04 May 2020

CSFI Fuller: Bankers in Wonderland

“Why, sometimes I've believed as many as six impossible things before breakfast” - Alice in WonderlandHow would Alice do as a commentator on the banking sector as it tries to fit the impact of Covid-19 into accounting models?

The most closely watched number in the first-quarter reporting season on both sides of the Atlantic has been charges for loan losses. Not just those that went bad in that period but those expected to do so in future. In the US, Citigroup’s $7bn of charges broke down into $2.1bn for actual losses and $4.9bn set aside to cover future ones.

In the UK, Lloyds Banking Group said on April 30 that Covid-19 provisions accounted for three-quarters of its £1.43bn impairment charges. Taken with the hit to its insurance operations from (mainly Covid-related) market price movements, little remained of its “pre-provision” £2bn operating profit.

The accounting is complicated by relatively new financial reporting standards – ASU 2016-13 in the US and IFRS 9 elsewhere – that demand a more forward-looking view of potential losses. But forecasting the future just became a quantum more difficult.

So, the first impossible thing for Alice the analyst to believe is whether it is going to be a V, U, bath or L-shaped recession. Economists, who practise the “dismal science”, and journalists thriving on bad news will err on the side of pessimism. What about the central banks, which have upped their game since the financial crisis in supervising banks’ financial soundness?

At the Bank of England, Sam Woods, who heads the Prudential Regulation Authority said on March 26: “While the reduction in activity associated with Covid-19 could be sharp and large, it is likely to rebound sharply when social distancing measures are lifted.” So, a V shape then. Three weeks later, the Bank’s governor, Andrew Bailey, not only said it was plausible that the second-quarter could see a 35% drop in GDP (as forecast by the Office for Budgetary Responsibility), but warned that there could be persistent “scarring” – so a U, or worse?

Anecdotally, the message that bankers are getting from prudential regulators is “don’t go over the top” in anticipating loan losses. The concern is that if bank capital is sequestered to soak up future losses, businesses that need loans to survive the next weeks and months will die of thirst.

All the mood music is to put the economy first. In any case, a sensible rule of accounting is that if the number will be meaningless because of uncertainty over the assumptions, then err on the side of caution. And that means ‘don’t jump to conclusions’ – NOT ‘plug in the worst number possible’.

The second impossible thing is to predict is if, how and when the dominoes might fall. A phrase used many times by Lloyds was “payment holidays” for up to three months. Under IFRS 9, there is a “rebuttable” assumption that the probability of default increases significantly when a payment is 30 days overdue, triggering an additional provision for losses over the full life of the loan.

We are deep into rebut territory. The short-term reason is that not all those taking advantage of the holiday offer are unable to pay. And, if the holiday gets the borrower over a temporary cash flow problem, its ability to repay the loan in full may be unchanged. The raft of government guarantees and central bank support also mitigates both the potential default rate and the ultimate cost to banks.

Looking further out we know that certain sectors have been particularly badly hit. Recent weeks have been littered with announcements of job cuts by airlines. Some US banks referred to problems in the oil sector when explaining their additional provisions. These scars are deep – and so is the rise in unemployment, with knock-on effects on credit card debt, car loans and mortgages. A further layer of uncertainty for the commercial property sector is: how many businesses will downsize or cancel moves to bigger premises now that they know they can operate with staff working from home?

As the influential author and bank watcher, Philip Augar, said in a discussion with the CSFI, “we are just at the beginning of this”.

Bearing in mind the falling dominoes scenario, the third impossible thing to believe is that banks have enough capital to absorb all potential losses. It is true that thanks to reforms enacted after the GFC, bank balance sheets are much stronger than they were in 2007-08 (a very low bar). At the four biggest UK banks, the percentage of common equity tier 1 (CET1) capital to risk-weighted assets (RWA) remains in the teens. It’s not quite so good at some of the big US and eurozone banks that reported in April, but what’s a percentage point or two? (a few billion $ or €). Why quibble when the Basel minimum is 4.5%, or 7% including the “capital conservation” buffer.

But add in buffers for systemic importance and the benign point in the economic cycle pre-Covid-19, and the big banks should indeed have entered the crisis with CET1:RWA percentages well into double figures. Look at the gross leverage ratio – equity to assets – and around 20x is common. This means that capital in the tens of billions could be wiped out by, say, a 5% loss in value on assets once worth a trillion.

The fourth impossible thing to believe is that the regulators will allow the accounting to play out in all its well-meaning transparency. Banks are highly cyclical companies – a recession spells heavy losses. If expectations prove to be too negative, provisions can be written back later. This reflection of “underlying economic reality” is better than the ancient approach of “cookie jar” reserving, which top-sliced profits in the good times and hid the extent of losses in the bad.

A smoothed performance profile is not credible for leveraged cyclical companies. But by ordering forbearance – another familiar old-fashioned word for bank watchers – and conservation of capital (witness buyback, dividend and bonus cuts), central banks are suppressing the impact of Covid-19 on bank balance sheets in the same way as the lockdown has suppressed the spread of the disease. Buying time is the watch-phrase.

The fifth impossibility is that bank lending to the “real economy” is being done on rational commercial terms. The bad are being given breathing space along with the good. Bank profits and dividends are being sacrificed as part of the communal effort. Read the press release of Barclays, Lloyds and others: the emphasis is on support for customers, colleagues and communities, not on return on equity.

In the US, a consoling thought is that the big banks had been making very healthy profits – JP Morgan notched up $36.4bn net last year, giving considerable headroom to ratchet up provisions. Eurozone banks went into the crisis with returns on equity averaging around 5%, less than half the US achievement. Few European entities have strong enough investment banking activities to provide much offset to loan losses – although Barclays, UBS and Credit Suisse stood out on this front in Q1. (By the way, investment banks should be saying a prayer to the late Paul Volcker for bequeathing the ‘rule’ that reined in proprietary trading – saving massive mark-to-market losses on highly risky holdings this time around.)

And the final impossible thing to believe is that banks will not be too big to fail. Even though this crisis is not of the banks’ making, they are already accepting a loss of autonomy as a condition of receiving central bank support. If they need to be recapitalised and private sector investors remain wary, governments may once again take equity stakes (some still prevail, witness RBS).

But then, I’m in journalistic mode, focusing on potential bad news. Is it just as impossible to believe that the recession will blow over once the lockdown lifts and pent-up demand is unleashed? Or that jobs will be created in technology, healthcare and pharma, home entertainment, renewable energy and things I cannot imagine to replace the ones lost? Or that banks (and shadow banks) will step up permanently to focus on helping customers to solve their debt problems, raise equity or savings levels, and manage their finances and risks better?

The White Queen, who taught Alice about belief in impossible things, had another immortal phrase for our unprecedented times: "It's a poor sort of memory that only works backwards."

CSFI

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