- After a slew of European bank rating actions in the spring, we have taken very few since, leaving around 45% of ratings on larger European banks with negative outlooks.
- Banks' second-quarter results confirmed many of our assumptions, but took us only slightly further forward in understanding the full implications for each bank.
- Asset quality remains central to future bank profitability and capitalization. However, comparability of loan book quality and provisioning metrics is poor, and is unlikely to become fully clear until late 2020 at the earliest.
- A laser focus on crisis risk management is not enough if banks will not only survive the pandemic, but thrive thereafter. Investment is indispensable, and consolidation seems inevitable.
- In time, we expect divergent patterns to emerge, whether between national banking systems or between domestic peers. We therefore continue to look for a differentiated view among rated European banks, focused on both their short- and long-term health, and will take rating actions accordingly.
Our base case for European banks remains essentially unchanged since we took a wave of rating actions in the spring. This is in large part because our economic base case, which is broadly aligned with market consensus, is little changed (see Economic Research: The Eurozone Is Healing From COVID-19, published Sept. 24, 2020). Economic recovery is underway, but will likely stutter, and the path could yet diverge significantly between countries. The adverse scenario--of a widespread reimposition of social distancing measures and setbacks in economic activity--remains more than theoretical, and is still the primary factor behind most negative outlooks in the sector. Even under our base-case forecast, we do not rule out that fiscal support could prove to be less effective than we currently expect, or that some banks' asset quality proves to be much weaker than at close peers. This would be particularly negative for banks for whom we already see a marginal capital assessment or where we have identified other material areas of concern, such as business model sustainability.
|Our Baseline Economic Forecast Continues To Envisage A Substantial Recovery In GDP Growth By End-2022|
|For a fuller range of economic indicators and our underlying assumptions, see "Economic Research: The Eurozone Is Healing From COVID-19," published Sept. 24, 2020. Source: S&P Global Ratings.|
In a global context, we expect the shape of the recovery for the major European banking markets to be, much like the U.S. and Japan, slow and unlikely to come before end-2022 (see Global Banking: Recovery Will Stretch To 2023 And Beyond, published Sept. 23, 2020 for more details).
Banks' second-quarter results confirmed many of our assumptions, but took us only slightly further forward in understanding the full implications for each bank. We didn't expect to be able to draw firm conclusions on how the banks will fare through pandemic-induced economic disruption--fiscal stimulus, forbearance, and insolvency law easing all remain in force, and the economic rebound remains at a very early stage. But, so far, we see little evidence to disprove our view that most Nordic and Swiss (and some other) banks will fare relatively well--aided by less sharp economic gyrations and, typically, stronger core profitability and high capital ratios. For the rest, we still see it as too early to determine whether the damage to individual banks' performance from the pandemic is temporary or if there are longer-lasting effects.
Overall, revenues held up slightly better than we expected in the first half. Investment banking performance was quite strong, particularly in Fixed Income, Currencies, and Commodities (FICC). But it also varied wildly, proving to be a useful counterweight for some banks (Barclays, Credit Suisse, Deutsche Bank), and a source of pain for others (Natixis, Société Générale, ABN Amro) (see European Investment Banks Face A Continued Fight To Remain Competitive, published Sept. 28, 2020 for more details). Lower client activity and fee waivers constrained other sources of fee income, but generally held up a bit better than we expected. Net interest income was, as we expected, typically buoyed by loan book expansion, and margin trends varied--sovereign bond carry trades offered support, but previous policy rate cuts weighed on U.K. banks. We expect second-half capital markets revenues to fall back significantly toward 2019 levels, fee income to strengthen more generally (albeit still well behind 2019 levels), and net interest income to follow banks' second-quarter trends.
Our anticipation that asset quality and provisioning would become more comparable than at the end of the first quarter was largely misplaced. Variances in key metrics still abound: due to differences in portfolio quality, but also to different management assumptions and accounting policies on stage migration. Some banks (for example, U.K., Irish, and Dutch) have provided quite heavily, partly reflecting a greater focus on higher-risk lending such as consumer credit, some hardly at all (such as those in the Nordics), and many rather moderately despite the high percentage increases on 2019 figures (see chart below, and European Bank Asset Quality: Half Year Results Tell Only Half The Story, published Sept. 28, 2020 for more details).
The combination of regulatory urging that banks' economic assumptions should look beyond the 2020 recession, the lack of historical economic precedent, and widespread forbearance initiatives together pointed to a more gradual loss recognition than IFRS 9's architects might otherwise have envisaged. This informed our view that 2020 would mark the peak in banks' new credit loss provisions, but that the 2021 provisioning requirement losses could also be significant for many of them.
As the tide of fiscal support goes out, we expect a shake-out in asset quality. This could occur later in 2020 or early next year, depending on the country, at which point we expect a further rise in unemployment and corporate insolvencies. Asset quality would vary anyway depending on the balance of banks' loan books to corporate, small and midsize enterprises (SMEs), retail mortgages, and consumer portfolios and we continue to expect retail mortgage portfolios to be the least affected asset class. However, looking past portfolio composition, through 2021 we anticipate greater differences to emerge across and within national banking systems. Given the importance of this topic to fundamental creditworthiness and future earnings, banks' transparency in asset quality reporting will be important to investor confidence--the economic assumptions made, the extent of forbearance, grade migration, and provisioning policy.
Bank liquidity continues to hold up well, aided by central bank abundance, retail deposit inflows, and the rapid rebound in debt market activity. Eurozone banks have borrowed heavily under the European Central Bank's (ECB's) targeted long-term refinancing operations (TLTRO III) and many saw large inflows of customer deposits. They have lent heavily to the private sector, particularly to corporates, and reinforced the sovereign bond holdings in their liquid asset portfolios. However, ECB statistics suggest that cash liquidity deposited back at the ECB has increased more than new borrowing taken from TLTRO III. It is unsurprising therefore that at the end of June, European bank regulatory liquidity coverage ratios (LCRs) were typically in line with or stronger than those at the end of 2019. We expect central banks to remain highly accommodative and therefore willing to further expand liquidity provision if needed.
Bank capitalization has typically remained robust, despite higher risk-weighted assets (RWAs) from expanded loan books. This is largely because European banks stopped equity dividends at the start of the year and less than one quarter of the major European banks reported bottom-line losses in the first half of the year. It also reflects the accommodative regulatory stance through the "quick fix" to the capital requirements regulation that delayed the application of toughened regulatory requirements. More importantly, it allowed banks to add back to capital some of the effects of rising expected credit losses for early-stage deterioration in borrower quality. We expect greater dilution in our risk-adjusted capital (RAC) ratios at year-end 2020, partly mitigated by continued dividend cancellations. Fairly robust regulatory capital ratios and eased buffer requirements (in terms of both size and composition) also mean that their capacity to service AT1 coupons remains generally comfortable--indeed for some banks it is more comfortable than we had expected pre-COVID.
Notwithstanding often poor pre-provision profitability, results from the ECB's July 2020 vulnerability exercise suggest that bank regulatory capital ratios could yet show good resilience. However, we remain highly mindful that capitalization trends vary, and that significant credit losses and rating migration through end-2020 and 2021 will add pressure to bank earnings and push up RWAs for many. The acid test is yet to come.
Overview Of The ECB's Vulnerability Exercise
In July, the ECB completed a "vulnerability test" on 86 eurozone banks. It concluded that they will have the capacity to cope with the impact of the COVID-19-induced recession, under a base-case scenario where most of the output lost is recovered by 2022. The test showed a likely fall in profitability and some capital depletion (2 pps over 2020-2022), but that capital would generally remain at a comfortable level (12.6% common equity Tier 1 [CET1] on average at end-2022), which would allow banks to continue channeling credit to the economy (see chart 6). The exercise highlighted discrepancies across players: about a quarter of the banks in the sample look likely to post double the capital depletion estimated for the overall group. Furthermore, in a scenario where the economy fails to rebound strongly, the effect on capital would be more significant across the board and the actual levels (8.8% CET1 at end-2022) much more concerning. See "The ECB Takes Comfort In Likely Eurozone Bank Resilience", published July 29, 2020, for more details.
The regulatory drive for resolvability--that is, to bail-in not bail-out--remains on track. Some regulatory deadlines were pushed out, but supportive capital markets mean that most European banks have continued to build their bail-in buffers. It remains a fluid topic, however. Policymakers seem to increasingly acknowledge the complexity in the EU crisis management framework, and the need to simplify aspects of it. At a bank level, we see some resolution authorities' stance on the preferred resolution strategy, the bail-in buffer, and the level of appropriate subordinated liabilities as evolving and subject to annual review and change (see The Resolution Story For Europe's Banks: More Flexibility Now, More Resilience Eventually, published Sept. 28, 2020, for more details).
We have made only minor revisions to our forecasts for the major European banks. This reflects the combination of a steady economic base case and few surprises from second-quarter reporting (see chart). We have also taken no COVID-related rating actions on the major European banks since early June, leaving the rating bias heavy negative weight (see chart).As such, we have not yet taken further rating action--positive or negative--on those with negative outlooks. Absent idiosyncratic surprises, we expect to draw firmer conclusions after third-quarter results on which banks are likely to remain resilient and potentially return to a stable outlook, and which are more vulnerable at their current rating level and may therefore be downgraded. However, outliers aside, we expect that significant uncertainties will persist for many banks and banking systems, meaning that they could stay on negative outlooks into 2021.
Second-Order Effects Via The Sovereign-Bank Nexus Could Provoke Further Policy Responses
The swift monetary and fiscal response across Europe, including the various sovereign-guaranteed loans schemes, has been a huge stabilizing factor. However, the longstanding sovereign-bank nexus--the intertwined relationship of European banks and their domestic sovereigns--has deepened as a result (see The European Sovereign-Bank Nexus Deepens By €200 Billion, published Sept. 21, 2020).
It is inevitable that nonperforming loans (NPLs) will rise over the coming 6-12 months. It is also likely that banks will eventually call on the credit support that European governments have pledged to a meaningful degree. So far, evidence is anecdotal, but for example a recent U.K. Business Bank survey suggested that 10% of borrowers under the government guarantee schemes felt that they would be unable to repay, with a further 15% likely to struggle. This 10% default rate matches the ECB's assumption in their bank vulnerability exercise. However, the terms and size of these government-guaranteed lending schemes vary materially by country. For example, utilized government-backed credit support to businesses was €123 billion for France, €96 billion for Spain, €93 billion for Italy, and just €54 billion for Germany.
Given the significant uncertainties, policymakers are naturally coy about discussing the topic for now. However, there seems to be widespread recognition that the long NPL overhang after the last crisis ultimately served to undermine confidence in peripheral eurozone banks and delay their ability to write new loans. Furthermore, NPL reduction in these markets in previous years means that the mechanisms for NPL divestments or securitizations, and market capacity to absorb them, are relatively well-established. However, these markets remain fragmented not least due to the absence of a common insolvency regime, and investor capacity and risk appetite for substantial new volumes of NPLs cannot be assumed.
While this remains a somewhat long-range issue, we consider it likely that some kind of NPL alleviation measures will eventually emerge, at least in the markets where NPLs rise the most. This could include markets where bank loan books are biased toward corporate exposures, and there is a meaningful weight of the hardest hit industries (such as transportation, tourism, gaming, lodging, and restaurants).
Policymakers will also be acutely aware of the weak valuations for European banks. Under our base case, we see the prospect of bank capital raising as quite remote. But, in a severely adverse scenario like that envisaged in ECB's vulnerability test, some banks might consider pre-emptive capital raisings. However, they are caught in a vicious circle--regulators can see widespread weak core profitability and assume that banks have weak access to private capital so have constrained distributions to shareholders until at least end-2020, and these constraints then undermine equity valuations. We expect that supervisors will remain highly cautious about easing these dividend stoppages, but that a blanket ban will become untenable if stronger banks demonstrably outperform their peers and would have greater resilience to adverse scenarios.
The easing of capital distributions also becomes a hard-sell politically when funding for the real economy remains critical, the government is guaranteeing portions of bank lending, and banks are benefiting from widespread relaxation of various bank regulations, for instance in relation to their capital buffers.
This relaxation and the availability of government-backed lending schemes has undoubtedly had a positive impact over the past months. Bank risk appetite, capital management, and credit extension depends heavily on future regulatory policy.
It is possible that some of these relaxations could yet become more durable, but we view policymakers' stance as quite clear that "quick fix" measures and other implementation delays are only temporary in nature. They will be cautious about retightening the screws for risk of constraining banks' ability to provide credit to the economy. But at some point, banks will have to rebuild their buffers.
It's Not All About COVID
Even under our base case, the economic and rate backdrop will remain weak for the foreseeable future. Many European banks were already wrestling with two paramount questions: how to harmonize balance-sheet strength with solid investor returns, and how to refine business and operating models in the face of the looming risks and opportunities of the digital era. And it is the strength of these business and operating models that will determine whether they not only survive the pandemic, but also thrive thereafter.
We continue to look for bank management teams to take a proactive and energetic approach to digital transformation. While scope for branch rationalization remains, we see digital transformation as the key lever to achieve significant organic cost rationalization without impairing the customer service proposition or losing ground to competitors (see chart 11). Bank executives are well aware that the attendant investment and restructuring costs put further pressure on banks' near-term profitability, and that the current social-distanced working patterns may impede executability. However, the cost of resisting the digital evolution would be far more damaging in the long term.
Regulators will not cheerlead potential mergers and acquisitions. However, we do see them as increasingly accommodating as they balance their assessment of the operational and financial risks associated with such deals with the sustainability and financial risks that would only grow in these overbanked markets (see ECB Set To Ease Regulatory Hurdles To Eurozone Bank Consolidation, published July 3, 2020). Even then, in-market consolidation--as is already underway in Italy and Spain--likely remains far more compelling for bank shareholders, given the significant ability to realize cost synergies and the absence of cross-border impediments to the free flow of resources that continue to undermine the completion of the Banking Union.
- European Investment Banks Face A Continued Fight To Remain Competitive, Sept. 28, 2020
- The Resolution Story For Europe's Banks: More Flexibility Now, More Resilience Eventually, Sept. 28, 2020
- European Bank Asset Quality: Half Year Results Tell Only Half The Story, Sept. 28, 2020
- Economic Research: The Eurozone Is Healing From COVID-19, Sept. 24, 2020
- Global Banking: Recovery Will Stretch To 2023 And Beyond, Sept. 23, 2020
- The European Sovereign Bank Nexus Deepens By €200 Billion, Sept. 21, 2020
- Historical Virtues Do Not Shield European Cooperative Banking Groups From Disruption, Sept. 14, 2020
- Austrian Banks: Resilient Amid High Downside Risks, Aug. 14, 2020
- U.K. Banks' Creditworthiness Will Be Tested As Fiscal Support Ebbs, Aug. 13, 2020
- The ECB Takes Comfort In Likely Eurozone Bank Resilience, July 29, 2020
- EMEA Financial Institutions Monitor 3Q2020: Low Profitability Lingers On, July 24, 2020
- Spanish Banks: COVID -19 Changes Everything, July 24, 2020
- Domestic Credit Losses For French Banks Could More Than Double Amid COVID-19 Pandemic, July 10, 2020
- The $2 Trillion Question: What's On The Horizon For Bank Credit Losses, July 9, 2020
- Global Banks Outlook Midyear 2020: A Series Of Reports Look At The Profound Implications Of The COVID-19 Shock, July 9, 2020
- ECB Set To Ease Regulatory Hurdles To Eurozone Bank Consolidation, July 3, 2020
- Asset Quality Not ECB Liquidity Will Determine Eurozone Banks' Fates, July 2, 2020
- Credit Conditions Europe: Curve Flattens, Recovery Unlocks, June 30, 2020
- Economic Research: Eurozone Economy: The Balancing Act To Recovery, June 25, 2020
- Capital Markets Revenue Should Be A Bright Spot For Banks In A Tough 2020, June 23, 2020
- COVID-19: Swiss Banking Sector To Remain Resilient, June 17, 2020
- How COVID-19 Is Affecting Bank Ratings: June 2020 Update, June 11, 2020
- EMEA Financial Institutions Monitor 2Q2020: Resilient But Not Immune To COVID-19, May 14, 2020
- COVID-19 Effects Might Quadruple U.K. Bank Credit Losses In 2020, May 4, 2020
- How COVID-19 Risks Prompted European Bank Rating Actions, April 29, 2020
- Europe's AT1 Market Faces The COVID-19 Test: Bend, Not Break, April 22, 2020
- Our Definition Of Default In The Context Of The EBA Guidelines, April 1, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Giles Edwards, London (44) 20-7176-7014;|
|Secondary Contacts:||Richard Barnes, London (44) 20-7176-7227;|
|Elena Iparraguirre, Madrid (34) 91-389-6963;|
|Nicolas Malaterre, Paris (33) 1-4420-7324;|
|Osman Sattar, FCA, London (44) 20-7176-7198;|
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