For professional investors only. Not to be relied on by retail clients.
This week we are right in the middle of the European banks’ Q2 reporting period. On 30 July for example we had results from a diverse group of Europe-listed banks, with Credit Suisse, BBVA, Lloyds and Standard Chartered all reporting. All have very different business models and footprints across varying geographies.
In Q1, when COVID-19 was sweeping across the world and the economic cycle was coming to an abrupt end, there was a lack of consistency in banks’ approaches to provisioning for future losses, with some being more aggressive than others. However, Q2 would give banks a whole quarter in the eye of the economic storm to assess the damage in what would be the peak of the recession, and thus these results were eagerly anticipated.
It became clear pretty early in Q2 that investment banking was having a terrific quarter, one of the best ever in fact, so the universal banks with large scale investment banking operations were also very likely to fare well.
We have long argued that banks need to prove themselves through the next recession in order to drop the stigma they picked up in the global financial crisis, and until they did this their bonds would continue to trade in a highly pro-cyclical way.
Private banking is not typically associated with taking large amounts of credit risk, so these businesses would be well insulated, but assets under management would surely have dipped in Q2, resulting in lower fees.
The mortgage lenders would be interesting as payment holidays blurred the outlook, but the focus would be on the percentage returning to scheduled payments at the first opportunity. This was not a sector or a problem that worried us unduly, as mortgage lending is one of the safest forms of lending across Europe, and we suspected borrowers had prudently taken holidays and would in the large majority return to payments swiftly. Losses should remain very low in this sector.
The most challenging and most cyclical part of banking comes in the provision of credit on an unsecured basis to both consumers and small businesses, where the default rate is much harder to predict. It also takes time for these losses to flow through. The bold action from authorities will have saved this sector from brutal losses, but we will see losses regardless of action, albeit most likely delayed. Similarly we expected corporate lending to be impacted by a huge swing to negative credit rating migration, as well as an overall spike in the default rate.
This last section of lending is what has given banks trouble in every recession, and this is why banks are treated by investors as one of the most cyclical sectors and why they tend to trade so poorly into a recession.
However, for the last 10 years bank regulators have done almost everything in their power to make banks less cyclical in their lending behaviour. I would stress the word less cyclical as there is absolutely no doubt that credit conditions have tightened significantly in Q2 as banks have sought to avoid inflation of their risk-weighted assets (RWAs), which would put pressure on their crucial CET1 ratios.
As Mark Carney put it in his outgoing speech as governor of the Bank of England, “this time banks can be part of the solution rather than part of the problem.”
Have the regulators achieved their goals?
While it is still too early to declare victory from the regulators’ point of view, there are some very clear observations in the results we are seeing.
Bank results are still volatile, as you would expect, but nowhere near as volatile as they would have been in prior cycles. From an equity standpoint, they are therefore still cyclical, but it is also clear that some banking businesses are less cyclical than others.
From a capital standpoint, however, the story is very different. In Q1, Europe-listed banks added to their buffers to regulatory capital minimums by an average of 55bp, partly due to a drop in capital requirements, but also partly due to capital retention forced upon them by the regulators as dividends and share buybacks were suspended (and remain so).
In Q2 the capital requirements are generally similar to the end of Q1, so less of a boost here but banks in the aggregate are still adding to their CET1 by retaining capital. In Thursday’s results, for example, Standard Chartered added 90bp, Lloyds 60bp, Credit Suisse 40bp and BBVA 38bp. Another example is Barclays, which boasts over 300 years of history and announced this week it held its highest ever level of capital at the end of Q2.
It is still early days in this recession, and we do expect loan losses to get higher as the year wears on and probably not peak until the first half of 2021, but the signs so far are good for bondholders and regulators alike. Banks have been able to take material provisions in the first half of the year and simultaneously have managed to increase their buffer to regulatory capital requirements.
What can we look forward to in Q3?
Realised losses are likely to grow in Q3 as government aid programmes roll off and delayed defaults start to come through, but the default rate in Europe is likely to be lower than we initially feared.
Payment holidays are ending, but the question is how many of these holidays will turn to loan losses. We are mainly concerned here with unsecured consumer loan holidays, but listening to the comments of bank executives in recent days, it appears a large majority of these are returning to payments again.
Private banks have weathered the dip in assets well; clients’ NAVs have bounced hard and asset gathering is their focus again, so likely a good quarter ahead.
Mortgage lending does not give us sleepless nights and we think this will be shown in Q3.
Investment banking is always tough in Q3 as it contains the summer months of July and August, and this year in particular a lot of activity was pulled forward into Q2. Financial markets are not going to be able to repeat Q2 from a performance point of view, so we expect a less exciting quarter ahead for the investment banks.
Finally, the regulators are not going to ease up now. Capital trapping has worked perfectly – why would they allow distributions before the peak in defaults? We cannot see dividend payments at least until Q1.
What does this mean for bondholders?
From a bondholder perspective, we have long argued that banks need to prove themselves through the next recession in order to drop the stigma they picked up in the global financial crisis, and until they did this their bonds would continue to trade in a highly pro-cyclical way. This has certainly been the case so far, but investors who dumped their bank bonds in the early days of the COVID-19 crisis will be ruing that decision now.
A combination of more prudent lending standards and much stronger regulatory oversight have made banking a much safer business for bond investors, in our view. Today investors are being paid for pro-cyclicality in bank bonds that is actually diminishing.
One question we are getting frequently at the moment is how we are going to become more pro-cyclical as the cycle develops. While we do believe we need to embrace pro-cyclicality, timing this with confidence is always the challenge. We think exposure to the banking sector is one of the least risky ways to do it.