Over the past couple of months risk markets have experienced unprecedented volatility, and the economic uncertainty caused by the COVID-19 pandemic looks set to continue while a proven vaccine or an effective treatment both remain elusive.
Given this backdrop, the consensus that Q2 will likely be the point of maximum headwind for the global economy is understandable, and it is also fair to conclude that rating migration will pick up and default rates will also rise, though both typically lag downturns in economic activity and therefore may not peak until Q3 or later.
Naturally, with banks being at the centre of the transmission mechanism, they are often viewed as a barometer of market sentiment. It is therefore important, particularly as we approach the period when the macro economic data is likely to be making headlines for all the wrong reasons, for investors to keep track of the latest earnings from the sector and update themselves on institutions’ relative balance sheet strength.
We have now seen a considerable number of Q1 releases from major lenders, and almost without exception they have been prudent in provisioning for future pain to come. Obviously, prudent provisioning helps alleviate the shock for any future loan losses but it also impacts the current headline net income number. For us though the key factor is capital, and how much of a buffer a bank has to absorb losses while remaining above the threshold for paying AT1 coupons. So far our analysis looks encouraging. Years of strict regulatory control, designed to making sure banks built up balance sheet reserve capital, was done with periods like this in mind.
In general the banks went into Q2 with a very strong capital base, we can see this from the numbers. We expect capital ratios to face headwinds going forward, not just from credit losses but also from an increase in risk-weighted assets (RWAs); RWAs grow as banks lend more and facilities are drawn down, and they also grow as assets become ‘heavier’ from a risk-weight perspective through ratings migration, which is something out of banks’ control now. However, offsetting this is the fact that largely banks are retaining all of their earnings, paying no dividends and ceasing share buybacks.
In many cases, this lack of distributions has meant that despite large loan loss provisions and increasing RWAs, capital levels in fact rose in Q1, adding to the ‘war chest’ of buffer capital that banks have to protect themselves from a prolonged economic downturn. Additionally, the regulators have helped by reducing capital requirements through the reduction or abolition of countercyclical buffers.
So while this is undoubtedly going to be a tough year for the banking sector, with most likely no dividends being paid and an unpredictable year for earnings, our outlook for coupons is very different and underscores why fixed income and credit markets tend to lead a market recovery in recession.
By way of a recent local example, this was illustrated perfectly by Royal Bank of Scotland this morning following the release of its Q1 numbers. Headline operating profit before tax was £519m, down 49% on Q1 2019, due to a considerable increase in provisioning of around £800m. No dividend was paid and no outlook on this was given due to the unpredictable circumstances. However, for us the key was the bank’s common equity Tier 1 (CET1) ratio of 16.6%, up by 40 basis points from year-end 2019, which equates to a significant 760bp of capacity above the Maximum Distributable Amount (the threshold below which AT1 coupons could be impaired).