G-SIBs and COVID-19: shock absorbers, not generators

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Introduction

When the World Health Organisation declared a Sars-CoV-2 pandemic on 11 March 2020, we saw Asia and Europe face lockdowns in Q1, with many US states following suit.

The policy response to COVID-19 led to treasuries introducing unprecedented fiscal support through furlough schemes, business rates relief, tax deferrals and underwriting and/or guaranteeing loans to businesses (e.g. UK CBILs, CLBILS, BBILs).

Central banks worked in tandem with fiscal authorities to reduce interest rates, introduce liquidity support to markets, expand their balance sheets with renewed “quantitative easing”, disperse capital through dividends and executive pay; and continue to lend by using capital (e.g. Bank of England reduced required Counter-cyclical buffer to zero).

We analysed 21 US and European G-SIBs*, benchmarking these two groups against each other for Q3 2019 and Q3 2020, to examine how banks have acted as shock absorbers and, specifically, how US and European banks fare relative to each other. Following this analysis we set forth a number of hypothesis on the outlook for the banking sector.

Take a look at our analysis below.

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“Excess capital’ increased overall in Q3 2020, with more than one-third of US and European G-SIBs moving into the upper-right quadrant. This is because increased loss provisions have been more than offset by the reduction in dividends.

CET1 excess increased overall between Q3 2019 and Q3 2020, except for at Wells Fargo.

European banks are catching up with their US peers in terms of Tier 1 leverage ratio excess, giving European G-SIBs more capacity to lend.

European banks’ liquidity coverage ratio is almost 27 percentage points higher than for their US peers, with all but Standard Chartered’s LCR rising over the past year.

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G-SIBs have expanded their balance sheets, driven by substantial government bond purchases, higher deposits at central banks, forbearance (e.g. mortgage holidays) and an increase in government-underwritten corporate loans.

Risk-weighted assets haven’t increased substantially, though this may change as government support measures are withdrawn and more losses are recognised.

Eurozone NPLs remain substantially higher than US, UK and CH levels, reflecting an overhang from the financial and Eurozone crises, and low growth levels. Thanks to massive fiscal support and forbearance, there was no sharp uptick in NPLs in Q3.

Loan loss provisions at US and European G-SIBs have broadly increased over the past year, but with some notable decreases. All US and European G-SIBs took lower provisions in Q3 vs Q2, suggesting they felt they were over-cautious with Q2 provisions.

Despite the increase in loan-books, loan-to-deposit ratios have fallen across G-SIBs, demonstrating the need for central banks to encourage banks to ‘lean into’ the crisis.

European banks have seen their loans growth rise, in contrast to US banks. This divergent credit growth trend is likely to close, as loans growth may slow considerably due to weaker demand and tighter lending standards.

Deposits increased, as households and corporates cut back spending and investments, and sold risky assets. Households also benefited from a massive expansion of unemployment benefits. This forced saving is likely to unwind.

There has been a 4% increase in non-net interest income across US and European G-SIBs. Banks with big capital markets operations, e.g. JPM, GS, DBK and BNP, or wealth management arms, e.g. MS, CS and UBS, enjoyed a market-fuelled boom.

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A handful of European banks have benefited from markets in Q3, but overall European bank returns lag their US counterparts substantially, and remain a disincentive to invest.

Price-to-book value had plummeted below one for all but one of US and European G-SIBs by the end of Q3, though positive vaccine news has boosted cyclical stocks, including banks.

European banks’ stock prices fell by more than US banks’ over the year, perhaps because of a bigger relative impact of dividend freezes.

There is break in the behaviour of the US and European banks indices: shortly after the Eurozone crisis, the US banks started to outperform European banks (in terms of share price).

Key findings

Regulatory defence lines: A tale of bulking-up

Strong capital was the bright spot. Despite a great deal of turmoil in financial markets, the solvency of the banking system – and G-SIBs in particular – has not been in question. G-SIB’s CET1 excess increased by 39% from Q3 2019 to Q3 2020. G-SIBs’ strong capital (and liquidity) can help build an economic bridge to the other side of this crisis.

Balance sheets: A tale of holding-up

Shock absorbers. In contrast to the GFC, during the COVID-19 crisis, banks played an important role in absorbing the shock to the economy (e.g., continuing to provide loans to businesses and households). However, there is a continued gap between US and European banks.

Investors: A tale of weak appetite

Continuing weak investor appetite for banks. Funding conditions remain tight and rating outlooks have been revised to negative, as banks are expected to face meaningful profitability challenges. In addition, regulatory edicts preventing share buy-backs and dividends have further reduced the perceived investment case for banks. This suggests that banks will be able to replenish their capital buffers only through earnings and retained dividends, rather than through rights issues. A reinstatement of dividends would be the best bet for banks to increase investors’ appetite (expecting a communication from the ECB by year-end).

Lower forever. Low interest rates are set to continue to weigh on bank’s net interest income for the foreseeable future against a back-drop of an improving, albeit very slowly, economy.

Conclusion

Vaccine impact. Vaccine developments reduce the risk of additional/extended lockdowns and could improve economic growth expectations. This implies that the negative impact of NPLs and provisions on banks’ performance (i.e. ROE) would be reduced in length and investors’ appetite is expected to go up.

Tighter lending standards. Banks are becoming more cautious in light of increased default risk, especially for cash-strapped companies in industries with poor recovery prospects.

M&A mixed picture. Persistent margin pressure could encourage banks to consolidate to reduce costs. In the US, large-cap banks may use their stock currencies to acquire small-caps. In the Eurozone, the ECB has signalled an acceptance of consolidation. The pattern will vary according to business model:

Investment banks (IBs). Consolidation among major European IBs could increase their cost efficiency and scale to compete against the US giants; and
Retail banks: Digitally-enabled banks may prefer to develop their own capability, buy FinTechs or partner with BigTech, thereby avoiding the legacy IT issues of other incumbents.

Beyond the business model factor, we expect M&A to largely occur in-market rather than out-market.

Tighter competition. The COVID-19 crisis, has accelerated a pre-COVID-19 trend, namely digitalisation and the consolidation of digital-only players (i.e. payments sector). This affects banks through downward pressures on fees and prices and more compressed margins. If this trend continues, banks’ profitability is set to come under further threat.

Structural transformation. Large-scale remote working has led banks to re-imagine the art of the possible, e.g. the pace of automation and digitisation and off-shoring and out-sourcing.

Testing resilience. COVID-19 has accelerated digitisation, thereby increasing the vulnerability of banks to operational outages and cyber threats. Exploratory stress test exercises, such as the Bank of England’s, in 2019, testing vulnerability to payments disruptions, may become more widespread.

*G-SIBs https://www.fsb.org/2020/11/2020-list-of-global-systemically-important-banks-g-sibs/