Massive Credit Losses to Hit European Banks in Q2 and into 2021, Particularly When Debt Moratoriums Are Lifted

Yves here. We’ve been warning for some time that Europe’s banks, and Italy’s most of all, are ticking time bombs. And coronavirus will hit them harder than US banks because in the US. most lending, such as commercial and residential real estate loans, is done on an “originate and sell/securitize” basis, while European banks keep many more loans on their balance sheets.

But the flip side is the EU is a master of extend and pretend. But as Herbert Stein said, “If something cannot continue, it will stop.” Nevertheless, EU regulators are making cheery noises. Perhaps the worst is past, but they may be making unduly optimistic assumptions about the extent of real economy damage and thus how many more loans will go sour.

By Nick Corbishley, for Wolf Street

The second quarter results of most large Western European banks will reveal further increases in expected credit losses as the economic outlook has “weakened substantially since the publication of 1Q20 results”, Fitch Ratings warns in its latest “Large European Banks Quarterly Credit Tracker.” This will put substantial pressure on the sector’s operating profitability.

European banks already had a profitability problem before this crisis began. The last time that average return on equity (ROE) in the sector reached the 10% threshold, which is broadly considered a healthy minimum, was in 2007, when the shares of European banks were at the highest level they have ever been. Since then, the average ROE of European banks has not come even close to regaining that level.

ROE was negative in three out of the five years that followed the share-price peak in 2007: in 2008, 2011 and 2012, as most European banks reported negative net income. Many would end up going under and getting bailed out or being absorbed by one of their somewhat healthier rivals. ROE began edging back upwards in 2013, reaching an 11-year high of 7% in 2019.

But in the first quarter, Covid hit, forcing many banks to provision for expected credit losses (ECL), with the result that sector-wide ROE slumped to 4%. Many large banks reported sharp drops in profits. Five big banks — HSBC, Deutsche Bank, Unicredit, BBVA and Societe Generale — posted net losses.

In the second quarter, more banks could take a hit if so-called “loan-impairment charges” (LICs) — an amount that a bank sets aside in case its customers cannot make the required loan repayments — rise sharply, Fitch warns.

At the 20 banks in Fitch’s analysis, LICs almost tripled year on year in the first quarter, to around €24 billion, eating up more than 55% of pre-impairment operating profit (compared with less than 20% in 2019). Fitch estimates that approximately half of the LICs “resulted from expected credit losses amid weaker macro-economic forecasts and management overlays on specific riskier loan portfolios, including the most vulnerable corporate sectors and unsecured consumer finance” [such as credit cards].

In the first quarter, the banks did not report a notable rise in impaired loans. But the main reason for that is that the economic fallout of the lockdowns had barely begun. As Fitch warns, impaired loans are “likely to increase significantly” in the second half of 2020 and into 2021, particularly when debt moratoriums are lifted.

Bad loans are still a problem in many parts of Southern Europe, including Italy, Portugal, Greece and Cyprus, a long-lingering legacy of the last crisis. Warnings are also being issued about a sudden surge of non-performing loans (NPLs) in Eastern Europe. The “Vienna” Initiative, a European bank coordination framework set up in the wake of the last crisis with a view to safeguarding the financial stability of emerging economies in Central and Eastern Europe, warned this week that banks in the region will soon be hit by a wave of bad loans that may last beyond 2021.

The Vienna initiative is anticipating three waves of bad loans: a first wave in the fourth quarter of this year as anti-Covid stimulus measures expire and struggling borrowers begin defaulting; a second, slower and more spread-out wave that may follow in the first half of 2021; and a third wave, resulting from the contagion effects of failures in different parts of the economy and supply chains, that is likely to appear towards the end of 2021.

As bad loan ratios surge, capital ratios will continue to decline in Q2 for many banks, Fitch warns. But it expects that large European banks will maintain sufficient buffers above regulatory requirements, which have been relaxed due to the crisis.

The EU’s banking watchdog, the European Banking Authority, concurs. Although it expects banks to suffer a capital hit of up to €380 billion as a result of the economic disruption from coronavirus, it believes that most banks’ capital position is much stronger than before the Global Financial Crisis. At the end of 2019, banks had on average capital equivalent to close to 15% of their risk-weighted assets, compared to just over 5% in 2011.

“The starting position of the banks [was] very good at the end of last year [and] the measures put in place since the last crisis have held up,” said José Manuel Campa, chairman of the EBA, in May. “As a result of all that, the buffers are large and should be sufficient in the short term so we are not worried about [the banks’] short-term ability to lend to the economy and in the long term to have sufficient buffers to absorb the eventual losses,” he added.

Just in case those buffers aren’t large enough, the ECB set out to enhance bank profits that would build those capital buffers. On Friday it revealed that it had offered banks a record €1.3 trillion of loans priced at negative -1% as part of its new TLTRO-III program, in part to make up for the profit-squeezing effects of the ECB’s negative interest rates.

In total 742 banks tapped the program, meaning that the average take-up per bank was €1.8 billion, twice as high as the previous record set in December 2011. More than half of the money disbursed will be used to repay earlier ECB loans that are about to mature.

These loans at a negative rate of -1% will result “in a gross transfer to banks of around €15 billion” over the next 12 months, says Frederik Ducrozet, strategist at Pictet Wealth Management. “Most banks should qualify. Add tiering and here you are: from NIRP to a net transfer to banks!” The ECB is also weighing a Eurozone-wide bad bank to remove up to €500 billion of bad debt off banks’ balance sheets.

A new tsunami of bad debts washes ashore in Italy while banks are still struggling with the debris from the prior tsunami of bad debts. ReadItaly Once Again on the Eurozone Worry List

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  1. Jeremy Grimm

    This post is “Greek” to me. Am I correct to read into this post that European banks place more unsecured loans than in the US? Who owes these loans at risk? There is mention of “vulnerable corporate sectors and unsecured consumer finance” but do European consumers face anywhere near the trouble US consumers face? I had the impression the European system for continuing consumer incomes in response to Corona was more robust than the in the US.

    The statement in the post — “These loans [ECB loans to banks] at a negative rate of -1% will result “in a gross transfer to banks of around €15 billion” over the next 12 months, says Frederik Ducrozet, strategist at Pictet Wealth Management.” — is especially curious to me. The ECB is loaning to banks and demanding negative interest rate? Does that really fool Europeans? Even in the US that would be skimpy cover for passing government money to banks. Here we pass complex laws several hundred pages long to hide and obscure the government giveaways to Big Money. Surely Europeans are not less sophisticated than Americans.

    1. flora

      The more I read about the Eurozone and the ECB the more I think they’re nothing more than a force majeure. But I am a bear, or bearrette, of very little brain. :)

  2. zamfir

    Yes, but it is slighty more complicated. While the loan is active, the bank transfers assets as security to the ECB. And the interest on those assets goes to the ECB during the duration of the loan. Also, if the bank just holds the cash (in an ECB account), the bank will pay that same 1% negative interest rate to the ECB. The. The bank will not earn money, they would only take the loss from not getting interest on the securities.

    So, banks can make money on this system: they lend out loans to the public, then use those loans as security at the ECB, and get a loan from the ECB (which they had already lend out, so they are even). On the whole this gets them somewhat less than 1% I think (because the securities and the loans don’t match 1 on 1), they have some operational costs, and a bit of risk on the loans remains with the banks. There is probably some easy money left at the end, but it’s substantially less than 1%

    Effectively, the ECB is paying banks to help them send freshly printed money to companies with corona cashflow problem. The ECB cannot do that itself, they do not have the organization to do retail banking on that scale (plus the banks already have a relation with the companies)

    Perhaps this can be done in a better way, but I am not sure that this way is particularly bad either.

    1. Zamfir

      addition: the post above was intended as direct response to the question by Jeremy: “The ECB is loaning to banks and demanding negative interest rate?”

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