On Tuesday, the Financial Stability Board released its preliminary report into lessons learned from the Covid pandemic, while acknowledging that it is not over and that its financial impact has only been mitigated by extraordinary monetary and fiscal policy.
The FSB sees a need to strengthen resilience in non-bank financial intermediation. It highlights the procyclicality inherent in margin calls, while looking back to the dash for cash at the start of the pandemic that revealed vulnerabilities stemming from liquidity mismatches, leverage and interconnectedness.
Central banks, in effect, replaced the markets.
Banks’ asset quality will deteriorate when the bulk of the public emergency support is withdrawn
Andrea Enria. Photo: Dirk Claus/ECB
That allowed some companies to increase leverage when they perhaps should have been put out of their misery.
High corporate and sovereign indebtedness was already a concern before the outbreak of Covid-19, the FSB points out. Rapid and large credit support has since increased debt levels, especially in the hardest-hit sectors.
As banks now start to report second-quarter earnings boosted by reserve releases, the FSB worries that the current low level of corporate insolvencies is predicated on continued policy support.
“Banks and non-bank lenders could still face additional losses as these measures are unwound,” it said.
Andrea Enria, chair of the supervisory board of the European Central Bank, recently had to point out the obvious: “Banks’ asset quality will deteriorate when the bulk of the public emergency support is withdrawn.”
More recently, in an exchange of views with the Finance and Treasury Committee of the Italian senate, Enria said: “ECB analysis tells us that pandemic-related public support may have increased the number of what are known as ‘zombie firms’.”
He added that those borrowers were a drag on the economy’s productivity “and expose the banking sector to disruptive adjustments”.
Key challenges
In its July financial stability report, the Bank of England notes the decline of performing loans that banks classify as at heightened risk of default, as well as banks’ expectations of lower impairments this year over last, amid a new consensus for overall 2020/21 impairments of £30 billion, down from £45 billion expected last year.
But the BoE warns that the potential for future credit deterioration remains, especially if unemployment and business insolvencies were to rise by more than expected.
“A key challenge will come when government support schemes unwind later this year as the economy recovers,” it says
This is why the FSB advocates gradual and targeted wind-down of tax-payer support, with authorities making the terms on which it is provided progressively less generous while sequencing the withdrawal of measures.
Given the negative output gap in Europe, the risk is of a premature withdrawal of fiscal support and that relates to the fiscal rules
Alvise Lennkh, Scope
Analysts at UBS point out that, looking across the EU, banks are already unwinding their own special support measures without, so far, sparking any rise in non-performing loans.
They point out that €877 billion of EU corporate and household debt had been subject to interest and/or principal payment holidays since the pandemic began, but only €203 billion remains in this limbo status.
UBS argues that use of these payment holidays was greater in countries with higher corporate and household debt-to-GDP ratios, while state guaranteed loan programmes were more targeted to companies with low default risk.
That’s highly debatable.
Banks struggled to hand out partially state-guaranteed loans at first because their own guidelines suggested that many of the recipients couldn’t service them. They were inundated with demand.
Given that it’s always easier to hand loans out than to get them back, that was a warning signal that should still be sounding.
The share of EU bank loans still in payment moratoria status is now modest at only 1.1%, albeit with laggard countries, especially where non-financial corporate borrowers have yet to resume normal interest and principal, including Portugal (13.8%) and Italy (3.6%).
Delta damage
The Delta variant is now driving cases up again across Europe. The UBS analysts suggest that an unconditional reproduction (R) number as high as seven or eight implies that 80% to 90% of a country’s population would need to be vaccinated to achieve herd immunity, even with a vaccine that was 100% effective at preventing case transmission.
The vaccines we have are not this effective, and no country has yet achieved that level of vaccination across its adult population, never mind the whole population.
But UBS insists that the Delta variant is unlikely to damage EU banks. It points to declining NPLs in manufacturing, real estate and wholesale/retail trade easily offsetting rising NPLs in the worst Covid-affected service sectors, which make up a much smaller portion of banks’ loan books.
Can we rely on what the banks say?
Enria is sceptical. He notes highly diverse practices under IFRS9 accounting standards, with differences across banks relating to the transfer of loans to Stage 2 – signalling an increase in credit risk – and the level of credit-loss provisions associated with such loans.
He says: “We observed that some of these practices systematically delay the identification of loans in this category, especially for riskier portfolios.”
And, he adds, “when banks’ balance sheets become opaque, it increases uncertainty for investors and creates the risk that banks will have to pay higher refinancing costs on debt and equity markets, thereby reducing their capacity to lend to the real economy.”
Right now, banks’ additional tier-1 (AT1) credit spreads are compressing. Investors are still hungrily searching for yield.
But euro area GDP is not expected to return to pre-crisis levels until 2022 at the earliest, raising the risks of a policy mistake, if for example, the ECB should be tempted to withdraw stimulus too early.
Its buying of government bonds has contained the cost of debt servicing, even as sovereign borrowing has risen.
Recovery plans
Alvise Lennkh, deputy head of sovereign ratings at Scope, looks ahead to the forthcoming revision and reintroduction of eurozone fiscal rules, following the activation last Spring of a general escape clause from the stability and growth pact.
That infamous pact was first agreed 24 years ago and repeatedly dodged over the decades that followed by various countries negotiating exceptions.
The world has changed since 1997: growth is lower, rates are lower, public debt is higher.
“The new rules need to be simpler and more observable,” says Lennkh, “and must cater to these new realities, which including ageing populations and higher investment needs, and not just reintroduce the old ones.”
He says: “Given the negative output gap in Europe, the risk is of a premature withdrawal of fiscal support and that relates to the fiscal rules.”
We do not consider these core or recurring profits
Jamie Dimon, JPMorgan. Photo: Reuters
The Next Generation EU recovery plan offers an opportunity for the most-indebted large eurozone countries that also show the weakest growth – such as Italy and Spain – to invest in their economies through grants.
Their recovery plans are yet to be agreed and their absorption capacities remain to be tested, as do the associated fiscal multipliers. But the European Commission sees the plan boosting Italian GDP by 1% this year and 1.8% in 2022, with 1.8% for Spain in 2021 and 2.3% next year.
Analysts at Barclays are hopeful that bank asset quality may continue to surprise positively, noting that the broad consensus assumes 2022 impairments to revert to 2015-to-2019 levels, whereas less unsecured exposure and more guaranteed lending may allow for more write-backs of reserve build.
To Euromoney, this near universal optimism from banks, rating agencies and policymakers all sounds a little Panglossian.
At least Jamie Dimon had the sense to make clear, when JPMorgan’s second-quarter profits were boosted by a net $2.3 billion of reserve releases, that: “We do not consider these core or recurring profits.”
Neither do we, Jamie. The question is whether losses from downgrades and defaults eventually rise to match those reserves, or – perish the thought – threaten to exceed them.
We might possibly be OK if no vaccine-resistant variant emerges. But the bank-sovereign doom loop is still knotted pretty tight.
