ALM Stress : Banks

Covid19 impact on Financial System. Part II: Banks.

Over the last 50 years banks have been the driving force in the rise in private sector leverage and with it the increase in global GDP (e.g. USA above left). What is the outlook for the banking industry following the recent financial market moves and announced monetary and fiscal policies? Countries with a weak banking system have not experienced the same credit growth as those with strong banking systems, and thus their GDP growth has underperformed. The weak Japanese GDP growth over the last 20 years (above right), and more recently that of Italy, are examples of how a weak banking system is linked to poor GDP growth.

To understand the outlook for banks, it’s first worth considering the key issues that affect a bank’s balance sheet and its’ profit and loss account and how the two relate to each other. It then becomes clearer how recent market moves will have already impacted banks and how current interest rate curves and announced policies will influence their future.

THE BALANCE SHEET (B/S) OF A BANK

The B/S is simply a statement at any particular point in time of a bank’s Assets and its’ Liabilities, with the difference between the two being the bank’s Capital (its’ net worth). Below is an example of a bank’s B/S:

In summary:

• A bank earns money from its assets and pays funding costs from its liabilities.

• There is a natural maturity mismatch between longer term assets (e.g. Loans) and shorter term liabilities (e.g. Deposits).

• Because of the maturity mismatch, the source and “stickiness” of funding is very important. A deposit flight can make a bank insolvent even if it is profitable.

• Equity Capital is the reserve cushion for any devaluations in the value of any Assets. The amount of Capital should be “enough” to cushion a bank from a rise in non-performing loans in an economic downturn. How much Equity Capital is deemed “enough”?

Equity Capital and the Weighted Risk Assets (WRA) Concept

Bank regulators ensure that Banks maintain a certain level of Equity Capital to protect their balance sheets against the risk of a devaluation of its’ assets, which might occur in a recession or financial market correction. They utilise the WRA concept that applies different weighting of riskiness for each asset that they hold on their balance sheets, which considers an asset’s credit rating, maturity and underlying market liquidity.

To determine the Capital required for each asset a bank holds, the risk weighting of that asset is multiplied by a percentage (~8%) of the Notional amount of the asset. For example, cash or holdings of government bonds are judged to be riskless, so they attract a 0% weighting and thus no capital must be held against them. A loan to a low rated corporate might have a risk weight of 100%, so the capital required would be 8% of the amount of the loan (100% x 8%). The table below gives an example of how a bank with 360bn of various assets would require 18.4bn of Capital for those assets. Note that in this case, Equity Capital is only ~5% of Assets (18.4 / 360).

Problems over the last 30 years in the Japanese, Scandinavian, Spanish, Irish, Italian, US (twice!), UK banking industries required public sector bailouts. These and the upcoming problems in the Chinese and Australian banking industries show that this RWA concept is flawed. If the WRA concept worked, banks would not have needed taxpayer bailouts. This is not a polemic statement – this is a view shared by many, including Mervyn King, former Governor of the Bank of England (see “The end of Alchemy” pages 138-139 and 258). There is more on this at the end of this post in the Addendum.

How is Equity Capital impacted when there is an Asset Impairment? A loan is classed as “Impaired” or as a “Non-Performing Loan” (NPL) when the interest on the loan is paid to the bank late or not at all. There are different classes of Impaired Loans and NPLs, but once the late payment starts, a bank should start making a provision in its’ accounts against that loan (*).

A bank creates a negative charge in the profit and loss account in the year it makes the provision for that NPL. At year end the bank will then report loans NET of provisions and the Capital will be reduced by the amount of the provision – i.e. both sides of the bank’s balance sheet will decline by the amount of the provision. Below left shows an example of an Italian bank’s Loans and Provisions, whilst the right is a Bank of Italy chart that depicts Italian banks’ NPLs post the GFC which negatively impacted their capital bases by more than Eur 150bn.

Below is Citi’s balance sheet before and after the GFC which shows a two year decline in assets due to the substantial decrease in Customer Loans and increase in provisioning. “Retained Earnings” in Equity Capital took a large hit necessitating a substantial increase in Share Capital (from the US Treasury). Clearly the WRA concept was flawed as the equity buffer was not enough to sustain the substantial losses during the GFC.

Non Customer Loan assets will also get impacted by market turmoil, for example short term and long term Investments in financial instruments as well as the inventory of financial assets held for a bank’s trading activities (for example Government Bonds, Corporate Bonds and Equity Investments and their derivatives). Some of these assets will not register a trading loss as they are not marked to market (normally because they are not traded but “held to maturity”), but those that are marked to market will create a loss in the profit and loss account if the asset’s price declines.

THE PROFIT AND LOSS ACCOUNT (P&L) OF A BANK

The P&L simply shows a bank’s profit or loss for a period, which is derived from three different areas (real example below).

1. Net Interest Income: This is simply the interest received on Customer Loans and Investments less the interest paid to fund those assets (Customer Deposits, Bank Bonds and Interbank Funding).

2. Fees and Commissions for services (e.g. loan arrangement, asset management, advisory services)

3. Changes to Asset Quality, which is where any investment appreciation or provisions for NPLs show up.

Dividends are taken from Profit After Tax, with remaining profits then added to Equity Capital as “Retained Earnings”.

COVID19 MARKET IMPACT ON BANK P&L and B/S

1. Net Interest Income (NII)

Over the last 10 years banks’ NII margins have already been negatively impacted by the sharp decline in interest rates. This has especially been the case for banks operating in negative interest rate environments, as they have great difficulty in charging negative interest rates on customer deposits which fund their assets. This is where the “Reversal Rate” kicks in and lending can contract, reducing income even further as a bank’s Total Asset size declines.

The recent sharp decline in 0 to 30 year interest rate curves has brought a global rather than regional “lower for longer interest rate environment”. The market currently prices that the 3 month interest rate in 10 years’ time will be a mere 1.00% in the USA, 0.25% in Japan, 0.50% in the Eurozone, 0.70% in the UK, 1.45% in Australia, 1.75% in New Zealand, 0.80% in Sweden and 0.95% in South Korea. This means that NII will be low not only for Japanese, Scandinavian and European banks, but also for all banks in Developed Markets for the medium term.

2. Non-Performing Loans

The political decisions to enforce population lockdown and close national borders have caused a severe disruption to corporate profitability and an unprecedented huge spike in unemployment. Clearly without government aid there would be a significant amount of companies and individuals not paying interest on bank loans, requiring banks to 1) classify such loans as Non-Performing and 2) undertake significant provisioning against those NPLs. As explained above, this would lead to losses to the P&L and lower Retained Earnings, thereby reducing Equity Capital. What is not yet clear is which companies will have access to government aid or indeed how many loans will become non-performing even with government aid.

There is a very big question mark outstanding about what aid pre-Covid19 “Zombie Companies” will receive. These are companies whose cashflow is not large enough to repay debt but can only service it. Banks have important exposure to companies who rely on refinancing to survive. If these zombie companies are not supported by governments, then bank NPLs could rise substantially.

What is unquestionable is that banks will be indirectly bailed out by governments through their fiscal aid to companies and individuals. Without this government aid, banks reported NPLs and provisions would be substantially higher and capital ratios would be notably weaker. It should come as no surprise therefore that banks have already announced dividend and bonus cuts (under Regulator duress). Given the enormous scale of (indirect) taxpayer aid to the banks, regulators could press banks to not pay dividends and bonuses in the near future until the fiscal deterioration to aid them has improved.

3. Investment Portfolios

There are two impacts on a bank’s Investment portfolio. The first is the short-term “mark to market” issue which I believe is of relatively small importance to the overall long term outlook for banks. The risk asset price correction of 2020 will have negatively impacted bank trading book inventories (MBS, Corporate Bonds etc), requiring a devaluation in asset prices that will be registered as losses on the P&L. Banks are likely to report hits to trading incomes as a result of this market correction.

The far more important impact from the Covid19 market turmoil will be the inability of banks to generate decent investment returns over the longer term from the low and flat term structure of interest rates. The huge shift lower in short and long term interest rates will have a SUBSTANTIAL and PERMANENT impact on the ability of banks to earn future profits on investment portfolios. This is very important as this has grown to be a major source of income for many banks as net interest Income margins tightened as rates declined.

The Japanese, Spanish and Italian banking crises all led to a behaviour with regards to their investment portfolios. In the late 90s, the Japanese banks received long dated swaps in huge amounts, entering carry positions whereby they received higher longer dated interest rates versus paying lower shorter dated interest rates. This carry accumulation allowed the banks to generate large operating profits that were used to offset the rising provisions for Non-Performing Loans, which together with Evergreening allowed them to delay restructuring for many years.

This same behaviour was carried out by the peripheral banks after the 2011 banking crisis. They bought high yielding government bonds in non-marked to market “Available for Sale” (AFS) portfolios (a rule introduced by Mario Draghi when Head of the Bank of Italy – some say to save MPS). These ZERO RISK WEIGHTED assets that required no capital were financed by very low ECB interest rates (and in some cases via the ECB’s very own repo operations). The income generated from these AFS Investments countered the rise in NPLs (and directly also allowed these countries to finance their debts as foreigners exited their bonds). With very low and flat curves, this very lucrative source of future profit from Investments is disappearing fast, and in a PERMANENT fashion.

MARKET VALUATIONS

The equity market already prices this negative outlook for banks as Price to Book (P/B) Ratios of banks have fallen sharly in 2020. The P/B is simply the market’s valuation of a bank’s “Market Capitalisation” (i.e. its’ outstanding shares multiplied by the market price of the share) divided by the “Share Capital” reported in the bank’s financial reports and accounts. A reading below 1 suggests that the market values the bank less than the value reported in its’ accounts.

The chart below shows the P/B for 5 banks in different geographical areas. Ever since the GFC there has been a P/B discount in place– it has become greater in the recent market turmoil.

Surprisingly this discount is not priced in the equity prices of banks in countries where real estate asset bubbles have recently popped (SNACS). The chart below shows that many still trade above book value, despite the recent share price corrections. Surely it will only be a matter of time before investors revalue these banks given their outlooks.

The problem with Price/Book historical charts is that 1) the Book value can change dramatically with provisions or with intervention, shifting the Book value down or up and 2) the past did not have such low interest rates. So comparing current book values with the past makes little sense – it does though give an indication of discount already being priced in and highlight the relative valuations been banks.

CONCLUSION

The Asset Liability Management of Banks has been severely impacted by the consequences of Covid19:

• There will be temporary and short term damages from trading losses and losses in investment portfolios.

• On a longer term horizon, there will undoubtedly be a rise in NPLs requiring provisioning. However the extent of this is very difficult to ascertain at the moment until the full extent of governmental aid to both householders and corporates is known.

• There will be a very serious longer term issues for future profitability from the inability to generate returns from the low and flat interest rate curves that now dominate global financial markets. This will tighten net interest income margins and bring a severe reduction to the income generated from Investment Portfolios that has been a major source of profit in the last decade. These are natural “Consequences” of the Japanification of global interest rate markets.

If these conclusions are correct, there could be a depletion of capital and/or an inability to generate substantial fresh new capital. Such circumstances, without government intervention will limit credit growth from banks to the private sector, as seen in the last 20 years in economies with banks with weak balance sheets.

The ability to generate or not generate capital will be the difference between whether economies can leverage again and so where asset valuation multiples can rise (e.g. US equity post GFC) or whether economies remain stagnant or even devalue (e.g. Japan post mid 90s onwards).

Regards Edward Ballsdon 13 April 2020

(*) History shows that banks become very creative when NPLs start rising, so as to protect capital and continue paying dividends (by under reporting provisions). There are numerous papers on how Japanese banks “Evergreened” their loans by giving interest payment holidays so as to not provision for NPLs. Spanish banks became the largest real estate agents post 2011 owning properties with functioning loans.

Addendum : A final comment on WRA.

The simplest way to demonstrate the failings of the WRA model in a period of excess credit growth is to show the relationship between the growth of Customer Loans against the growth of Capital, and how the latter just gets swamped by NPLs when a problem occurs. The chart below shows the extraordinary rise in Customer Loans for the 5 largest banks in Spain between 2002 and 2011, when the Spanish Real estate bubble then popped.

Outstanding Loans increased by Eur 1.1 trillion from 338bn to 1.43tr in that period! The real problem arose from the small NOMINAL increase in Equity Capital – between 2002 and 2011 it increased by Eur 81bn from Eur 42bn to Eur 123bn. By 2011 the situation was primed whereby it would only take ~ 10% of the NEW loans made in that period to go bad to wipe out the entire share capital. The same exact problem occurred in Japan, in the 80s and 90s, and then to the Irish, UK and US banks in the GFC.

Incidentally, Customer Deposits did not grow at the same pace, so the ratio of Customer Loans to Customer Deposits increased from 112% to 127%, with the funding difference being made up by a $325bn increase in Bank debt.

With regards to banks in the SNACS countries mentioned previously in this post, below shows the Loan, Deposit and Equity growth for the main 4 Australian banks. The chart looks pretty similar to the Spanish chart above. Furthermore findings of the Royal Commission into Australian bank lending suggest that similar lending practices were at play as in Spain in the 00s.