The large global banks with European and North American origin have entered the COVID-19 pandemic in better conditions since the last major financial market event given the decade long clean-up from the fall-out of the Global Financial Crisis (GFC). The banks’ capitalisation, funding and liquidity positions, as well as asset quality have been the strongest since the GFC. However, earnings were challenged especially for those banks based in jurisdictions with prolonged low and negative interest rates and less diversified business models. Nevertheless, we believe most banks are expected to remain profitable in 2020 – albeit at lower level than we had previously forecasted and despite large provisions for expected credit losses in preparation of the expected asset quality deterioration once fiscal stimulus and bank-specific support measures will be withdrawn.
Risks of a stimulus-fuelled recovery
The banks’ key challenges are driven by the duration of this pandemic and the recovery process, which are likely to hurt asset quality, earnings and capital. Fiscal and monetary stimulus, introductions of moratoria and global regulators’ substantial flexibility to adjust to a fast-changing situation through regulatory forbearance measures, which include – but are not limited to – reduced capital buffer requirements and the classification of deferred loans as arrears, have mitigated the degree of economic destruction. These measures will allow banks to absorb credit risk migration within their loan books while continuing to lend to businesses and households to support the economic recovery. However, we believe the unnecessary extension of looser regulation or even a final removal of the improved standards since the GFC could fuel risks that may eventuate over the next years and could lead to negative rating actions, although we expect banks’ management teams to be mindful of the rating implications. We believe that current strong capital levels of the largest European and North American banks could weaken once we see actual credit losses to materialise. Though, most banks will be able to rebuild their capital – even under the previously stricter regulatory rules – ensuring the banks remain consistently strong through the economic cycle. Hence, we believe negative rating actions on the banks are likely to be limited.
The pandemic is likely to provide some opportunities for the stronger banks. We believe in a low interest rate and credit growth environment, stronger cost management is vital for banks to generate consistently strong pre-provision profits in order to absorb future credit impairment charges. Most likely, cost synergies would be achieved through consolidation, although other risks may arise at a time when management teams should be focused on their immediate strategy. Nevertheless, we expect transactions to be focused between players operating in the same country while cross-border acquisitions may remain challenging. In Europe, Spanish and Italian banks have started the process with potential mergers being announced in recent months although some talks have receded, indicating the substantial corporate culture differences even within one country. However, we expect more of these transactions in highly fragmented markets while banks in more concentrated, oligopolistic markets are expected to focus on technology and branch optimisations, and potentially consider diversifying their business models though the acquisition of complementary businesses.
Our 2021 Outlook
We believe 2021 is likely to be a challenging year for banks globally although there may be pockets of opportunities for banks with strong franchises and capital levels. Earnings are expected to be impacted by low rates and there potentially may be more credit impairment charges. Any release in these provisions is unlikely to occur before 2022 as management teams would want to have more clarity on the duration of the pandemic and the speed of economic recovery. We also believe banks will need to balance their earnings aspiration with their social and environmental responsibilities, especially in areas such as climate change and consumers’ financial wellbeing. We expect asset quality ratios to show signs of weakness once monetary and fiscal stimulus and support measures are withdrawn with expected timing differences in each country. Once asset quality deteriorates, currently strong capital ratios could weaken absorbing some of the currently strong capital buffers. However, we believe global banks under AMP Capital’s research coverage1 should continue to meet regulatory requirements. The banks’ liquidity and funding positions are expected to be significantly supported by central banks’ funding facilities and strong deposit growth, which has reduced reliance on capital markets funding with very subdue supply for investors.
AMP Capital sees value in global banks’ subordinated and hybrid papers
Our deep understanding of global banks is based on fundamental bottom-up analysis, which provides us with confidence to invest across a bank’s capital structure. We still expect to see good value in European banks’ Additional Tier-1 instruments as their credit spreads provide a fairer representation of the banks’ credit profiles. Although credit spreads have tightened substantially since the March 2020 sell-off, many of these notes have traded at wider levels compared to pre-pandemic levels, which is mostly not the case for higher ranking instruments.2 In addition, we believe the removal of capital buffer requirements over the short term should limit any risks for the banks to breach in their maximum distributable amount related CET1-trigger, which is crucial for coupon payments.
1. Research coverage includes fundamental bottom-up analysis of approximately 40 global banks.
Subscribe below to Market Watch to receive my latest articlesAndrea Jaehne | Senior Credit Analyst, Global Fixed Income
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