Why COVID-19 is unlikely to trigger a fresh financial crisis

In May, the US Federal Reserve (Fed) warned of potential strains on US banks amid elevated risks from loan losses and falling asset prices as the world seemingly heads for the deepest recession in living memory.¹

Worries that the economic downturn will take a toll on profitability has led to sizeable falls in the price of equities and debt issued by banks since the start of the COVID-19 crisis. Nonetheless, and despite the Fed’s warning, financial markets appear confident the recession is unlikely to morph into a fresh financial crisis.

This belief in lenders’ prospects to withstand COVID-19 is explained in no small part by the action regulators took to ensure there would be no repeat of the global financial crisis of 2007-2009; particularly the tightening of bank capital requirements.

In this Q&A, the AIQ editorial team brought together Oliver Judd (OJ) and Jaime Ramos Martin (JRM), respectively co-head of global credit research and global equities fund manager at Aviva Investors. They argue that trying to extrapolate the impact of COVID-19 from first quarter results is fraught with difficulty given the uncertainty over the economic outlook, the differences in the assumptions banks are making and their policies toward taking loan loss provisions.

Instead, they believe investors should focus on banks with more resilient business models and stronger capital positions, whose securities have in some instances been sold indiscriminately along with their weaker rivals.

Judging by financial market pricing, most investors seem convinced we won’t see a repeat of the financial crisis. Are they right?

OJ: The policymaker response has been rapid and swift. It has actually been hard to keep track of all the changes. By contrast, if you go back to the financial crisis there was a year between the failures of Northern Rock and Lehman Brothers – and yet authorities did very little during that time that improved investor sentiment.

Predicting how the economic situation will develop is fraught with uncertainty, but we are not concerned about the threat of a new banking crisis at this point. Although banks took substantial provisions in the first quarter, which exceeded market expectations, they were absorbable. Most banks remain profitable. Furthermore, these provisions are against what are currently no more than potential future losses.

If every borrower defaulted and there was little or no trading going on, profits would obviously disappear. But for now, it looks as if the provisions taken in the first quarter ought to cover any actual losses in the second.

JRM: All the banks provide economic scenarios when taking these provisions. Most are expecting a fairly brisk rebound in economic activity, so if you take 2020 and 2021 together there may be a small decline in GDP. However, it is possible things could get much worse. A lot depends on how long governments are able to maintain fiscal support and what happens to infection rates when lockdowns are eased.

In a worst-case scenario, if economies do not bounce back strongly in 2021 and there are a lot of creditor defaults, provisions could be three or four times higher than we have already seen. However, that is not our central scenario.

Although many banks have halted dividend payments, so far few, if any, have needed to raise capital. Could this change?

OJ: When you consider first-quarter earnings, the savings from halting dividends plus trading income has more than offset the impact of higher provisions to guard against potential future losses. As a result, regulatory capital buffers have more or less been maintained.

JRM: There has been a substantial increase in banks’ corporate loan books as firms drew on credit lines and accessed liquidity. That growth in loans, combined with rising provisions, has led to capital ratios declining, but it has been marginal.

It is important to remember these are general provisions taken against potential future losses. There have been limited actual losses. At the same time, regulators have eased some capital requirements and so banks have roughly the same room for manoeuvre they had coming into the crisis.

As for when dividend payments might resume, that is hard to know. Again, it depends on how long the crisis lasts. But banks with decent capital buffers will be in a better position than their peers to reinstate them. If we get a recovery and everything goes back to normal, some of the stronger banks may even pay out a special dividend or buy back shares.

There has been a wide variation in the provisions taken. Are some banks being economical with the truth?

OJ: If you take the UK lenders, they have used quite different macroeconomic assumptions. Barclays is expecting a rapid recovery, Lloyds a less rapid one, and RBS uses a proprietary model and does not publish an explicit central forecast at all. They also have different business mixes. Lloyds and Barclays are comparatively exposed to unsecured lending via their credit card arms. As a result, they have taken bigger provisions than RBS, which tends to be more focused on secured lending. But that does not mean any of these lenders are necessarily hiding something. There’s just so much uncertainty.

JRM: Some Nordic banks took a general provision in the first quarter. Their argument was that they would have more visibility in the second quarter, and they saw little point in rushing to take provisions. These decisions were understandable since some countries in this region never had a lockdown.

As an investor, you can estimate the potential impact on a bank’s profits by plugging in your own GDP forecasts and working out if a particular bank has a business model that makes it more exposed to particular risks. You then need to ask: does the bank have any reason to hide anything?

Where banks have huge capital buffers common sense tells you they are more or less telling the truth. More cynicism is required when looking at banks that have less room for manoeuvre.

Does this not make it harder than usual to assess value?

OJ: There is a lot of confusion about who is being conservative and who is not, so we are not making big portfolio decisions based on quarterly results. We are looking at who has the biggest capital buffers and who has taken a reasonable assumption in terms of the macroeconomic picture.

More generally, we have been comfortable with the banking sector following the original financial crisis, given the extent to which capital was rebuilt and balance sheets were repaired. And we have been comforted by what policymakers are doing now. We recognise there is massive uncertainty. However, from a creditor’s perspective, there is a lot of pain that can be taken before we start to feel potential hits, regardless of where we are in the capital structure.

In terms of bank credit, our portfolios did not have exposure to a large amount of risk coming into this crisis as valuations had started to look expensive. Given the degree of capital strength enjoyed by banks, we are happy with the way portfolios are positioned.

JRM: We have taken a similar approach. If you summarise the overall picture in the first quarter, revenues were either in line or better than expected, but loan provisions were worse. However, while a drop of 20 to 30 per cent in headline earnings per share might at first glance seem dreadful, that fall is explained by the upfronting of future losses. It’s hard to react to that given the degree of uncertainty.

We are looking for opportunities in banks that have better business models and stronger capital positions than others, and yet in some cases have been treated the same. This gives us an opportunity to increase positions in banks we already liked.

Oliver, if you compare different parts of the capital structure, do any areas offer better opportunities right now?

OJ: We are focused on tier two subordinated debt and some senior unsecured bonds. Spreads over comparable government bonds widened massively in March. Although they have since tightened a long way, there is an opportunity to make good relative value calls.

As for additional tier one securities, the riskiest part of the credit structure, we are more cautious. Some of these bonds were trading for as little as 60 per cent of their face value, implying multiple coupons would be missed. While prices have since partially recovered, there is some concern regulators may force banks to scrap coupon payments, which is permitted as long as they are not paying dividends. However, so long as the worst economic outcomes can be avoided, these bonds still seem to offer decent value for investors with a higher risk tolerance.

Contributors

Oliver Judd

Co-Head of Global Credit Research

Read more about Oliver Judd