Credit Investors Take Heed: A Different Landscape Will Emerge For European Banks

Financing costs for European banks will increase after TLTROsCredit investors take heed: a different landscape will emerge for European banks

Sam Theodore (Scope Insights) | The pandemic is fast pushing the European banking sector into a new and different stage;one thatnone of uscould have anticipated. At this time there is no reason for credit investors to fear outright bank failures since this is not a copycat of the last financial crisis. (Even so and rather surprisingly, the risk of default for European banks is high in several credit-strategymodels.)There is, however, a clear need to reassess some of the underpinning rationales for investing in the debt of European banks.The dynamics of the landscape a rechanging and a return to the past is not likely anytime soon.

National governments, the European Commission, the ECB, Bank of England, and other central banksare putting in place unprecedented pandemic-related rescue programmes for businesses and households. Bank regulators have provided clear indications of temporary forbearance and supervisory leniency –in capital buffers, NPL recognition, and loan-loss provisioning.

In exchange, banks are expected to engage heavily in the effort to prevent a total collapse of entire sectors of the economy facing unprecedented threat–through repayment moratoria, forbearance, removing interest from overdrafts; in general,keeping the engines of lendingto businesses and householdsrunning. When the pandemic crisis subsides, banks will likely be asked to participate all-hands-on-deck in the reconstruction process.

This is exactly what banks were asked to do in the decades after World War II; many of them as state-owned entities. Now, with a more comprehensive regulatory architecture in place ,there should be no need for taxpayer-subsidised re-nationalisations. If a large bank proves unable or unwilling to fulfilits changing mission, early intervention or even resolution could be initiatedtoforce itsrepositioning–mostly through replacing senior management, adjusting the business model, and discontinuing unnecessarily risky activities.

Large banks’ debt and capital instruments should be safeThere will be no need for debt bail-ins if the bank is notfailing or likely to fail.Which in general should not be the case as European banks’ prudential metrics on balance remain relatively strong, with ample excess capital and liquidity cushions.

As for smaller banks no longer able to carry on under difficult market conditions, they would plausibly be strong-armed by their regulators to merge into financially healthier peers. The avenue of insolvency proceedings is not likely to be pursued –unless the bank is in a critical state due to its own mistakes –as doing so would unnecessarily create market panic which could ripple over the entire sector.

One particular area of investor concern is the safety of AT1 coupon payments. In all likelihood, a bank will always choose to keep coupon payments going. The cost of temporary non-payment would be too prohibitive for the respective bank in terms of future market access compared to the relatively modest financial boost. An AT1 coupon payment is typically in the EUR40m-50mrange, far lower than dividend payments.The only plausible scenario for AT1 coupon non-payment is that of the supervisors prohibiting the bank from paying.Which, again, is not likely to be the case for the foreseeable future and with bank capital levels being where they are.

Bank priorities changing tack

In this new landscape, going all-out to maximise shareholdervaluecan no longer be a top goal inbank strategies. Not if banks want to earn the image of a helping hand rather than be stuck with that of an unreformed spoiler. Based on their current communications, somebanks appear not to have internalised the new dynamics.But this will change.

Prodded by their supervisors, or (more positively) in a minority of cases at their own initiative, many large banks have announced that during the pandemic they will skip dividend payments, forego stock buybacks, reduce or cancel management bonuses, and avoid staff layoffs.This is a good start.

But things won’t get any easier for the banks.They will have to operate in an environment likelyafflicted bymaterially higher levels of business and personal financial hardship, bankruptcies, and a sharp spike in unemployment.The social welfare layers prevailing across most of Europe, to which the new unprecedented public-sector financial support will be added, should attenuate the impact of the economic meltdown.At least for a while. But in this new frightening world,banks will be expected to keep tagging along with their new role for some time.Bailing out in mid-course to resume unnecessary risk-taking to boost returns will not land well with the world around them, least of it their supervisors.

Blow on revenues likely In this new landscape,European bank revenues (which were not high to begin with)will be substantially affected.This will transpire very soon.Q1 results will offer a partial glimpse, followed by a more depressing Q2,several quarters before the impact of deteriorating asset quality also hits.

The new situation will probably be most visible in wholesale/investment banking and in asset management.In a depressed and profoundly worried market,investment banking activities will have to take a back seat, at least for some time. Besides, banks may wisely decide to steer away from re-engaging in high-risk high-return transactions and other such activities. These will not sit well with the general expectation that banks need to focus on helping businesses to survive and preserve jobsand help households make ends meet.For a while at least, investment bankers may have to lay low. Expected higher volumes of distressed-credit trading may not sufficiently replenish the bucket.

As for asset management, in the current market it is very likely that the downward pressure on volumes, new net money flows, yields and fees will intensify, convincing more squeezed players to exit the field.The pandemic crisis will entail massive investment losses globally–unlike the situation during the last financial crisis.On the other hand, banks are likely to book fees from governments for disbursing and monitoring state-guaranteed or subsidised loans.Some of the larger fintechs and neobanks are also trying to get a foothold in this business.

Worsening asset quality –with a lag

Despite supervisory forbearance for asset quality, credit losses will ultimately have to be provisioned for, and at that time the impact on the bottom line will be felt. The level of pre-provision earnings is likely to be insufficient to provide a reassuring cushion. Entire industries will be hurt –airlines and transportation, tourism, hospitality, entertainment, fossil fuels, and key manufacturing sectors (cars, aircraft, ships).A large number of SMEs will fold, not being able to come back when the pandemic is over.

The V-shaped expectation of many in the market may not be realistic. First, the mandatory lockdowns are likely to be kept in place for longer than the few weeks people assumed at the beginning.Second, it is certain that when the lockdowns are eased the world will not revert quickly to the pre-pandemic lifestyle. Not as long as a successful coronavirus vaccine is unavailable to all. By the looks of it, this will be a 2021 story at best.