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Coronavirus Shock Likely to Reduce Some Banks' Capital, Increase Credit Vulnerabilities

Reviews & Outlooks	1409 VIEWS
Reviews & Outlooks
1409 VIEWS

Sunday, May 10, 2020 / 12:24 PM / Moody's Investors Service / Header Image Credit: Financial Times

The rapid global spread of the coronavirus has led to a deteriorating economic outlook, sharply lower oil prices and broad financial market upheaval, generating an unprecedented credit shock across many sectors worldwide. Our current baseline economic scenario assumes pandemic-driven disruption of economic activity through the second quarter of 2020 will be followed by some modest recovery in the second half of 2020. However, the potential for a prolonged downturn is increasing.

The shock has not led to immediate or wholesale changes in the underlying credit strength of banks, as represented by their Baseline Credit Assessments. However, the credit strength of many banks will become increasingly vulnerable to the extent that the economic shock broadens and lengthens. The current deterioration in profitability coupled with further weakening of asset quality will likely lead to weakening capital for at least some banks. Thus, when comparing a bank to its peers, the level of capital with which the bank entered this recession and its ability to retain capital throughout the next several years take on particular importance.

Under these conditions, we expect to continue to place more banks on negative outlook. Changes in ratings would most likely be triggered at the point where our forward view is that capital will materially deteriorate without a return to pre-crisis levels within two to three years.

Banks' strong capital and liquidity entering the crisis have limited the immediate erosion of their underlying credit strength and ratings

Our assessment of bank credit is properly grounded in a forward view of solvency and liquidity. For solvency, gross risk is the risk of a loss of value in the bankâ€™s assets and potential mitigants include capital and profit generation. For liquidity, gross risk is the risk of a loss of funding and potential mitigants include access to cash and liquid asset reserves, including routine central bank facilities.

Banks entered this crisis with much stronger capital positions than ahead of the last global crisis in 2007-08. However, the strains on households and corporates will likely lead to a steep increase in loan loss provisioning, if this is not already happened. For some banks this will expose profitability as a weak spot in their solvency profiles, and their limited means to absorb losses via the income statement means that sustained pressure on asset quality will raise the risk to their capital, although with some variation in degree of severity globally.

Similarly, banks entered this crisis with much stronger liquidity than in 2007-08. And unlike a decade ago, the funding pressure on most banks has been limited, benefitting from prompt monetary easing and liquidity initiatives by central banks globally. Some cash outflows have been triggered by corporates drawing down extensively on bank borrowing lines, but in many cases these funds are then placed back on deposit. Therefore, aggregate deposit increases are broadly matching lending in many systems, leading to more liquid resources for at least the near term until these deposits may be needed.

Since the outbreak of the crisis, we have changed deposit ratings for only a very modest 5% of our rated universe, or 49 banks out of almost 1,1002 . Of those, 22% have been investment grade. As we have previously commented3 , for most banks where we expect the impact to be less severe or more short-lived, reviews for downgrade or negative outlooks are more likely than immediate downgrades. Since the outbreak of the crisis, 12% of deposit ratings, or 126 banks of almost 1,100 in our rated universe, have been assigned a negative outlook or been placed on review for downgrade. Of those, 48% have been investment grade. For a number of banks with speculative-grade deposit ratings, the primary driver of the negative change, either in outlook or rating level, was a reduction in our assessment of the government support providerâ€™s capacity to provide support to banks within its system.

Prolonged, broader downturn could lead to material and sustained erosion of capital, and possibly rating changes

In the current coronavirus-induced recession and its aftermath, capital levels will be a key differentiator of credit profiles among banks. Generally, banks are facing a sharp deterioration in asset quality and reductions in profitability from already low levels, while central banks are providing extraordinary levels of liquidity and governments have strong incentives to support banking systems to foster an eventual recovery. Thus, when comparing a bank to its peers, the level of capital with which it entered this recession and its ability to retain capital throughout the next several years take on particular importance.

While the coronavirus credit shock has not led to immediate or wholesale changes in the ratings of banks so far, the credit profiles of many will become increasingly vulnerable to the extent that the economic shock broadens and lengthens. Under these conditions, we expect to continue to place more banks on negative outlook. Changes in ratings would most likely be triggered at the point where our forward view is that capital will materially deteriorate without a return to pre-crisis levels within two to three years. Conversely, we would not expect to take any negative rating actions when we are highly confident that capital levels will broadly return to pre-crisis levels within two to three years.

A prolonged downturn as a result of the crisis would make the likelihood of a swift rebound in asset quality less likely. Such a scenario might prompt an extension of government support measures for corporates; however, this may only delay recognition of problem loans rather than prevent an ultimate rise in nonperforming loans (NPLs) as the economy emerges from the crisis. Alternatively, governments may find it difficult to time the withdrawal of support measures to match the pace of economic recovery, triggering an earlier recognition of NPLs. Regardless, our forward view of capital will be informed by both the degree and sustainment of increases in NPLs and declines in pre-provision income, which together drive changes in capital levels.

New accounting rules have led to earlier recognition of loan loss provisions than under the accounting rules in place around the 2007-08 global crisis. The extent to which those provisions will become credit losses is subject to great uncertainty and, while typically a lagging indicator, will likely be an important consideration in any rating change.

Pre-provision profitability will also be strained by lower interest rates, though the drop in interest income will be partly mitigated by lower funding costs and expense management. In particular, certain banking systems struggled to generate sufficient profitability before the onset of the crisis. For banks in these systems, where we believe profitability challenges are more structural than cyclical, ratings may still be lowered despite sustained levels of pre-crisis capital.

Our analysis will also consider managementâ€™s own plans to achieve capital targets, which could include capital raises, as well as temporary relaxation of regulatory standards for liquidity and capital ratios. We will also incorporate the effects of government aid programs, which can support the broader economy and reduce credit risks at financial institutions by stimulating aggregate demand and employment through loan guarantees and direct funding to borrowers, thereby providing further time for banks to recover

As mentioned, banksâ€™ pre-crisis liquidity has been inherently strong, and it has remained so in recent weeks. Because of this strong starting point, as well as substantial external liquidity support, we do not anticipate broad confidence issues in banking systems. Nonetheless, any evidence of deteriorating liquidity, such as an idiosyncratic loss of market access or deposits from a â€œflight-to-qualityâ€ within a banking system, could lead to a rating downgrade.

Ratings are forward-looking opinions of relative credit risk and, accordingly, we expect to remain measured in any changes to ratings given the global nature of this shock. However, the pace of change may be greater in developing markets than developed markets, consistent with our view that developing markets tend to have lower credit quality and weaker, less stable solvency and liquidity profiles.

Changes in government support could also lead to rating changes

Certain banks, particularly in developing markets in Asia, Africa and Latin America, benefit from a level of government support. Though the banks' intrinsic credit profiles may properly reflect coronavirus-related pressures, the ratings for those banks could still deteriorate if the sovereignâ€™s capacity to provide support weakens.

At the same time, in both the developing and developed world, we will also consider where government actions may in effect temporarily increase their willingness to provide support to banks given their strategic importance as a way to broadly support the economy, mitigating downward rating pressure.