Executive Summary

The unique nature of the COVID-19 crisis and its impact on the banking sector calls for an innovative response that balances the needs of the general populace, customers, and shareholders. That being said, while all parties have a vested interest in seeing strong economic recovery through the resolution of distressed loan situations and the continuation of the provision of credit, the desired means through which these ambitions are achieved will inevitably lead to divergent trains of thought.

Therefore, in order to be an ultimately successful one, the response to this issue is one that necessitates a holistic approach that will minimise potential conflicts, as well as the total cost to the general populace.

To achieve this result, it is essential that:  

– Viable companies are allowed to survive and continue employing staff,

– The capacity of banks to continue lending and stimulate economic growth is maintained, and

– State support is allocated efficiently to maximise its impact.

To do so requires a variation to the so-called “bad bank” resolution structures that have been used previously to resolve banking crises, an alternative we have dubbed: the “Good Bad Bank”. Sensible structuring of state bad bank arrangements (particularly transfer mechanisms) can avoid excessive “bailing out” of banks while being more cost effective for society than allowing significant business failures and an ossification of the banking sector.

Background

The financial impact on the banking sector of COVID-19 differs from other crises as it is a broad-based global shock simultaneously impacting consumer demand, production, and supply chains.

Some of the characteristics which make this crisis unique are:

– Very broad-based (very few businesses have had a good crisis – even Amazon has found increased costs are offsetting gains),

– Sudden and complete shut-down (compared to a normal crisis where a progressive slow-down in demand allows firms time to adjust),

– Little or no time to prepare (either staff or stock levels),

– Efforts to re-open will be staggered and confusing,

– Extremely rapid rise in unemployment (over period of days not months),

– Likely ongoing (12-24 month) hit to consumer confidence.

Also of great significance: we are entering into this systemic crisis at a time when global economic growth was already slowing, and when national economies and banks are arguably in a weaker position than at the start of the global financial crisis of 2008.

For example:

– Growth is weaker than pre-2008 crisis, e.g. EEA GDP growth 1.2% in 2019 compared to 3% in 2007.

– Growth is slow despite persistent government stimulus to spur economic activity, which has led to high government debt: Euro Area government debt is currently at 88% of GDP, compared to 65% in 2007 before the last major crisis.

– Countries with the weakest banking sectors also have the worst performing economies. For example, Italy has had years of low growth (0.2% in 2019), high government debt (135% end-2018 vs 104% of GDP in 2007), high unemployment (>10% vs 6% end-2017) and a high budget deficit (-2.2% of GDP).

And, while governments and regulators in many countries have intervened by introducing key emergency measures (e.g. subsidies, bank forbearance/moratorium, liquidity support, etc…), when factoring in the reality that most did so rapidly and without an attached framework in place to aid in efforts of normalisation once the worse of the crisis passes, it is reasonable to suggest that the starting point for government support is weaker when compared to their capacity to do so in 2008.

Conversely, many banks are better capitalised than prior to the 2008 crisis, although problems persist in some countries.

For example:

– Many banks are still burdened by legacy non-performing loan (NPL) books from the last crisis (>€600 billion across EU markets), particularly in southern and south-eastern Europe, e.g. Italy at 7% officially acknowledged average NPL ratio, Cyprus at 20% and Greece at 35%. This is very different to 2008 when banks entered the crisis with historically low NPL ratios.

– Many European banks also retain significant indirect exposure to legacy NPLs, whether through financing provided on NPL sales or retained risk on certain NPL securitisations.

– The quality of bank loan books is not as high as might be expected. For example, the covenant-light leveraged loan market reached record volumes in 2019, and loan-to-value ratios on real estate lending were driven by valuations at rent levels in many cases at or close to historical highs and yields which were at unprecedented lows – similar to the market in 2007.

– The low quality of bank assets is apparent in Europe’s banks, having been trading consistently at an average of 50% price-to-book in recent years.

– Central banks have announced several initiatives to provide capital relief to banks (e.g. suspending countercyclical capital buffers) in order to encourage continued lending to the economy during the current crises.

– However, banks’ stronger capital positions and the recent regulatory accommodation need to be considered in light of the following:

– The latest EBA adverse scenario stress test in 2018, which modelled a cumulative fall in GDP over 3 years of 2.7%, unemployment reaching 9.7% in 2020, and a cumulative fall in residential and commercial real estate prices over 3 years of 19.1% and 20% respectively, resulted in a decrease in capital from c. 14% at the time to c. 10% for European’s largest banks. In our view it is likely the current crises will push all of these metrics, and the resulting decrease in banks’ capital, well beyond the EBA adverse scenario.

– Despite the accommodative stance taken by regulators, banks are likely to limit their support to the economy as they seek to assure market counterparties, bondholders and shareholders that they will not impair their capital positions.

– Legacy NPLs continues to weigh down the broader system. Of the ~€450 billion of NPLs which have left the balance sheets of European banks since the crisis, a very large proportion currently remain unresolved, sitting instead with alternative capital providers. These unresolved loans represent a continued drag on general economic performance.

The Issue

COVID-19 and the associated public health measures represent a massive and sudden exogenous shock to the real economy, and unlike previous crises this is not a cyclical downturn, deleveraging event, or the self-correction of market exuberance. But it has, depending on the market:

– Derailed a process of gradual economic re-equilibration and long-term growth, and / or

– Accelerated and exacerbated a pending correction in asset prices caused by excess liquidity.

The reflex (and correct) policy response from governments and central banks is a proactive approach to attempt to freeze economies to December 2019 levels of employment, productivity, and growth terms.  Therefore, social and public policy has focused on measures to support economic growth via:

– Maintaining employment,

– Supporting businesses to stabilise & revive,

– Maintaining communities and the provision of services, and

– Promoting consumer and business confidence and spending.

Banks have a critical role in facilitating these objectives through:

– Providing the channels through which government credit support schemes can be executed,

– Maintaining active general lending in an otherwise stalled economy,

– Managing distressed loans, via forbearance and moratoriums, in a manner that is, for the near term, aligned with public policy objectives:

Maintenance of employment,

Provision of services,

Protection of recoverable businesses.

However, over the longer-term, prudent bank management practices are likely to be misaligned with public policy objectives. As economies emerge from the crisis phase banks will:

– Defensively create capital buffers,

– Restrict lending in an uncertain economy,

– Focus on distressed loan management, implementing risk-adjusted recovery maximisation without a focus on externalities such as employment and other government objectives.

The Response – The “Good Bad Bank”

In order to resolve this crisis in an effective manner, what is needed is a government “Good Bad Bank” to assist private sector banks in resolving NPLs in a manner that is consistent with both private sector shareholder goals, as well as the government policy aims of maintaining a strong economy and maximising employment. 

The rapid implementation of a public sector bad bank structure will ensure effective public policy transmission and avoid one of the pitfalls from the 2008 crisis when new credit creation stalled, resulting in a prolongation of the downturn. To be most effective there should be a clear pathway from the current temporary crisis measures to a resolution framework, so that borrowers do not give up hope or lenders act precipitously, resulting in otherwise preventable insolvencies.

However, as outlined above, the actions of prudent banks (particularly if capital is stressed) will prioritise the interests of shareholders, and without intervention, will likely conflict with and impede public policy objectives.

Stressed Banks Management Actions		Public Policy Target Behaviour
Build up capital buffers (reduce RWA) Reduce lending in uncertain environment Focus on legacy recovery activities not new lending Rapid resolution of NPL to cash maximisation Prisoners dilemma of foreclosing quickly rather than risk further deterioration- no focus on multiplier effects		Actively advance new credit Use prudential capital buffers to support new lending Focus on providing stimulus funding Fully evaluate externalities in lending Gentle management of NPLs to preserve employment, businesses and communitiesIncrease risk appetite in uncertain environment

Separating banking sector assets between:

– “Social policy bad bank” assets where an ongoing degree of management and forbearance is required to support the wider social benefits generated by those assets (employment, housing, etc), and

– Normal economic assets that remain in the banking system

Will permit the wider public policy objectives of both strong banks to support economic growth while minimising the fallout from the current crisis.

Bad Banks		Good Banks
Mission to consider externalities – not profit driven but a holistic approach to value Support potentially viable business on long road to recovery Consider employment implications of actions Consider impact on communities Corporate mission to support societies		Elimination of legacy book frees up capital Elimination of NPL income creates new lending pressure Efficient mechanism to implement government-supported credit programmes Management focus on new business, not on legacy

Ultimately, it is in the interests of governments, customers, and bank shareholders to support economic recovery in the most efficient manner possible. And this, we believe, requires the  implementation of a “Good Bad Bank” structure that will work with both banks and customers to ensure a smooth transition from the current regime of government-sponsored COVID-19 measures, to a post-crisis, economically viable system that stabilises employment through the continuation of viable businesses.

David McDiarmid: david.mcdiarmid@res-am.com

Richard Henshall: richard.henshall@res-am.com