Rating agencies predict pain for EU banks

By Selwyn Parker

14 December 2020

Thanks to beefed-up, post-financial crisis reserves and generous government support, the European banking industry has proved resilient so far throughout the pandemic-triggered economic wreckage.

But a bout of consolidation probably lies ahead, in part because of competition from fintech for lower-cost digital distribution channels.

That’s the view of rating agency Scope in its 2021 European Banking Outlook following what it calls the “first real-life stress test” since the bank crash of 2008.

“There has been no banking crisis as supportive fiscal, monetary and supervisory policies have neutralised credit, funding and solvency risk,” notes Scope’s Dierk Brandenburg, head of the financial institutions team for the Outlook. “Strong sector fundamentals will be key in avoiding worst-case scenarios.”

Although the quality of loans will deteriorate, most banks will be able to absorb high credit costs because of their pre-provision profits, he believes.

Looking further ahead though, Scope foresees a round of cost-cutting and M&A, the latter driven by a forced rethink of distribution. “Covid-19 accelerated the move to digital channels, raising the cost of carrying obsolete distribution networks,” the agency explains. “This is especially true in systems characterised by a high number of bank branches such as Germany, France, Spain and Italy.

Overall, Scope expects domestic deals will dominate M&A activity. The agency warns however that it may be prudent of banks to invest heavily in digitisation so as to “conquer customers through better products and competitive prices rather than by acquiring outdated distribution networks.”

Elsewhere, the medium-term outlook for the banking industry is hardly encouraging. “As the pandemic rolls on, banks must prepare for a long winter,” warns McKinsey in its latest annual review of the global industry, citing a double whammy of severe credit losses right through until late 2021 followed by a “muted global recovery” that may last past 2024.

“Depending on the scenario, from $1.5trn to $4.7trn in cumulative revenue could be forgone between 2020 and 2024,” the consultancy warns. So far, global banks have provisioned $1.15trn for loan losses through the third quarter of 2020, which is a lot more than they did through all of 2019, McKinsey points out.

As in Europe, banks have not yet had to take heavy hits in the form of write-offs, mainly because of forbearance programmes and government support. But that will change: “we project that in the base-case scenario, loan-loss provision in coming years will exceed those of the Great Recession.”

Meantime Fitch predicts that banks in Latin America will probably be hit hardest and longest by the pandemic. “The economic fallout from coronavirus will continue to weigh heavily on LatAm banks’ financial performance in 2021,” predicts Fitch in an early December report. “The majority remain on a negative rating outlook, in line with the region’s sovereign rating outlooks and our expectations for sustained pressure on operating environments.”

Although the largest banks in, for instance, Brazil and Mexico, should not suffer unduly from problems of capitalisation and liquidity in 2021, they are unlikely to escape unscathed either. “Asset quality is likely to deteriorate further while profitability will remain low relative to historical trends as lending and revenue generation will be anaemic,” the agency believes.

Further, predicts Fitch, there remains the very real risk of an extended resurgence of the pandemic. “[This] would derail LatAm’s recovery and weaken bank financial metrics relative to historical trends and rating benchmarks,” the agency warns. Overall, Fitch’s outlook for LatAm banks in 2021 is worsening because of an expected “tepid economic recovery.”

Meantime in other developed markets the main institutions still face challenges, for instance from long-running ultra-low interest rates. According to another early December release by Fitch, rock-bottom rates are likely to persist after the coronavirus has passed because of economic weakness squeezing net interest margins.

Larger banks should fare better because they can fall back on a more diversified mix of revenues to compensate for lower net interest margins. “The profitability of large diversified banks is partly shielded by fee-based revenue from capital markets activity, which is less affected by interest rates,” Fitch reports. “However smaller, less diversified banks may struggle to remain profitable without taking extra risks, such as lending to riskier segments or over a longer duration.”

And like Scope, Fitch concludes that the resulting pressure on profitability could trigger cost-cutting and consolidation.

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