutdown and the first thing they will mention is much higher levels of common equity capital: up from 6% to 7% before the great financial crisis to 12% to 14% today. 

“But more importantly,” said Moynihan, “we’re doing what we do best, which is helping our teammates, importantly, but also our clients and our small business customers and our medium-sized business customers to continue to have access to credit.”

Every bank in the world wants to sell you something. Today the big offer is mortgage repayment holidays.

Jovita Carranza, administrator of the Small Business Administration (SBA), was there too to draw attention to what now sounds like a small number: the $18 billion the SBA has to support all those big banks in extending loans.

Carranza told the bank chief executives: “I’m looking forward to working with every one of them to leave no money on the table of those $18 billion, so we can provide support for the small businesses.”

Did Gordon Smith, chief executive of consumer and community banking at JPMorgan and sitting in for Dimon, bristle at such a small number? 

“Your fair question is: ‘Are we still lending?’ And over the course of the last 40 days at JPMorgan, we’ve extended $26 billion worth of loans to both consumers and small businesses,” Smith said.

Trump was pleased. 

“That’s great,” he told Smith, and asked him to say hello to Jamie.

So, here’s one last set of big numbers, again from the US, ones that the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency – the supervisory agencies – are now prone to repeating. 

Since the global financial crisis, US banks have built up substantial levels of capital and liquidity in excess of regulatory minimums and buffers. The largest banking organizations hold $1.3 trillion in common equity and $2.9 trillion in high-quality liquid assets. 

That’s even bigger than $2 trillion support package the US senate failed to pass on Sunday, causing markets to sink again on Monday before a relief rally when agreement seemed likely on Wednesday. 

Liquidity buffers are meant to sustain lenders’ funding so that they can withstand the temporary closure of conventional liability markets through a big bank-specific or system-wide stress, and not collapse because nobody else will lend to them. 

Regulators now want the banks to dip into these buffers and keep lending to everyone else, especially households and businesses. 

If the banks need funding, the Federal Reserve is encouraging them to use the discount window. On the day it cut the target for the federal funds rate by 100 basis points, the Fed also cut 150bp from the cost of bank borrowing at the discount window, while removing its requirement for excess reserves. 

Banks normally never want to be seen using the discount window in case markets read it as a sign of distress and a liquidity crunch. But on March 16, JPMorgan confirmed that it and other large US banks had been executing public discount window transactions.

Jamie says hi back.

Governments will sell hundreds of billions of dollars’ worth of their bonds to the banks; central banks will buy them from the banks, effectively funding governments. (Let’s call this what it is.) They will also provide other forms of liquidity to the banks. 

In return, banks will extend interest payment and other debt-service holidays to mortgage borrowers and corporations, and keep credit lines open. 

Banking and financial systems are complex and often fragile interconnected ecosystems. 

A sudden and startling transition is now beginning. In the aftermath of the financial crisis, governments strove to end the privileged position of banks as contingent liabilities of their sovereigns and to recast them instead as like other private corporations, funded by equity investors and creditors entirely at their own risk and with living wills for wind-downs if banks mismanaged their exposures.

In the months ahead banks will become agencies for channelling state aid. 

Unlikely governments are doing extraordinary things. The UK government has undertaken to pay companies 80% of the wages of employees they might otherwise have laid off, subject to certain monthly maximums. 

The German government, which its neighbours have been urging to spend throughout the 20-year history of the single currency, announced in the fourth week of March an emergency support package for households, small business and larger corporations of €600 billion, roughly 18% of GDP.

On Thursday March 19, the European Commission announced a temporary framework – suspension might be a better word – for its state-aid rules.

Member states will be able to provide guarantees to ensure banks keep providing loans to customers who need them. The EC notes that some governments plan to build on banks’ existing lending capacities and use them as a channel of support to businesses. 

Previewing this, Commission executive vice-president Margrethe Vestager, in charge of competition policy, said: “The new temporary framework will recognize the important role of the banking sector to deal with the economic effects of the Covid-19 outbreak, namely to channel aid to final customers, in particular small and medium-sized enterprises. The temporary framework makes clear that such aid is direct aid to the banks’ customers, not to the banks themselves.”

So while holders of bank equity and debt have been selling these off over fears of weaker earnings and higher loan losses, that doesn’t quite recognize what banks are now becoming, which is pass-through vehicles for governments whose key value is that they have the local reach to businesses and households.

The EC’s new state aid framework was quickly tested.

On Sunday, Vestager announced approval of two new German support measures implemented through the Kreditanstalt für Wiederaufbau (KfW). 

The first covers up to 90% of the risk on loans up to €1 billion and of up to five years maturity to meet companies’ liquidity needs. 

The second is a loan programme in which KfW participates together with private-sector banks to provide larger loans as a syndicate. On these, member states may cover up to 80% of the risk of a specific loan, although not more than 50% of the total debt of a company.

The temporary state aid framework will be in place at least up until the end of December 2020. The EC will assess whether it needs to be extended before that date.

Once frowned upon by regulators, forbearance is now official policy. 

Before the US supervisory agencies announced their support for banks that choose to use their capital and liquidity buffers to lend and undertake other supportive actions, they first sounded the banks out themselves and had a few answers for their inevitable questions. 

If a US bank is subject to the liquidity coverage ratio and this now falls to less than 100%, it must submit a plan to its supervisor. But there is no requirement to rebuild high-quality liquid assets within a specific time period. 

Supervisors will engage with management on the plan for rebuilding its liquidity buffer, but will not change the supervisory assessment and rating of a banking organization solely on this basis. 

On capital buffers, US supervisors reminded banks that those with regulatory capital ratios below their capital buffer requirement do face restrictions on capital distributions and discretionary bonus payments. 

However, on March 17, 2020 the agencies modified the buffer restrictions by revising the definition of eligible retained income through an interim rule to ensure these automatic restrictions apply only gradually as intended.

By increasing the amount of retained income available for distribution, this interim rule lets banks dip into their capital buffers and continue lending without facing abrupt regulatory restrictions. 

It is understandable that investors, analysts and bankers are struggling to draw lessons from the great financial crisis for what happens next. But this is very different. Banks are not the cause of this likely severe recession. They may have contributed to the over-leveraging of many corporations that will struggle in the months ahead, but they come into this in much stronger shape themselves. 

Instead of initiating the problem, banks may be a prominent part of the solution. How should they behave at this point in a fearful health crisis?

Bankers tend to be optimists. They want to believe the lockdowns will be short lived and the subsequent recovery robust. 

In March, Euromoney was talking to bankers about how soon and how fast cash-rich private equity buyers might go to work when financial markets stabilize once the duration and severity of the pandemic and the lockdowns becomes clear.

They want to send a positive message.

One at a US bank tells Euromoney: “We are providing liquidity on debt and equity trading, and we are still providing underwriting for bond deals and for buyouts. If a client sees an opportunity, we can finance it.”

“The calls on bank liquidity and drawdowns on revolving credit facilities are the same as we have seen in every crisis,” says Pier Luigi Colizzi, head of M&A for Europe and Middle East at Barclays. “But banks are much better capitalized today than they were going into the great financial crisis or the eurozone crisis of 2011. Also, the measures now being out in place by central banks, including the ECB, the Federal Reserve and others, give more comfort to banks.

“Banks are open for lending and for underwriting, even though pricing is hard with markets moving so much intraday and we do need some stability.” 

Normally such bullish animal spirits might be commendable. But these are not normal times. On Monday, Sam Theodore, managing director at Scope Insights, laid out four suggestions for steps senior management of European banks should now take without prodding from their regulators. 

First, Theodore says they should not take bonuses in 2020 – or next year either if the pandemic extends into 2021. Partly this comes back to banks presenting themselves this time as part of the solution and not of the problem. 

“While many bankers will be working hard during this difficult period, so will health workers and employees in other services critical for society who do not get and do not expect banker-level bonuses,” Theodore writes. 

“The most rewarding outcome for a bank in the age of the pandemic should not be closing a juicy commission-rich deal but saving a business from virus-triggered bankruptcy and its employees from being laid off. In any event, the absence of a bonus could disincentivize bankers from contemplating high-risk high-return transactions, which is just as well.”

Second, he suggests banks suspend dividends, even though receipt of these is a big reason for owning bank stocks. That would be one way to conserve capital for lending. It goes without saying that buybacks should also be off the table. 

Third, they should postpone staff reductions. Cost cutting can wait. Finally, they should rein in risk taking as a means to boost earnings.

“Specifically, any activities liable to push a bank into new areas of risk – such as M&A and similar transactions which may make sense during more normal times – should be best avoided for a while,” Theodore argues. “Management time and effort, stretched to the extreme in these difficult times, are better spent steering the bank’s activities to support and guide businesses and individuals impacted by the coronavirus.”

To some Euromoney readers that may sound absurd, even offensive.

Santander executive chairman Ana Botín and chief executive José Antonio Álvarez

But also on Monday, the board of directors of Banco Santander announced that they would consolidate any dividend for 2020 into a single payment yet to be determined in May 2021. Directors pointed out that the bank meets the capital requirements to maintain its current 40% to 50% pay-out ratio and is comfortable with buffers above regulatory requirements, but that its priority now is to direct resources to people and businesses in need.

Is this a sign that the bank sees so much trouble ahead that distributions might have to cease anyway or is it an enlightened move?

In addition, the board announced that the executive chairman, Ana Botín, and chief executive, José Antonio Álvarez, will forgo 50% of their total compensation (salary and bonus) for 2020 while non-executive directors will have their compensation reduced by 20%. 

The group remuneration committee and its country heads will propose how to translate this commitment to the management teams in the various countries where Santander runs large banks. 

The group’s bonus policy will be reviewed so that the maximum required resources are directed to supporting customers.

“The scale of the task before us demands a huge collective effort,” said Botín, “with governments, central banks and other authorities, the private sector, charities and individuals, working together to limit the spread and provide care for those affected – whether directly or indirectly. We are committed to ensuring that Santander plays its part.”

Like many other banks, Santander is already providing payments holidays to affected customers and emergency liquidity, including €20 billion of pre-approved facilities to support impacted customers in Spain.

The reduction in senior management and board compensation, together with voluntary contributions from Santander employees, will finance a fund, initially expected to be worth at least €25 million, to be deployed in the production and purchase of medical equipment, protective clothing and other necessary supplies to treat people affected by the virus.

Maybe Euromoney’s emotional resilience is being tested along with our hard cynical shell, but this looks rather commendable.

Meanwhile, on Tuesday, Finansinspektionen (FI), Sweden’s financial supervisor, wrote to that country’s banks and credit institutions telling them not to pay dividends this year, explaining: “The purpose is to ensure that these companies have continued good resilience to any credit losses and the capacity to maintain credit supply.”

Norway’s regulator, FSA, has already requested this. Dividends will likely be suspended across the Nordic region. Analysts expect this to add on average 140bp to Nordic banks’ common equity tier-1 ratios. Sweden’s FI has already cut its requirement for additional counter-cyclical buffers from 250bp to zero. 

Across Europe it’s likely banks will not be paying dividends.

Tougher times lie ahead for banks. You don’t have to look far for reasons to worry. They are everywhere. 

It is no surprise that many companies, desperate to conserve cash resources, are quickly drawing down on revolving credit facilities. Every stress test for every bank always assumes this will happen.

Often when lines are drawn, corporations with no immediate use for the cash deposit it right back at their lending banks. This is classic private money creation.

Saul Martinez, US banks analyst at UBS, reports on some worrying anecdotal evidence that smaller community and mid-cap banks may be at a disadvantage to the large national banks today. Companies may be culling the number of banks they hold deposits with, drawing credit lines with non-primary banks but then depositing the proceeds in their primary accounts with larger institutions. 

This is a trend to keep an eye on, even though the Fed is guaranteeing bank access to funding right now. What if business also shifts along with deposits?

And if we get through the next three months, what happens to loan portfolios over the medium term? 

It is tempting to hope that after the lockdown closures, economies that have been protected by state aid channelled through the banks will then bounce right back. If Euromoney had a dollar or a euro for every analyst report suggesting this happy outcome since mid February, we could keep ourselves in toilet roll and hand sanitizer for life.

More likely though, the consensus now holds a U-shaped recovery as the very best we can hope for, with a long convalescence after the lockdowns in which some companies, especially highly leveraged ones in vulnerable cyclical sectors, will fail. 

At some point, non-performing loans start to rise. All that remains to be seen is how fast and how far.

Analysts at Berenberg, exasperated at the absence of transparent data on banks’ industry exposures, have been using new tools to count the times the word “aviation” appears in bank filings, presentations, earnings and conference call transcripts, going back 20 years. 

By mid March, they were starting to worry about the exposures to this most troubled sector of the French banks, which also have high exposures to energy, travel and leisure.

Likely loan losses come just as new accounting rules require banks, under IFRS 9, to provide against expected losses across the full lifetime of a loan if a borrower suffers a significant deterioration in credit quality. Expect to hear a lot more about this measure in the weeks ahead. 

Right now banks hope that organized loan forbearance, sanctioned by governments and supervisors, may delay the mass shift of loans into this so-called level-two bucket, where provisions rise dramatically compared with when new loans are first put on and banks only have to reserve against one year’s worth of expected losses.

Banks have enjoyed record low NPL performance in recent years thanks to low rates and modest unemployment. That is over now. The rigour of their underwriting standards in recent years will now be tested. 

UBS analysts dare to be hopeful: “In areas like leveraged loans – a market which has seen strong volume growth and a significant deterioration in headline credit standards – we believe banks have acted as manufacturer rather than significant investor.” 

But if the problem resides somewhere else, what is banks’ exposure to those holders?

With spreads in that market widening sharply in March, expect to see some indication of second-order damage from exposure to collateralized loan obligations, as well as from retained portions of leveraged loans, when banks announce their second-quarter results.

Further ahead concerns may crowd in on higher-quality exposures as well.

Ever since ECB president Christine Lagarde’s unfortunate “we are not here to close spreads” remark on March 12, investors in bank equity have also worried about European banks’ exposure to Italian sovereign bonds. 

This is likely to be at around or above 100% of tangible net asset value for most large Italian banks, but also a hefty exposure for some Spanish banks.

For now, this worry seems to have been contained by ECB buying. 

Let’s hope it stays that way. Because sovereign debt is at the centre of the support packages every country is relying on to get through this, and every banking system too, however strong each was when it started.