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Fiorino: in this pandemic, asset quality is key to banks' health

In this launch issue of Fiorino, our blog focused on deciphering complexity in global financials, we assess how banks are preparing for corporate defaults resulting from lockdowns across economies worldwide.

No default of their own

For now, the true scale of business and financial failure wrought by the coronavirus outbreak remains as unclear as the trajectory of the pandemic itself.

Yet banks are fully aware of one certainty: a large spike in loan losses lies ahead, with many already seeing the bleeding edge of debt defaults.

Asset quality, along with liquidity and capital, will be one of the key metrics that determine how banks – and which among them – come through the coronavirus crisis in good health.

In my view, asset quality will be the most influential metric for global financial institutions during the rest of the year. This is due to:

  • Loss of output from many industry sectors, the pace at which economies are reopened and whether the conronavirus is contained
  • The effects of accommodative actions by governments, central banks and, indeed, commercial banks themselves
  • New ‘life-of-loan’ accounting principles implemented by banks – which consider past events, current conditions and forecasts – and the provisions they have accrued

Without a doubt, all banks will have to increase loan loss provisions (LLP) in the days, weeks, months or even years ahead.

Rough guide to rough times

How bad could it get? History, as always, provides a useful, if rough, guide.

The financial crisis offers the most recent benchmark of bad-times bad-loan trends. At its height, European banks’ LLPs hit 1.7% of the total loan book, compared to about 0.7% at the tail-end of the dotcom recession in 2002. Over the same period, US banks’ LLPs rose to almost 3.5% relative to 1.2% in 2002.

By a longer historical yardstick, LLPs typically ranged between 1% to 1.3% of loan books during ‘normal’ recessions.

Each recession, of course, will impact various sectors of the economy in different measure, depending on the unique features of the times. Initially at least, the COVID-19 crisis has put the hospitality and transportation industries under extreme pressure – in addition to the already troubled oil and gas sector.

The late 2019 slump in oil markets highlighted a number of US and European banks heavily exposed to oil and gas sector debt, which has tumbled further as the coronavirus shutdown snuffs out demand for oil.

Key questions with answers at bay

Investors in banks will need to analyse the exposure of each institution to at-risk sectors in order to determine whether the write-downs will represent a capital event (and hence a need to raise fresh equity) or an earnings event, where profitability may disappear for a number of quarters.

A couple of key questions arise when considering the impact on banks’ loan books amid the pandemic, namely:

  • How will the various moratoria on interest payments and loan guarantee schemes play out in practice?
  • What is the small-to-medium enterprise default rate likely to be?

While some of those asset-quality answers are beginning to materialise, much still lies under a cloud of economic uncertainty, ongoing policymaker intervention and a global health crisis yet to be contained.

US reporting season: downside dialogue

If there was a single asset-quality takeaway from the recent US reporting season, it is that investors are likely guessing about how high LLPs can go.

In general, the Chief Financial Officers of both multinational and regional banks are acting cautiously, placing more stock in the prospects for a U-shaped rather than V-shaped recovery. For example:

  • CIT Group, whose debt we hold in our portfolios, confirmed its Q1 2020 LLP was $513m, which is three-times the sum it set aside for all of 2018.
  • JP Morgan, the largest and most-covered bank, has an estimated LLP range of 4.1%-1.9% of total loans for 2020 – equating to a cool $40-19bn.

The banks even expressed a willingness to dip into their capital conservation buffers – wedges of common equity tier 1 capital – if LLPs are depleted. These shock absorbers are large, currently exceeding 1% across the board.

Even if investors can’t gain clarity about the precise amounts of loss provisions being set amid the pandemic, these are indications that banks are taking the downside risks seriously.

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