Covid-19 has resulted not only in a health crisis but has also presented enormous economic challenges for Europe. The European economy is heavily reliant on the financial health of its banking system, with European banks providing around 70% of corporate and 90% of household financing—double and triple the proportion seen in the United States, where financing is heavily reliant on capital markets; write David Zahn, head of European fixed income, and Tom Petersson, European financials research analyst, at Franklin Templeton.
European banks have weathered the pandemic well thus far, benefitting from policymakers’ large fiscal and liquidity support packages, as well as the flexibility regulators have shown.
Unlike in the 2008–2009 global financial crisis (GFC), there has not been a credit crunch, as government-guaranteed funding programmes and generous TLTRO3 provisions have allowed credit to continue to flow to the real economy. These measures, coupled with repayment moratoria, have limited near-term liquidity-induced borrower defaults and allowed banks time to gradually build up loan loss provisions to minimise the impact on earnings.
How resilient is the European banking sector?
European banks entered the covid-19 crisis with generally strong balance sheets. The sector average CET1 capital ratio is at post-GFC highs and well above capital requirements. Similarly, liquidity positions are also good, albeit aided by extraordinary levels of bank funding.
But while balance sheets mostly remain strong, profitability was already weak going into the current crisis.
In the two years prior to the GFC, eurozone annual loan growth averaged 9–12%, compared with only 2–3% in the two years prior to the pandemic. As such, loan books are generally more seasoned and there has not been the same relaxation of credit standards.
Looking ahead, the outlook for loan impairments is uncertain and will depend on the speed of the EU’s vaccine rollout. Bank management teams are currently guiding for a marginally lower cost of risk in 2021 versus 2020, but as the third lockdown grips Europe, there is clearly some upward pressure on this guidance.
Despite their weak profitability, most banks should be able to absorb future expected loan impairments through their earnings, which will minimise the impact on their capital positions.
Repayment moratoria an early indication of future potential loan losses
Actual loan losses have been low so far, due to fiscal support packages and repayment moratoria schemes, but are expected to increase going forward as these temporary programmes expire.
The end of temporary moratoria represents a possible asset quality cliff risk, but we expect that policymakers and regulators will maintain their extraordinary fiscal and liquidity support until the worst of the pandemic has passed, which should help to contain the asset quality deterioration.
While the asset quality outlook is uncertain, markets can take comfort from the banks’ strong capital position. The average CET1 capital ratio has almost doubled over the last decade, from 8.8% at the end of 2008 to 15.4% as of end-September 2020, well above capital requirements. This provides a good buffer should loan losses surprise to the upside.
Policymakers need to learn from past mistakes
Going into the pandemic, several banking systems in Europe were still dealing with the fallout from the GFC and the eurozone’s sovereign debt crisis. Non-performing loans (NPLs) tie up capital and can restrict banks’ ability to lend to the real economy.
To prevent a repeat of the past and speed up the recovery from the covid-19 pandemic, it is essential that banks are not left to deal with the asset quality fallout on their own.
In mid-December, the European Commission put forward a comprehensive action plan to address the future build-up of NPLs as a result of the pandemic, including the formation of a network of national asset management companies/bad banks that can purchase NPLs from banks.
While we welcome the proposal, we would caution that similar proposals have met with fierce political resistance in the past and so it remains too early to tell whether this latest proposal will receive necessary approval.
Functional banking system critical for recovery
We continue to believe that a functional banking sector is crucial for Europe to navigate these difficult times and ensure that its economy can recover. However, a more prolonged deterioration in the economy than currently envisaged, or a premature withdrawal of current fiscal and liquidity packages before the economy has fully recovered, continue to pose risks to the sector and its recovery.
Whilst the European banking sector has weathered the covid-19 pandemic well thus far, we expect that fundamental profiles will gradually deteriorate as the temporary fiscal and liquidity support packages are phased out.
However, European banks in general are well prepared to deal with the expected fallout of the pandemic. Despite their weak profitability, loan impairments should be largely absorbed through earnings and banks’ strong capital position should generally provide a good buffer to absorb potential adverse surprises.
Within our fixed income portfolios, we remain constructive on the sector and maintain overweight positions, although we believe the strategic importance of the sector is now better reflected in valuations and as such positioning in the portfolios should reflect this reality.
This article was written for Expert Investor by David Zahn, Head of European Fixed Income and Tom Petersson, European Financials Research Analyst at Franklin Templeton.