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The ECB Takes Comfort In Likely Eurozone Bank Resilience

The ECB's vulnerability analysis, published yesterday, concluded that most banks will prove resilient against the COVID-19 pandemic--in its central macroeconomic scenario--a view that S&P Global Ratings shares. The test--a desktop exercise rather than a formal stress test--envisioned a 2020-2022 macroeconomic base case that broadly aligns with our own, with the eurozone economy rebounding post-shock and almost returning to pre-COVID-19 levels by end-2022. Profitability would be dented; the ECB forecasts the sector as a whole would be loss-making in 2020. Nevertheless, capital ratios should prove fairly resilient. On average, the ECB calculated depletion of CET1 capital at almost 2 percentage points over 2020-2022, with most of the decline concentrated in the first year. With an end-point weighted-average CET1 ratio of a healthy 12.6% in 2022, banks should continue to be able to extend credit to help secure economic recovery.

This fairly moderate effect on banks broadly aligns with our base-case expectation, and is consistent with our current position, whereby we have downgraded very few European banks so far despite the unprecedented decline in economic activity in the past quarter. The macroeconomic forecast, stronger bank balance sheets, and fulsome fiscal support are central to this relatively benign view.

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However, the base case is hardly a clean bill of health. On aggregate, eurozone banks might remain relatively resilient, but there could be wide disparity across banks. The ECB in particular highlights that a quarter of eurozone banks would see their CET1 capital ratios decline by 4 percentage points--twice the average calculated for the 86 banks included in the exercise--leading to a less comfortable average CET1 ratio of 10.7%. By implication, this means that some banks will likely be well below this average.

We agree with the ECB that corporate-focused banks are likely to struggle most, and that some banks' limited earnings buffers undermine their resilience to a rise in credit losses and so to capital depletion. The ECB data suggests, for example, that small domestic retail lenders could post lower credit losses than global systemically important financial institutions and universal banks, but end up with higher capital depletion.

We share the view that one of European banks' abiding concerns--existing core profitability challenges--will be compounded by the effects of the pandemic. The ECB outlook for 2020 profits is weaker than ours, as it envisions that on aggregate, this group of banks will report €53 billion net losses. This is explained by an almost 20% decline in revenues and credit provisions more than doubling. Compared with the ECB forecasts, ours anticipate a more gradual recognition of credit losses over this year and next, rather than a big hit in 2020, resulting in a smoother effect on bottom-line results. Despite its expectation that banks would report profits again from 2021, the ECB forecasts 2022 sector profits at just 65% the level of those recorded in 2019. This highlights that bank management teams cannot afford to loosen their focus on the medium-term challenge of business and operating model sustainability; arguably, they should double-down on related initiatives.

The ECB's adverse scenario is more troubling. The assumed deeper economic downturn and slower recovery would spur a much higher spike in unemployment, resulting in corporate and personal insolvencies. In this scenario, the cumulative GDP decline over 2020-2023 is 6.3%. The ECB found that this scenario would undermine banks' asset quality and significantly drag down their capital ratios. On average, the cumulative CET1 ratio depletion by end-2022 was estimated at 5.7 percentage points, more significant in the first year, but, in contrast to the central scenario, continuing during 2021 and 2022. In this adverse case, the average CET1 ratio would stand at a more stretched 8.8% in 2022, declining to a thin 6.8% for the group of banks in the 25th weakest percentile. At this level, the weakest banks would, in our view, struggle to persuade the market that they remained viable.

In this context, the ECB has continued to urge banks to avoid unnecessary distributions. It extended the recommendation to avoid paying dividends and buying back shares to January 2021, while also specifically asking banks to carefully consider the extent of their variable remuneration, all with the aim of preserving resources. While this caution is contested by some equity investors, particularly because the approach is blanket rather than tailor-made to specific banks--we view the regulator's stance as understandable and also the approach least likely to spur a confidence crisis. On the other hand, to ease some banks' concerns and encourage them to continue channelling credit to the private sector, the ECB also clarified that the temporary relaxation of liquidity and capital requirements will not be reconsidered until at least end-2021 and end-2022 respectively.

Our negative outlooks on many European banks reflect diverse elements of downside risk, but the dominant recurring feature is the possibility of a weaker, longer path to recovery and its effect on banks' creditworthiness, particularly where there were pre-existing weaknesses. We also remain highly mindful that there could be significant divergences across European economies, and so across European banks, the vast majority of which retain a predominantly domestic focus.

If this adverse scenario plays out, the policy response will be important. It is hard to judge in advance, but we still see substantial capacity to soften the blow. In March and April, supervisors reacted quickly to cut buffer requirements, but they could choose to go further. Governments could delay the taper in their fiscal support measures, and existing government guarantee schemes often still have substantial unused drawdown capacity. Bank liquidity is unlikely to become a systemic problem because the primary market has bounced back to life, and the ECB and other central banks have shown themselves willing to do what it takes to keep this concern off the table. A pragmatic application of the state aid framework would likely facilitate direct support for banks, which could still arrive in the form of bad asset alleviation. Equity injections are well beyond our current base case. Ongoing discussions around setting up special-purpose vehicles to house problem credits could revive. As in the 2008-2010 financial crisis, the strongest banks might even be encouraged to take over weaker ones (another reason to keep them well-capitalized, even if they could be in a better position than others to distribute dividends).

In the near term, asset quality, and its effect on capitalization, will be the primary determinant of eurozone banks' fates. We expect banks' second quarter earnings to provide much stronger insights on this topic, though they are unlikely to be conclusive - fiscal support measures for corporates and households remain in force, so the full underlying effect remains obscured. We expect a full picture to emerge only from late autumn 2020.

Our ratings reflect a high degree of uncertainty about the impact of coronavirus outbreak and pace of the recovery.  

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: As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst: Elena Iparraguirre, Madrid (34) 91-389-6963;
Secondary Contact: Giles Edwards, London (44) 20-7176-7014;
Research Contributor: Marta Heras, Madrid (34) 91-389-6967;

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