European Banks: Six Months Into The Pandemic, A Tougher Spot But No Crisis

European banksBuilding of the European Central Bank at Frankfurt

The European banking landscape does not look much worse six months into the pandemic-triggered economic crisis than before Covid-19 struck.Loan-loss provisions are higher, there is negative pressure on top-line revenues and gloomy market predictions linger. But the prospect of a new banking crisis is remote.

The principal merit goes to the regulatory architecture set up in Europe after the Great Financial Crisis (GFC). Much criticised at the time by banks, investors and other market participants alike, the new framework has largely delivered on its promises, albeit with some work to do in areas such as conduct risk. The banking sector has been able to tackle the challenges of the pandemic in an exponentially stronger prudential and financial position than when the GFC hit.

1.In March, we sketched out six banking themes during the early stage of the pandemic crisis. How have these six predictions turned out so far?Central banks cannot be expected to act as “white knights” the way they did during the GFC. In fact, the major central banks –Fed, ECB, Bank of England –played a central role in shoring up the financial downside of the current crisis. Unlike the GFC, they have mainly done so hand in hand with their governments. But save the day they did.The fear that, facedwith a sceptical market, over-stretched balance sheets would prevent central banks from acting on a large scale proved to be misplaced. As a matter of fact, the size of central banks’ balance sheets no longer carries the fear factor it did in the years after the GFC.

Interventionist central banks like the ECB or the Fed have reassured the market and performed their magic in restoring confidence (alongside direct government interventions). Even if the prominent financing role of central banks will shrink in the post-pandemic years, it will not go back to the situation pre-2008. For the foreseeable future, capital market issuance, investment, and trading decisions will be influenced by the knowledge that powerful central banks, primarily the ECB, are willing and able to support issuers and the market by purchasing debt securities on a large scale. This is the new normal. For investors, this is arguably as supportive as a government bailout of the issuer.

2. Governments can and should beexpected to play a bigger role in addressing the growing stress, in the form of fiscal stimulus or aiding the financing of sectors in distress. Co-operation among governments –going against national-populist tendencies –would also help.

This is very much the way the scenario has played out, with governments in developed markets providing unprecedented financial support to their economies via direct financing, guarantees, and debt moratoriums. In other words, not to banks this time (financially stronger banks being in no need of support) but directly to economic agents themselves with banks playing the role of distribution agents.

As for inter-governmental co-operation, the EUR750bn pandemic und vividly showed that when there is a will there is a way. For the time being at least, national populists are not calling the shots across Europe.

Government intervention has been a necessity, but it has also created a powerful precedent. The return of market confidence after the first pandemic shock has been clearly pegged to the belief that state intervention and support are here to stay and bear fruit. The market economy survives to a large extent thanks to the umbilical cord of public-sector support. Which inherently also positions Europe’s banks, whether they admit it or not, closer to meeting public-sector priorities than in preceding decades. For credit investors, this should be reassuring.

3. This time around, unlike the GFC, the banking industry is displaying reassuring prudential and financial metrics; besides, it cannot be blamed for the new crisis.

This has indeed been the case. The European banking sector shows ample and stable liquidity, pumped up by opportunities for cheap funding (retail deposits, TLTRO, compressed market funding spreads), in total contrast to the rapid funding erosion and liquidity collapse that started the GFC. More surprisingly, capital levels have held up well through the pandemic so far, even in the face of higher provisions and, for some banks, revenue squeezes. On balance, the CET1 levels of large European banks easily exceed their SREP requirements. This includes the large Spanish and French banks, which often raise more investor concerns in this regard than, say, Nordic or UK banks. Based on current expectations, there should be little fear that capital positions will deteriorate markedly in H2 or in 2021.In addition, as the banks themselves kept repeating, and with good reason, they were not to blame for the new crisis like last time around. In fact, a silver lining of the pandemic for the banking sector is a change for the better of its public image. Especially as banks are expected to finance Europe’s post-pandemic economies and help businesses and households through difficult times. This role is significantly more important for European banks than for their US counterparts, as Europe’s credit markets remain more intermediated by banks than in the US. European banks are not out of the woods, however. On balance, their profitability remains feeble and the tough macro environment does not suggest a light at the end of the earnings tunnel any time soon. It is increasingly clear that the sector remains burdened by excess capacity facing shrinking demand, fast-paced digitalisation, and product commoditisation. Unavoidable consolidation –mostly in-market –looms for the sector in H2 and 2021.

4. Bank supervisors should avoid unnecessary toughness when dealing with banks experiencing virus-related problems. This has been the case and supervisors’ leniency is unlikely to change.The pandemic has found European supervisors much more in the saddle than their predecessors at the outset of the GFC. Supervisors should be viewed as the unsung heroes of the European banking industry’s post-GFC recovery. From a box-ticking approach, prudential supervision is far more proactive and risk-based and not solely rules-based. As European banks on balance show reassuring prudential metrics, less complex business models, and limited risk appetite, their supervisors have become more supportive. The much-feared regulatory risk (regulators imposing measures which would make banks less investable) looks to be more a thing of the past. As the pandemic crisis hit, supervisors encouraged banks to draw on liquidity and capital buffers without worrying that by doing so they would breach supervisory standards. In addition, the implementation of tougher loan-loss provisioning rules (IFRS 9)is being slowed down, as is the process of NPL recognition.

5. The pandemic crisis is not the right time for banks to contemplate transactions or actions that could lead to additional risks, or at least give the market that impression. This remains the case, and with almost no exception the large European banks show very reduced appetite for taking on new risks to boost profits. The less the banks are seen trying to capitalise on a situation that is stressful for most –including their own customers –to opportunistically boost earnings, the less their public image and mainstream business activities will suffer. By-and-large, the current crop of European bank CEOs and boards remains risk averse. But avoiding high risks is not tantamount to preventing them from crystallising –e.g. money laundering events. The structural post-GFC evolution of Europe’s large banks into more risk-averse businesses has been able to help them tackle the challenges of the pandemic without too much bleeding elsewhere.

6. The light at the end of this tunnel will be when a vaccine and its mass commercialisation are successful.

This was true six months ago and it remains true today