Financial Services risk:
The Covid-19 lanscape

"This is in large part the result of a somewhat “Faustian Pact,” says Ludovic Subran, Chief Economist at Allianz. Policymakers have taken swift action to sweeten the deal for banks to ensure that they continue to provide an emergency liquidity lifeline to the private sector, despite rising credit risk. The measures range from central banks showering banks with new funding options and supervisors easing capital as well as liquidity requirements to national governments extending generous public guarantees to reduce direct exposure.

“Unprecedented policy support, however, may not be enough to shield European banks in particular. Amid the sharp economic downturn and the expected gradual recovery, non-performing loans (NPLs) are bound to increase notably. Are they prepared for the hit?” says Subran.

Although capital ratios improved across the board in recent years, doubts remain as most banking sectors were already quite vulnerable before the onset of Covid-19, the result of more risk-taking in a decade-long historically low interest rate environment. Analysis by Allianz Research revealed various pockets of vulnerabilities that have emerged over the past few years in the Eurozone banking sectors in particular. The French and Italian banking sector, for example, had the largest total amounts of NPLs in Europe. Turning to the NPL ratio, it was higher than the European Banking Authority indicative benchmark of 5% in Italy and Portugal.

Regarding the provisioning of NPLs, Dutch and British banks happened to have the weakest coverage of NPLs, exposing their banking systems to a sudden deterioration of asset quality. On the other hand, German banks were by far the worst performer in terms of profitability and cost efficiency, despite the consolidation efforts of the sector. Return on equity (RoE) was also weak in Portugal, while Belgium stood out with weak cost efficiency. Finally, banks in Portugal and Spain had the largest credit exposure to those sectors that are hit hardest by Covid-19, including accommodation and food service and art, entertainment and recreation. “A deterioration of asset quality after Covid-19 seems inevitable,” says Subran. “It could easily impede banks’ willingness and ability to lend to the economy, which in turn risks delaying the start of the new investment cycle.”

EU banks’ profitability (RoE) tanked in the 12 months leading up to June 2020 dropping to 0.5% down from 7.0% as a result of a sharp rise in impairment costs. With structural headwinds firmly in place – in the context of a protracted low interest rate environment – revenues will remain under pressure in the coming years.

“To get Europe’s banks back on a solid footing, it is high time to address the sector’s underlying weaknesses by embracing efficiency and digitalization and pushing ahead with sector consolidation,” says Subran. “In other words: ‘The Faustian Pact’ of the pandemic has to be turned into something more sustainable. If, for example, Eurozone governments would double their efforts to complete the Capital Market Union as well as the Banking Union, it would go a long way to create a market environment for European banks in which they could strive and exploit economies of scale.”

So far, these income effects have resulted in the “transfer” of billions of euros from private households to the state and corporate sector. The intermediating banks, too, have suffered in the process. As financial companies, mainly banks, boast both an asset-overhang and a positive interest rate differential they are the only sector with a positive net interest income. But since the financial crisis, it is in continuous decline, falling by €120bn to €450bn p.a. between 2008 to 2019 in the Eurozone. Cumulated changes amount to €865bn (8% of 2019 GDP). As assets outgrew liabilities, albeit by a relative small margin (2.8% p.a. vs. 2.2% p.a.), the main culprit was narrowing interest margins: while rates on received interest dropped by 294bp, rates on paid interest by “only” 270bp. The former might be attributable to the fact that banks piled into low-yielding assets such as sovereign bonds in recent years; the latter reflect the fact that banks usually enjoy the lowest rates of all sectors on their liabilities – the chunk of them being bank deposits – limiting the extent to which they can fall.

Covid-19 might have stopped the slide temporarily. When it hit the economy in 2020, banks provided the real economy with plenty of loans, satisfying corporates’ hunger for cash. This was made possible by governments’ generous support schemes and liquidity injections by central banks. The latter alone amounted to €1.8trn in 2020. “From now on, however, the going will get (much) tougher. The outlook for loan growth and losses is less than rosy,” says Ludovic Subran, Chief Economist at Allianz.

So far, guarantees and moratoria precluded the normal process that economic recessions lead to higher credit losses and non-performing loans. Support measures kept insolvencies artificially lower: defying economic logic, corporate insolvencies even declined by around 10% globally in 2020. In some European countries, the drop was even much larger. “This scale of ‘insolvency freezing’ indicates the possible backlash: For most European countries, double-digit increases in insolvencies are on the cards for this or next year when these measures are gradually phased out,” says Subran.

The stakes are high: by the end of August 2020, guaranteed loans and loans under moratoria accounted for 7% and 15% respectively of the total stock of euro area corporate loans. “With interest rates staying at rock bottom for the foreseeable future, the expected increase in credit losses, and tightening credit standards, it will become much harder for banks to compensate lower margins by higher lending volumes,” says Subran. “The decade-long slide in interest income could even accelerate after the short, pandemic-related reprieve.”

In future, this continued decline in revenues might weigh even more heavily on banks as other businesses become more contested, too. “Covid-19 ushered in not only a new era of zero interest rates it also turbo-charged digitization in general and digital payments in particular. The cash-less society is no longer a wild dream. Even central banks have started to think seriously about introducing e-money,” says Subran.

At this juncture, it is not clear which players might benefit the most from the cash-less economy. But competition in the business of payments will heat up, threatening banks to lose an important interface with clients, as they enter the race with a big handicap: Against the backdrop of structurally low profitability of the European banking sector, plagued by overcapacity, cost-cutting efforts could make it more difficult for banks to meet their digital transformation needs. 

“Ironically, the onset of Covid-19 was a boon for banks’ loan business, engineered by the massive interventions of governments and central banks. But this blessing in disguise is not meant to last. The aftermath of the pandemic will reveal the weak points of the sector with renewed brutality,” says Subran