Banking Sector Reforms Key in Mitigating Covid-19 Related Downturn

Whilst a quick search of Amazon and eBay reveals that although they are right out of crystal balls (along with surgical masks and hand sanitizer), we believe that as a result of regulatory and supervisory reforms over the last decade, the banking sector is relatively better placed to withstand the potential economic fallout of Covid19 than it was the financial crisis of 2007-12.

Starting with capital adequacy, the most fundamental measure of a bank’s ability to withstand stress, bank core equity tier one (CET1) ratios pre-crisis averaged 7.5% of risk weighted assets in Europe in 2007, but for GSIB’s and other large banks the ratio was lower, at around 6%.  Due to Basel III’s reforms these ratios are today more likely to be at least 12%, and in many cases 14% and upwards.

Figure 1

Key Stress Test Assumptions 2018-19

 

USA

EU

UK

National GDP fall

8%

8.30%

4.70%

Unemployment

10%

9.70%

9.20%

House price falls

25%

19%

33%

CRE price falls

35%

20%

41%

However, it remains a concern that the Covid19 may impose credit losses in a manner and on a scale not experienced previously.  For example, defaults on residential mortgages may be cushioned by state forbearance schemes, but banks heavily exposed to airlines, leisure and tourism may suffer disproportionally higher losses in their corporate lending than capital models predict.  The level of government intervention in particular industries and the economies in general may be a critical driver of eventual credit losses in the banking sector.

Complementing the much-improved capital ratios of the sector are the stress tests performed by regulatory authorities in the USA, Europe and elsewhere.  The objective of these annual exercises is to ensure that large banks can survive stressed environments whilst retaining minimum levels of capital. Examples of the key stress test assumptions are provided in Figure 1.  The severity of these assumptions is often based upon the 2008-10 recessionary period, however some variables, e.g. unemployment, look as though they will be quickly exceeded by the economic fallout resulting from Covid-19.  In response to this weaker than expected environment, the sector appears in some cases to be taking prudent action to further buttress capital levels. For example, in the UK the Prudential Regulatory Authority has imposed a dividend moratorium to preserve equity levels.

One important factor currently directly influencing capital levels is the recognition of loss provisions.  This can be highly variable across jurisdictions and individual firms. In Germany under IFRS 9 Deutsche bank has moved away from so-called “point in time” loss models to a more “through the cycle” view and therefore reduced its provisioning charge substantially for Q1, thus improving profitability and capital.   By contrast in the USA, where pending accounting standards will require full lifetime provisioning, the sector provided $24 billion of losses in Q1 2020, an increase of almost 500% from quarterly levels over the previous 5 years.   Ultimately, whether prudent, early recognition of losses or a more phased approach is appropriate in these unique circumstances depends upon whether Covid-19 is viewed as a temporary or more lasting impact upon economic output.

Another factor likely to lend greater stability to the banking system than in 2007-8 is the greater emphasis placed on stable funding and liquidity. The Basel III liquidity coverage ratio now requires all banks to hold sufficient high-quality liquid assets to withstand a 30-day stress including a complete lock-out of wholesale and currency funding.  Whilst this has resulted in much greater levels of liquid assets, it has, along with the net stable funding ratio, dis-incentivised the use of short-term wholesale funding sources that were such a means of transmission of the 2007-8 liquidity crisis.   In place of the short-term wholesale funding banks have largely funded themselves with either more stable deposits or long-term wholesale sources, taking advantage of flatter yield curves.

Partly related to the improvement in bank liquidity is the de-coupling of systemic risk over the past decade.  The reduction in short term wholesale funding is part of this trend, reducing reliance upon availability of funding from other banks, funds or shadow-banking entities.

Another reduction in systemic risk has occurred through the extensive re-regulation of over the counter (OTC) derivatives.  Although central counterparties (CCP’s) for derivatives existed in 2008, the requirement for vanilla contracts across interest and credit index trades means that their ability to “fire-break” counterparty defaults is now much more significant.  For OTC contracts which are not centrally cleared, regulation of margin levels is similarly designed to protect bilateral counterparties much more effectively.

Finally, formal bank resolution regimes have been established in many parts of the world to facilitate orderly recapitalisation or wind-down of failing firms.  In Europe the Bank Resolution and Recovery Directives (1&2) and in the USA the Orderly Liquidation Authority section of the Dodd-Frank Act, provide resolution authorities with clearly defined powers to resolve failing firms whilst maintain financial stability.  In parallel resolution eligible liability requirements, (although not fully complete in many parts of the world, particularly for smaller firms) have been in place at a transitional level for globally systemic important banks (G-SIB’s) since 2018.  Such liabilities are likely to be ultimately at least equal to the loss-absorbing capital for international and domestically systemically important firms, providing a clearly identified pool of liabilities to provide recapitalisation in the event of failure.

Covid19’s effect on the financial sector is as yet unknown, and ultimately may be dependent upon the size of assistance that governments are willing (and able) to provide to their economies. Many uncertainties exist, not least the ability of banks to earn revenues and recapitalise in an environment where fee-based income is collapsing, and yield curves may become a long-term flat-line. However, the measures that we have outlined above to increase capital adequacy and liquidity, reduce systemic risk and improve resolvability can be argued to at least have “mended the roof whilst the sun shone”, and leaves the sector as well placed as could be expected to face the uncertainties of 2020 and beyond.