Loan-loss provisions in the spotlight at European banks

In Barclays’ 123-year history, the British bank has never faced the prospect of so many loans going bad at the same time.

As the coronavirus lockdown wreaks havoc on global economies, one number will take centre stage when British and European banks start reporting first-quarter results this week: loan-loss provisions. 

Investors are expecting these charges to surge to, and even beyond, levels not seen since the financial crisis, piling pressure on lenders’ already fragile business models.

Analysts estimated loan-loss provisions could quadruple or more in the first three months of the year, while bank profits could fall by 50 per cent on average over the whole of 2020. Ominously, they warned the worst is yet to come.

“The headline provision number will dominate and rightly so,” said Jonathan Pierce, an analyst at Numis. For UK banks, £1bn-£1.5bn for each bank on top of normal charges for the first quarter “is not out of the question”.

Line chart of Provision charge as % of loans showing Loan loss estimates have increased in Europe and the US

At Barclays, which booked £448m in impairment charges in the same period last year, “the charge we assume this year is double anything seen since its incorporation in 1896”, he added. 

The pressure is compounded by a new dynamic: “forecasting provisions will be no more than guesswork”, said Mr Pierce. This reflects both the unprecedented nature of the health crisis — with the duration of lockdowns still unknown — and how new accounting rules that force banks to recognise possible impairments much earlier than in the past will be implemented. 

Economists are already predicting an economic fallout that will be the worst since the 1930s. Meanwhile regulators, fearful of banks suffering such heavy losses that it restricts their capacity to lend, are encouraging executives to moderate their estimates until the full repercussions are clearer.

A leading indicator can be seen on Wall Street. America’s six largest lenders increased their first-quarter loan provisions by a combined $25.4bn — a year-on-year rise of 350 per cent — mainly due to potential impairments in their credit card and commercial lending books. 

However, few expect European banks to be as conservative as their US rivals, in part because they are not profitable enough to shoulder the full potential losses upfront. 

“In general, the US tends to be quicker at front-loading losses than the Europeans,” said Philippe Bodereau, a portfolio manager at Pimco. “They charge off bad loans much more aggressively and have more effective bankruptcy rules. In Europe, they tend to smooth out the losses over a much longer period.”

Stuart Graham, founder of Autonomous research, added: “European banks won’t show a similar sharp increase . . . [because] regulatory messaging encourages banks against being trigger happy.”

Mr Graham estimated bad debt provisions could wipe another €25bn off eurozone banks’ predicted €65bn earnings for 2020. He had one key caveat: “Too many of our conversations involve the phrase ‘nobody has a clue’ right now.”

Already in Europe, UniCredit — the biggest bank in Italy, the eurozone’s most fragile banking market — has announced it will set aside an extra €900m to cover potential loan losses. Credit Suisse said last week that provisions for the first quarter surged 600 per cent year-on-year. On Sunday night, Deutsche Bank said it had taken €500m of provisions for credit losses during the first quarter, up from €140m in the same quarter of 2019.

European banks enter this crisis in a far weaker position than their American counterparts, and are on average half as profitable. Years of ultra-low interest rates have dragged on their returns, while Wall Street rivals have continued to steal market share in investment banking. All of this means the cushion to absorb a big spike in impairments is modest.

Measuring credit froth in global banks

Still, most investors think banks will be able to withstand the fallout from coronavirus better than they did the 2008 financial crisis. On average, bank capital requirements are now 10 times higher and they are less active in risky trading activities. Nor have they been on the kind of “credit rampage” that preceded the last crisis, said one investor.

Nonetheless, the crisis is set to further deteriorate their already lacklustre earnings. UBS has cut its profit forecasts for the UK banking sector by a third this year and by almost a fifth in 2021. So far the benchmark index of European bank stocks has plunged 42 per cent this year and the UK equivalent is down 40 per cent.

Deutsche Bank — which at its nadir in mid-March was trading at just 0.16 times the book value of its net assets — is now worth about €12bn. The increasingly popular Zoom video conferencing company is valued at $50bn.

Coronavirus will have a disproportionate effect on banks with retail and commercial-focused business models. Such lenders have high fixed costs to run hundreds of physical branches, thousands of local employees, and get most of their income from charging interest, said a senior European banker.

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“Their margins are collapsing as interest rates are slashed, but their costs stay the same, while provisions for non-performing loans are skyrocketing,” he added.

Investor concerns have homed in on unsecured retail lending — credit cards, personal loans and car finance — which in the most recent Bank of England stress tests had a five-year cumulative loss rate of 25 per cent. Barclays and Lloyds in the UK are particularly exposed.

For European banks that still have prominent markets divisions, there may be bright spots. Hedge funds and ultra-wealthy clients scrambling to reposition themselves amid the market turmoil was a boon to trading desks: on Wall Street, bond and equity trading revenue jumped by almost a third in the first quarter.

But these are small mercies for what one investor described as “a friendless sector for a number of years”. The investor added: “Bank equity prices were stressed before Covid and now are very distressed. It’s not like there’s much hope baked in.” 

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