Concerns about the ability of European banks to withstand the impact of the second wave of COVID-19 are increasing. In his latest survey on loans, the European Central Bank observes that banks are tightening the criteria for granting credit, mainly because the macroeconomic environment has deteriorated and the creditworthiness of borrowers is suffering.
the financial stability review emphasizes that “profitability forecasts will be revised downwards. … The continued weakness in profitability could hamper the ability of banks to support lending to the real economy, especially as interest rates are expected to remain low.
The threat of bad debts
Widespread concerns that banks’ loan portfolios will be much worse in 2021 and 2022 are prompting EU authorities in Brussels to act. The European Commission is expected to present new proposals on the treatment of non-performing loans in mid-December. The European Parliament is currently examining a set of proposals from the European Commission and European governments to facilitate the consolidation and securitization of bad loans in order to spread some of the risk among a larger group of investors.
However, despite the darkening of the horizon, there is no sign of the feverish panic that gripped the public authorities and the banks in the aftermath of the great financial crisis, more than 10 years ago. There are also few signs of the virulent antagonism between politicians and the financial sector that made banks toxic in the political debate following the crisis of the day.
On the contrary, this time the public sector and the banks worked together.
Both sides are aware that they need each other to help the economy at large. A set of voluntary, prudential and legislative measures introduced in the spring, including payment holidays and generous state guarantees for new loans, have enabled banks to continue lending. And, thanks to the post-crisis global framework, the banks entered this emergency much better capitalized and therefore more robust than in the recent past.
European banks have not fully recovered from the latest crisis
The sector is still largely fragmented along national borders. Europe is still “overbanked”. The necessary wave of consolidation never took place, at least not across borders. The banking union is still far from being completed.
Banks have entered the emergency with low profitability and see their profitability further eroded by the crisis. According to the ECB, return on equity, a key metric in determining a bank’s success, has fallen to 1.7% on average and will not fully recover for some time. In 2021 and 2022, the central bank estimates that ROE will simply increase to 3.1% and 5%, respectively, a far cry from what many CEOs promised investors just a year ago. While some of them hoped that interest rates would eventually rise and allow their institutions to reap the rewards, they no longer expect that to happen anytime soon.
If European political leaders succeeded in creating the conditions for a truly and fully integrated European banking sector, banks would have been in an even stronger position in the face of the current crisis.
In search of other sources of income
In other words, with interest rate margins squeezed for the foreseeable future, banks must rely on different sources of income. Can it be a different pricing structure? This too could be difficult, as digitization allows big technologies to engage more and more in traditional banking activities, especially in payments. Costs are expected to decline further in the near future.
However, these are underlying challenges that predate the health emergency. They are simply exacerbated by the impact of the pandemic. A more immediate concern for the authorities is what will happen to banks and loans once the current support measures expire. Small and medium-sized businesses have made extensive use of state-guaranteed loans that mature by the end of the year, especially in countries like Spain, France and Italy.
In June 2020, in France alone, banks declared 78 billion euros ($ 94 billion) in loans subject to state guarantees. In Spain the figure was 73 billion euros. According to the EBA, these loans have an average maturity of between six months and five years. More than a third expire in the summer of 2021. After that, the loans will have to be repaid or refinanced.
But as they will no longer be supported by governments, banks may become more reluctant to lend. What the ECB would like to avoid is that COVID-19 creates the conditions for a bond between corporations and sovereigns in which strained sovereigns and a weak corporate sector mutually reinforce their respective vulnerabilities, especially since sovereigns are increasingly exposed to the corporate sector through contingent liabilities. .
No sign of reappearance of the Doom Loop
For the ECB, this is a warning signal, because the sovereign / bank link has been a “major amplifier of the sovereign debt crisis in the euro zone”. In 2020 to date, euro area banks’ exposures to domestic sovereign debt securities increased by nearly 19% in nominal amounts, the largest increase since 2012 ”according to the ECB report Financial Stability Review Last Month.
However, the ECB does not appear to be concerned about an imminent reactivation of the so-called catastrophic loop between banks and sovereigns, because “so far the vulnerability of banks to higher holdings of sovereign debt securities was contained because valuation changes were modest. This is thanks to extraordinary monetary policy measures and the proposal for a stimulus fund.
Such a scenario would seem worse in countries where banks are too dependent on national markets. European political leaders might want to reconsider their traditional red lines on completing the banking union. Had they succeeded in creating the conditions for a truly and fully integrated European banking sector, the banks would have been in an even stronger position in the face of the current crisis.
Robust banks are central buffers in times of stress. As the second wave of COVID-19 forces parts of the mainland economy to freeze deeply, it is clear that the stress is far from over.