Developed market banks ‘can withstand higher defaults’ - World -
defaults up

Global systemically important banks (G-SIBs) can afford core capital ratios to fall by 5 percentage points before eating into capital buffers, according to Capital Economics.

Despite the fallout from Covid-19, developed market banks should be able to withstand higher defaults next year, according to consultancy Capital Economics.

The balance sheets of developed market banks have remained in reasonably good shape this year and credit losses have stayed low, but as governments pull back policy support defaults are likely to rise next year.

Capital Economics analysed the finances of 195 developed market banks – in the US, Japan and western Europe – with more than $10bn of risk-weighted assets that reported results in the third quarter of 2020.

“Despite advanced economies suffering the worst recession in 75 years, banks are in general better capitalised now than they were before the virus,” wrote senior global economist Simon MacAdam in a report published on December 3.

According to Capital Economics, about two thirds of developed market banks were better capitalised in the third quarter this year than in the fourth quarter 2019.

The balance sheets of a “thin tail of banks” have taken a significant blow this year, but these do not include any systemically important institutions, Mr MacAdam wrote.

“No bank that accounts for more than 1% of either US, European, or Japanese risk-weighted system assets has seen their core capital ratio fall by 1%-point or more,” he added.

“Even where the crisis has eroded bank capital, the hit mainly came in the first half of 2020, with capital ratios in the third quarter generally on the up, including some especially solid rises at Japanese banks.”

Retained earnings recovery

Balance sheets have been primarily shored-up by a recovery in retained earnings, according to the report.

Banks front-loaded bad news about expected credit losses in the first half of the year, laying the ground for a steep drop-off in loan loss provisions in the third quarter of 2020.

"Limits on shareholder pay-outs helped conserve capital too. Dividends were banned in Europe and capped in the US, so more profits were booked on the balance sheet. And a ban on share buy-backs brought an abrupt halt to the trend rise in treasury stock holdings, providing additional relief for core capital,” Mr MacAdam wrote.

While banks have been given a clean bill of health in the third quarter, they are not out of the woods yet, Mr MacAdam warned.

“In the near term, surveys report that banks are tightening lending standards, particularly on loans to firms, citing uncertainty about borrowers’ creditworthiness. This raises the risk of liquidity lifelines that are keeping firms afloat being withdrawn,” he wrote.

“Further ahead, when economic conditions allow, unprecedented policy support – which has so far obscured the underlying health of banks’ credit exposures – will be reined in. This will bring unviable borrowers into sharper focus and cause many to finally face their day of reckoning.”

As a result, losses will crystalise as governments step back – a process that has begun to unfold in China, he said.

Subdued default risk

There are, however, a number of reasons why defaults are unlikely to deal a big blow to banks in developed markets, according to Capital Economics.

“As economies weaken over winter, policy will remain accommodative,” Mr MacAdam wrote.

“The ECB [European Central Bank] is likely to beef up its PEPP [Pandemic Emergency Purchase Programme] and TLTRO [Targeted Longer-term Refinancing Operations] programmes at its December meeting, which will be welcomed by banks and keep borrowing costs low. Meanwhile, loan guarantee schemes are being extended beyond the end of this year and will probably be extended further into 2021 where deemed necessary.”

Even if defaults rise by more than banks expect, most have a lot of scope to absorb additional losses

Simon MacAdam, Capital Economics

In addition, the banks are well covered for future defaults, according to the report.

“They have been forward-looking in provisioning for losses while loan write-downs have stayed near record lows, leaving loan loss reserves largely untapped,” Mr MacAdam wrote.

Another positive is that the approval and distribution of Covid-19 vaccines will inject life into businesses that are near the brink, reducing financial stress for debtors.

“The vaccine news effectively brings forward the time by which economies can normalise. This will reduce the scope for borrowers’ cash-flow strains to snowball into insolvencies, and possibly more so than banks had assumed when they provisioned for losses in the first half of 2020. This is especially true of vulnerable industries like tourism, for which the summer holiday season may now have been saved,” Mr MacAdam wrote.

“Even if defaults rise by more than banks expect, most have a lot of scope to absorb additional losses.”

Surplus core capital

Global systemically important banks (G-SIBs) can, on average, afford for core capital ratios to fall by 5 percentage points before eating into capital buffers, with the weakest G-SIB still 3 percentage points clear of the regulatory target ratio, according to Capital Economics.

“European and big Japanese banks have ample surplus core capital,” Mr MacAdam wrote. “The weakest link among developed markets is Japan’s small banks, but we do not believe they pose a serious problem.”

The scale of damage inflicted by Covid-19 on private sector balance sheets will not be clear for some time, but according to Capital Economics, the risk of a massive bout of credit losses inducing a banking crisis remains low.

“The bigger challenge for developed market banks in the years ahead is an extended period of rock-bottom interest rates,” Mr MacAdam added.

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