Following the release of Q1 earnings statements, Atlanticomnium’s Romain Miginiac suggests that Covid-19 has not derailed the credit story of European banks.
As an investor, is it possible to have a positive view on the bonds of an issuer while having a negative view on the equity? The disconnect in performance between bank subordinated debt and bank equities, where bondholders have seen more than 70% outperformance over the past five years, is a fascinating case study. Such dislocation in performance between both asset classes reflects two stories – a balance sheet story and an earnings story. On the one hand, bondholders have benefited from a ramp up in regulation leading to capital accumulation and de-risking of bank balance sheets – bank fundamentals have never been stronger. On the other hand, low / negative rates and increased competition have pressured net interest margins and returns, while capital accumulation has mechanically eroded banks’ return on equity (RoE) – weakening the outlook for shareholder returns.
Chart 1: Subordinated debt continues to outperform bank equities (five-year total return)
Past performance is not an indicator of future performance and current or future trends. For illustrative purposes only.
Covid-19 impact on banks – government and central bank actions mitigate the economic shock
The Covid-19 situation, in our view, reinforces, rather than derails the narrative above. Clearly this unprecedented shock to the economy will not leave banks unscathed, particularly as loan loss provisions are poised to surge over the coming quarters. As credit analysts, rather than economists, we have limited insights or visibility on the actual economic impact of the situation. Nor do we have a clear view on the path of recovery. As a result, we focus on banks’ ability to absorb losses rather than attempt to forecast potential losses.
Furthermore, while estimates of economic growth and unemployment rates point to unprecedented levels, reflecting lockdowns across most of the world with deep ramifications on economies, we do not believe these should be taken at face value. Indeed, central banks and governments have taken steps to mitigate the impact on the economy, including ensuring sufficient liquidity for corporates and individuals (unemployment benefits, etc).
We believe this should ultimately reduce the number of defaults for corporates and individuals and in turn non-performing loans and credit losses on banks’ books. Nevertheless, the asset quality of banks’ corporate and lending books will inevitably deteriorate, as government and central bank intervention is unlikely to fully mitigate the impact of the crisis – especially in more vulnerable sectors such as energy, travel or leisure. In contrast we anticipate lending to individuals to be more resilient as government measures should limit income reductions, and lockdowns reduce consumer discretionary spending.
For equity holders, the road ahead is likely to be bumpy as profits are crippled by rising loan loss provisions, and again the outlook for shareholder payouts is bleak. Indeed, as equity is effectively the most junior (subordinated) part of a bank’s capital structure, losses are imposed on shareholders ahead of bondholders, deposits and other liabilities. Regulators have asked banks to suspend dividend payments and share buyback programmes (or at least scale down significantly), to conserve capital. For bondholders, this effectively means that pre-provision profits, the first line of defence, are fully available to absorb losses. Adding banks’ excess capital on top, the capacity to absorb losses is extremely significant. For example, the European banking sector’s average 15% common equity tier 1 (CET1) ratio at 2019-end is equivalent to circa EUR 550 billion of excess capital to circa 10% average requirements, on top of more than EUR 200 billion of annual pre-provision income1.
This number is particularly relevant for subordinated bondholders, and especially AT1 contingent convertible bonds (CoCos) where coupons are at risk when capital ratios fall below requirements (MDA level – maximum distributable amount). With regulators easing capital requirements for banks to provide temporary relief to allow banks to support their customers and the economy by boosting their lending, excess capital positions are poised to remain very strong. Combined with pre-provision profits, bondholders entered the Covid-19 crisis with more than EUR 750 billion of loss absorbing capacity before coupons are at risk. To put this number into perspective, the European Banking Authority (EBA) assumed EUR 358 billion of credit impairments as part of a 2018 stress test, a scenario worse than the global financial crisis.
Q1 results take-away: Covid-19 remains an equity story
A number of European global systematically important banks (G-SIBs) have now reported first quarter results, providing a useful and representative insight into the Covid-19 impact. We use a sample of seven G-SIBs as a proxy to illustrate the impact of the Covid-19 on banks’ Q1 2020 results2.
In line with our expectations, earnings have been impacted by a surge in loan loss provisions as issuers brace for a deterioration of the macro environment, although banks remain profitable. As a result, credit costs in our sample have jumped to an annualised 1.2% of loans compared to 0.5% in 2019 or close to three times the amount, with a range of 1.7 – 13x. Banks have been helpful to provide disclosures around assumptions underpinning loan loss provisions for potential future credit losses. For example, Barclays at the worst point assumes a UK and US GDP decline of 51.5% and 45% (8% and 6.4% decline at year-end 2020) while unemployment is expected to surge to 8% in the UK and 17% in the US (from 3.8 and 3.7% respectively, 6.7 and 12.9% estimate for 2020-end). HSBC expects full-year loan loss provisions of USD 7-11 billion, well below the quarterly run rate of the first quarter of USD 3 billion. This seems to suggest banks are frontloading the impact of the Covid-19 and that either future provisioning needs should be lower or we will see write-backs when credit losses end up below expectations.
Considerable uncertainty remains surrounding the Covid-19 situation as several countries remain in lockdown and at this stage we have limited visibility on the full impact on the economy. Therefore, we assess banks’ ability to absorb further loan loss provisions. Even following the significant surge in losses in Q1 2020, pre-provision profits to loan loss provisions remains at 2x, meaning that theoretically banks could absorb twice the impairments in the following quarters (compared to Q1 2020) with earnings alone, without touching excess capital. This outcome is a strong signal for bondholders, as banks can absorb a further deterioration of the macro environment while remaining profitable and not impairing capital buffers.
Chart 2: While banks’ cost of risk has surged, ability to absorb losses remains solid
From a capital perspective, banks’ CET1 ratios have mechanically declined as a result of higher risk-weighted assets (denominator) from both higher lending exposures and market volatility. This comes despite absolute levels of capital that have slightly increased on the quarter. As corporates have drawn on their credit lines to secure liquidity and banks have supported their customers, lending balances have increased. Elevated market volatility also contributed to the rise in risk-weighted assets for market risk. Average CET1 ratios dropped by 0.4% to 13.1% compared to year-end 2019 levels, although this remains largely unchanged compared to the first three quarters of 2019. As discussed previously, regulators have eased capital requirements for banks, which has lowered capital requirements and MDA levels. The overall effect has been an increase in banks’ average buffer to requirements, from USD 12 billion to USD 13 billion for our sample, boosting the headroom to protect bondholders.
Chart 3: Capital buffers have been boosted by eased requirements
Earnings to remain under pressure, balance sheets rock solid
From a credit perspective, Q1 2020 results have been encouraging and reflect the resilience of the banking sector in the face of an unprecedented economic shock. Although lockdowns are starting to be gradually relaxed, uncertainty remains elevated and estimating the potential impact on the economy is difficult. There is no doubt that loan loss provisions will remain elevated, well above the 2019 run rate. Nevertheless, we take comfort that banks’ macro assumptions seem conservative or at least reflect a deep shock to the economy. Second, capacity to absorb losses through pre-provision profits is elevated as banks remain profitable with a significant buffer above Q1 2020 loan losses in case further provisions are needed over coming quarters.
Even in case of moderate negative deviation from the current expectations, we believe earnings should be sufficient to absorb provisioning requirements, leaving banks’ excess capital positions unscathed. Bondholders should take comfort as banks are in an extremely strong position and in our view risks for bondholders have not materially changed, including coupon risk on AT1 CoCos.
Overall, the credit story for European banks remains intact, in our view. Strong excess capital positions with pre-provisions earnings are more than sufficient to absorb the impact of Covid-19. While earnings are under pressure, banks remain profitable and ultimately we believe this is an equity story and not a balance sheet story.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers.