The ECB has announced an unprecedented slate of measures to support eurozone economies and financial systems grappling with the effects of the COVID-19 pandemic. Its actions are intended to ensure, among other things, that liquidity keeps flowing to households and private-sector companies. Most European banks have rebalanced their funding profiles since the last downturn and have significantly strengthened their liquidity positions. Consequently, S&P Global Ratings doesn't believe Europe's banks face short-term refinancing risks. We anticipate that banks will use the ECB's facilities because of their attractive terms and conditions; banks can earn one cent on every €2 borrowed, just by redepositing the same amount of money with the ECB.
Therefore the announcement that eurozone banks borrowed €1.3 trillion under the ECB's latest targeted long-term refinancing operations (TLTRO III) on June 18 didn't come as a surprise. Banks are being asked to channel this liquidity at affordable prices to the private sector, particularly to corporates, thus helping to shore up market confidence and ensure the flow of money to local economies.
However, eurozone banks' future creditworthiness will largely depend on how and when economies in the region rebound after the sharp contraction in the first half of 2020. The ECB's supportive stance is key to preventing a credit crunch in the short term, but governments' policies, fiscal capacity, and flexibility are even more important to restore the region's economies and enhance business conditions for local companies. In this context, the efficiency of governments' measures to aid non-financial sectors will play a significant role in how banks' asset quality evolves.
Despite a wide range of monetary and fiscal initiatives to reinforce corporate businesses--in the form of grants, loan guarantees, corporate sector purchase programs, and deferred tax arrangements--the recovery of corporate sectors appears fragile, and is uneven. If there were a further economic setback, the quality of banks' loan books would deteriorate sharply and credit losses might end up eroding their earnings and capitalization.
The ECB's Goal Is To Keep Liquidity Flowing
Since COVID-19 started spreading across the globe, central banks have responded to the first signs of volatility and expected economic stress in their respective regions. The list of supporting measures the ECB has launched for the eurozone over the past three months is long. They include the following:
Five ECB Measures To Support Eurozone Banks
- The introduction of a Pandemic Purchase Emergency Program (PEPP), initially set at €750 billion and increased to €1.35 trillion in June. The PEPP is aimed at supporting funding conditions in the real economy and runs until June 2021.
- Revised TLTRO III terms to ease conditions for banks to borrow from central banks and channel cheap funding to domestic economies.
- The launch of pandemic emergency longer-term refinancing operations (PELTRO), which allow banks to discount different classes of bonds at favorable conditions.
- Temporary capital relief to enhance banks' capacity to lend to the private sector.
- The establishment of currency swap lines with other central banks to ensure that, despite market volatility, European banks can accommodate customers' potentially rising demand for foreign currency assets.
For Most Eurozone Banks, The Risk Of Short-Term Liquidity Shocks Is Limited
Most European banks don't face any significant refinancing risk over the next few quarters, in our view, although we acknowledge that some entities or systems might be more vulnerable to liquidity shocks in a stress scenario. For the past 10 years, they have gradually but firmly enhanced their financial profiles, which were severely hit by the previous global economic turmoil. They've successfully rebalanced their funding profiles, reduced reliance on wholesale funding, and reinforced their liquidity positions (see chart 1), among many other actions to strengthen capital and improve efficiency.
Eurozone banks' funding needs are expected to remain limited over the coming months. Their wholesale funding maturities are well spread over time, and reliance on short-term financing is generally manageable. We anticipate that demand for corporate credit will stay fairly robust, albeit below recent levels (see chart 2). We also expect deposits will continue increasing and that banks will remain capable of funding their lending activity, also benefiting from the availability of ECB funding. For example, in March, when lockdowns were first announced in Europe, several corporate entities drew large amounts of money from their committed bank lines to be prepared for this unprecedented situation. This spike in corporate borrowing was temporary however, and didn't have a material impact on banks' funding profiles since retail lending was muted, and most corporate customers redeposited the amounts to their banks account.
Eurozone Economies Stand To Benefit
The large amount of funding the ECB has made available to banks should sustain liquidity in the region and provide companies, particularly small and midsize enterprises, access to funding at affordable terms (see chart 3).
It's no surprise that eurozone banks tapped a whopping €1.3 trillion from TLTRO III in June, given the ECB's very favorable borrowing conditions. Although banks used the majority of this amount to repay outstanding ECB debt, a significant portion (about €500 billion) is likely to remain on their balance sheets to fund new lending and other securities investments. Banks have to make greater use of collateral to access the ECB's refinancing facilities, thus reducing the amount of available assets on their balance sheets. However, we don't see increasing encumbrance as a major problem, mainly due to most banks' healthy buffers, the generous terms of central bank access with a wider range of collateral eligible for these operations, and the rapid rebound of debt markets.
Increased Sovereign Debt Holding Could Pose Latent Risks
The revised terms of the ECB's main refinancing operations could encourage banks to enlarge their sovereign bond holdings. These acquisitions would immediately benefit banks' net interest income, since they could easily gain a carry trade on their sovereign portfolios without consuming capital. Yet they would also reduce the effectiveness of the ECB's measures and the potential positive impact on eurozone economies by constraining the direct flow of funds to the private sector. Moreover, if banks were to significantly expand their direct exposure to sovereigns, this could reinforce the sovereign-bank interdependence that European authorities have been trying to disentangle for the past 10 years.
Also, these additional income sources would not be a panacea for European banks' formidable profitability challenges. The average return prospects for many banks in the region were already gloomy before COVID-19, so the additional market and economic stress related to the pandemic is likely to result in higher credit losses and even weaker results. Although the abundant liquidity support provides temporary relief, some banks' business models will remain under pressure without strategic measures to tackle costs and restructuring to navigate through the prolonged low-interest-rate environment.
Monetary stimulus is available and plentiful, but banks cannot rely on it forever. In our view, given other looming pressures, such as compliance with leverage ratios and output floors, European banks would be better served by entering advanced asset securitization markets and seeking wider funding diversification to avoid becoming dependent on temporary central bank facilities. Despite increased volatility in capital markets after COVID-19 started spreading across Europe, we believe many European banks' access to capital markets remains largely intact.
Asset Quality Will Determine Banks' Futures
Funding risks are limited, but asset quality remains the main risk to European banks' creditworthiness as the world is hit by the worst recession since World War II. European governments have set up various support measures, which include moratorium schemes, temporary unemployment support, grants, guarantees for corporate loans, corporate sector purchase programs, and deferred tax arrangements to provide temporary relief for companies.
However, these cannot act as permanent solutions to companies' restrained cash flow generation. We expect that the recovery of the corporate sector will be uneven and largely rely on the recovery of consumption, travel, and trade. This might be particularly difficult for speculative-grade borrowers (rated 'BB+' and lower) operating in some of the weakest and most affected sectors. Future corporate default rates will depend to a great extent on governments' capacity to revive national economies and on companies' flexibility to adapt to new business and operational challenges. If the eurozone's economic prospects were to weaken, for instance because of renewed lockdowns or a slower-than-expected recovery, banks nonperforming loans could increase, straining their credit profiles.
S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
- How COVID-19 Is Affecting Bank Ratings: June 2020 Update, June 11, 2020
- Bank Regulatory Buffers Face Their First Usability Test, June 11, 2020
- The European Crisis Backstop Is Underpinning Corporate Funding Conditions, May 19, 2020
- EMEA Financial Institutions Monitor 2Q2020: Resilient But Not Immune To COVID-19, May 14, 2020
- How COVID-19 Risks Prompted European Bank Rating Actions, April 29, 2020
- COVID-19 Countermeasures May Contain Damage To Europe's Financial Institutions For Now, March 13, 2020
This report does not constitute a rating action.
|Primary Credit Analysts:||Luigi Motti, Madrid + 34 91 788 7234;|
|Natalia Yalovskaya, London (44) 20-7176-3407;|
|Secondary Contact:||Elena Iparraguirre, Madrid (34) 91-389-6963;|
|Research Contributors:||Marta Heras, Madrid (34) 91-389-6967;|
|David Szalai, Paris;|
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