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Banks emerge as part of solution to Covid-19 economic crisis

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The operating environment for European banks will be challenging, but resolution and senior debt bail-in are extremely unlikely. Banks will have to be a key piece of the puzzle as authorities seek to minimise long-term economic loss.
So far, only a few banks have issued explicit profit warnings as a direct consequence of the economic slowdown. “We expect more to come in coming months, potentially ahead of the next reporting season which starts mid-April,” said Marco Troiano, deputy head of financial institutions at Scope Ratings and author of a report, out today, on the impact of banks of the coronavirus crisis.

Troiano believes the policy reaction to the crisis has been strong as far as the financial system is concerned, and it may get stronger over time as the extent of the economic damage becomes evident. “But we do expect private and public sector borrowers eventually to come under pressure due to their elevated debt loads,” he warns.

Temporary cash flow relief may delay the emergence of credit losses but more marginal borrowers will struggle to recover from months of missed income. “This will eventually result in deteriorating loan quality for European banks, unless their most vulnerable clients are supported by government grants and social security measures,” Troiano continued.

The rapidly deteriorating operating environment will translate into lower revenues from falling volumes across business lines that will at least initially more than offset potentially rising margins. Combined with higher provisions, this will hit profits and possibly capital. Troiano says the balance of risks will change throughout the crisis, with operational and cyber risk more relevant in the earlier stages due to the direct impact of the virus on operations. Asset risk will manifest itself over a longer timeframe, especially in view of forbearance measures.

Regulatory risk will likely resurface once the early, acute phase of this economic crisis is over and regulators can assess the full scale of financial damage. Scope rating actions on European banks over the coming months will be skewed to the downside. Scope’s base case is that loan losses and RWA inflation will stop short of putting bank credit in jeopardy for most banks. “We do not expect the crisis to result in a material increase in probabilities of regulatory action on senior bank debt. This category of debt can only be bailed-in in resolution, a possibility that remains remote even if the outlook were to deteriorate further,” said Troiano.

Bank resolution is ill suited to be deployed during the acute phase of an economic crisis, though it may emerge at a later stage to resolve specific banks that fail to emerge strong enough. On the other hand, more junior layers in the capital structure are closer to the regulatory action frontier, and we believe that losses and capital depletion will eventually increase the risk to these securities, starting with AT1. Troiano notes that AT1s are directly exposed to P&L volatility and potential erosion of supervisory buffers. “While lower regulatory capital ratios will reduce the distance to MDA triggers, this is likely to be offset by lower combined buffer requirements and, in certain cases, the ability to fill certain buffers with subordinated debt instead of equity in the euro area,” he said. It is also unlikely that regulators will enforce additional triggers related to MREL requirements in this situation.

However, with the recent market repricing of the AT1 space, non-call risk has also increased materially, as the economics of any call decision have worsened.” Scope believes opportunistic as well as strategic M&A will likely re-emerge over time in fragmented EU banking markets. “Battered bank equity prices offer banks with the strongest balance sheets an opportunity to pinpoint where they would like to increase market share. Regulators are also likely to see mergers as a way to facilitate weaker players out of the market” said Troiano. The full report can be downloaded here. 

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