On May 25th, The European Banking Authority (EBA) published its first report on the initial effects of the COVID-19 pandemic on the European banking sector. A summary of this report can be found below.
The COVID-19 pandemic has continued to spread rapidly and on a global scale. By mid-May the total number of confirmed cases in the European Union (EU) had already exceeded one million. In response to the rapid spread of the virus, governments across Europe have imposed containment measures to limit social interactions and economic measures aimed at reducing the impact of the crisis on households and businesses.
In April, the International Monetary Fund (IMF) estimated a drop in GDP for the euro area of 7.5% in 2020, with an expected recovery of 4.7% in 2021. The European Central Bank (ECB), for its part, forecasts in its publication “Economic Bulletin Focus”, three possible scenarios for the impact of the pandemic (mild, medium and severe) on the euro area, signalling a contraction in GDP of approximately 5%, 8% and 12% for 2020, followed by GDP growth of approximately 6%, 5% and 4%, respectively in the following year.
Furthermore, the contraction in economic activity is expected to have a significant impact on the labour market. The IMF forecasts unemployment in the euro area to rise to 10.4% in 2020, from 7.6% in 2019 while it estimates a drop to 8.9% in 2021.
So far, various measures have been implemented at regional, national and EU level to support business and household economies. At EU level, the European Council ratified the Eurogroup aid package of € 540 billion. Support measures at regional and national levels include business grants, loan guarantee schemes, and loan default initiatives.
The EU banking sector before the crisis
The great financial crisis of 2008 put the banking sector on alert, and since then some of the most important ratios have improved markedly. Average CET1 (Capital) increased from 9% in 2009 to almost 15% in the fourth quarter of 2019, while loan defaults fell to 3.1%, after having reached a maximum of 7.1% in 2014. From the point of view of liquidity, a crucial metric during times of crisis, the average LCR for the banking sector reached almost 150% in the first quarter of 2020.
However, given low interest rates, banks’ economic profitability has remained a challenge in recent years. This assertion is supported by EBA data which shows that almost half of EU banks are still unable to cover their cost of capital.
Asset Quality and Composition
During the fourth quarter of 2019, EU banks held 23.7 trillion euros in total assets on their balance sheets, a 7% increase compared with Q4 2018. The two main components of total assets were loans and advances (66%) and debt securities (13%).
Regarding debt securities, it is important to highlight the effect that a deterioration in their valuation can have on capital, taking into account that a large part is sovereign debt and that 45% of it has a maturity of more than five years hence its more sensitive to changes in interest rates.
With respect to the loan portfolio, the segments that have increased the most in recent years are precisely the segments exhibiting the highest credit risk, such as small and medium-sized enterprises (SMEs), which grew by 8% during 2019 alone, and consumer credit which increased 9% over the same period. In addition, loans to non-financial institutions (NFCs) increased 4% and to households 5%.
The EBA cites that the increase in loans with higher credit risk was not only due to the banks searching for higher returns in a low interest rate environment, but also to the growing demand for loans thanks to macroeconomic conditions, a drop in unemployment rates and a strengthening of consumer confidence. These trends were suddenly halted during the first quarter of 2020 as the crisis began to loom.
As mentioned above, delinquencies have decreased significantly since 2014 (7.1%). However, the non-performing loan ratio in the fourth quarter of 2019 stood at 3.1% with a total volume of € 529 billion, a notably higher level than before the global financial crisis. The increase in financing needs will also generate higher levels of indebtedness for households, businesses, and governments in the coming years.
The banks’ first quarter results show the first signs of deterioration in asset quality, but everything points to further deterioration. Asset quality will be one of the key challenges for banks in the quarters and in the years to come.
Financing and Liquidity
On the liability side, the main driver on banks’ balance sheets is customer deposits, which amounted to 50.4% of total liabilities during the fourth quarter of 2019. With a few exceptions aside, customer deposits balances have not declined due to the crisis.
The other major form of bank financing is through issuing debt securities. These products represent the second largest item on the liability side of EU banks’ balance sheets. Due to increased volatility and spreads in the European debt markets, there were no new debt issues by banks until mid-April.
Since March, both the EBA and the ECB have implemented various measures to try to help banks with their financing needs. Some banks had already taken advantage of the first months of the year to carry out refinancing operations at low cost. However, the EBA raised the possibility that some financial difficulties could arise and that financing costs will increase for those banks that have yet to refinance significant amounts due over the next 6 to 12 months.
Closely linked to financing issues is the key issue of the crisis, liquidity. To allow it to closely analyse the short-term liquidity situation, the EBA uses the LCR coefficient, which, on average, has been well above the required 100% minimum limit, although it warns that this liquidity coefficient is designed precisely for times of crisis like the current one and therefore expects LCR ratios to decrease over the coming quarters.
Regarding LCR coefficient composition, during the first quarter of 2020 liquid assets have remained at levels similar to those of the fourth quarter of 2019. What have increased the most are precisely inflows of level 1 assets, mainly due to increasing exposures to central banks. On the outflow side, a structure similar to that of the end of 2019 is also maintained, notwithstanding an increase in outflows generated by companies making use of committed credit lines.
European banks low level of economic profitability when compared with their US peers, is worrying. While European Banks generated an average Return on Equity (ROE) of 5.9% in the last quarter of 2019, US banks recorded 9.5%. The EBA blames it on low margins and operating cost pressures. Furthermore, it warns that this ratio may be further affected not only by the sharp reduction in economic activity, but also by the depth and scope of the policy measures adopted in each jurisdiction.
With Net Interest Income (NII) potentially under pressure, a sensitivity analysis indicates that for every 10% decrease in interest income from loans to households and non-financial companies would result in a decrease in the ROE for European banks of 119 bp and 100 bp, respectively. Also, a 10% decrease in commission income would impact ROE by 122 bp. But that’s not all, these same percentage decreases in interest and commission income would have a negative impact on capital (CET1) of 22bp, 19bp and 23bp, respectively.
Under this scenario, banks would be incentivized to write more loans in an effort to increase their main source of income. For this they will need additional funds and that is why the ECB has upped the amount of available financing, as well as relaxing the conditions that certain bank guarantees must meet.
Since the start of the crisis, banks mortgages businesses have been put on standby, while NFC loan growth, principally due to a boost in committed credit lines and publicly guaranteed loans, has risen sharply. However, the positive impact of loan growth on interest income could be lessened by shrinking margins in a low interest rate environment.
The EBA believes that banks are well covered as they have been constantly strengthening their capital positions due to regulatory requirements.
At the end of 2019, the average CET1 index of EU banks reached 14.9%, significantly above regulatory capital requirements. In addition, banks enjoy a business buffer of € 270 billion (equivalent to approximately 3% of RWA). Lastly, the leverage ratio was 5.7% at the end of the fourth quarter of 2019.
Banks’ risk-weighted assets (RWA) have been declining since the last financial crisis and, at the end of the fourth quarter of 2019, credit risk represented 84% of total RWA.
However, during the first quarter of 2020, even though banks’ earnings increased capital, CET1 has on a whole decreased due to an increase in RWA. This increase in RWA is a result of a general deterioration in asset quality, thanks to increase credit commitments and market risk.
For this reason, regulators have decided to take action on the matter and have announced measures related to the relaxation of capital requirements, provided banks with the possibility of making use of preestablished capital buffers, created precisely to allow them to confront periods of crisis. The ECBs’ main objective is to augment the loss-absorbing capacity of the European banking sector and maintain financing options for all sectors of the economy.
Thankfully, the banking sector in general is well prepared for this liquidity and capital crisis, in large part due to the obligations established by regulator after the 2008 financial crisis. Furthermore, they have been able to navigate the operational difficulties caused by the confinement and social distancing measures taken by governments throughout the region.
The ECB has helped financial institutions cope with the crisis through the approval of financing measures focused precisely on providing liquidity for banks to pass on to its customers, mainly NFCs. On the capital side, the measures allowing banks to make use of the preestablished shock absorbers have also helped.
Finally, the low profitability of European banks appears to be a trend that will continue for a long period of time, given continued low interest rates and pressure on operating costs.