The exceptional situation arising from the Covid-19 outbreak during the first quarter of 2020 was unexpected and not anticipated from a financial reporting perspective. As lockdown started in Europe and the US in mid-March 2020, banks were faced with a situation never seen before in terms of the limited time they had to assess its impact before publishing their results at the end of March. Organisational challenges and significant uncertainty relating to the economic implications placed banks in a challenging position to evaluate their provisions on credit risk, which must be estimated on a prospective (forward-looking) basis since the transition to IFRS 9 in 2018.
Consequently, many banks applied manual overlays to the assessment of their provisions rather than building its forecasts through its complex mathematical models for Q1 reporting. The results led to a very significant increase in provision for expected credit losses in banks across the world.
First assessment of the crisis
In the context of the time constraints and infancy of the pandemic for Q1 reporting, Q2 results were highly anticipated because banks now have more hindsight to evaluate the impact of the crisis on their customers and their risk of long-term credit losses. Adjusted economic scenarios, including GDP and unemployment rate for the years ahead, have been aligned taking account of the pandemic’s expected impact on the evolution of the global economy.
As expected, we can observe an increase of provisions for expected credit losses at Q2 in Europe as well as in the United States. Globally in the United States, provisions for credit risk have roughly doubled during the first semester of 2020 (e.g. +94% for Wells Fargo and +106% for Bank of America), reflecting the seismic shock to the American economy. However, net results from banks are disparate according to the core activity of the banks and their geographical area. Indeed, in the United States, institutions with a strong investment banking activity enjoyed the benefits of a highly volatile market. In contrast, Wells Fargo posted its first losses since the crisis in 2008. In comparison, J.P. Morgan reported a profit of $4.7B and Goldman Sachs $3.6B at half-year 2020.
Several factors can explain this increase in provisions in the United States. Firstly, a transition more recently to CECL in the United States compared to IFRS 9 for European banks in place since 2018. We saw similar increases in the EU when banks had first to implement IFRS 9. Secondly, US banks have always been exposed to a higher level of credit risk due to the structure of the US economy with a high level of debt. Significant rises in provisions related to credit cards in the United States are confirming this trend. Finally, the key economic indicators such as unemployment levels (11.1% in the US at June 2020 compared to 7.1% in the EU) are unfavourable compared to the EU, directly impacting economic scenarios implemented in expected credit loss models.
In Europe, results at Q2 2020 vary to a degree in each of the larger economies within the Union. We can see though that the level of provision increases is more restricted than in the United States. The impact on net results is also more limited. A primary reason for this is that European banks have long since commenced significant restructuring projects to reduce their fixed costs in the context of continued low-interest rates.
In Continental Europe, the increase of credit risk provisions at the half-year of 2020 is contextually low considering the pandemic. In France, BNP, BPCE, Credit Agricole and Société Générale have respectively increased their provision of +5%, +4%, +6% and 13%. In Spain, BBVA and Santander have increased their provision of +9% and +6%. The same conclusion can be met in Italy where Intesa San Paolo reduced its provision of -4% during the first six months of the year.
These limited movements can be explained by the prudent historical approach already applied by banks in these countries to estimate their credit risk provisions. Before the pandemic took effect, the large French banks had average coverage of expected credit losses of 2.0% of its entire loan book. The coverage rate in Spanish banks was 2.7% and 3.8% in Italian banks. In comparison, the average coverage in the large UK banks was 1.3% and 0.7% in German banks. When taken in this context, it is not a surprise to read that Commerzbank and Deutsche Bank increased their provision for credit losses by +23% and +21% respectively during the first half of 2020.
In the UK, we have seen even more of an impact. Barclays, RBS and HSBC increased their provision of 38%, 68% and 52% respectively during the first half of 2020. Lloyds has the most significant increase in the UK, with a rise of 120% of provision in the last six months. For Lloyds, its expected losses coverage was very low before the beginning of the pandemic (0.7% of the loan to customers portfolio) compared to other banks in the UK and the EU. The significant rise of provisions in the UK could be interpreted as a sign of a pessimistic assessment as to the recovery of the UK economy due to a hard Brexit and the slow response to Covid-19. On the contrary from the perspective of the EU, the first assessment of EU banks shows a potential sign of confidence in response to Covid-19 in these countries and at EU level (e.g. support measures provided by governments and institutions, an ongoing project of debt mutualisation in the EU, etc.).
In Ireland, we note several approaches taken by the Irish domestic banks marking some blur in the analysis of the future of the Irish economy. PTSB increased its provision by 7% but had already a portion of exposure with a significant increase in credit risk (stage 2 exposure according to IFRS 9) significantly high compared to other banks (26.5% of stage 2 exposure for FY19, growing to 32.9% at HY20). PTSB had already a high coverage rate of its credit risk at 5.0% before the crisis, now 5.4% at the end of June 2020.
In comparison, Bank of Ireland booked an increase of expected credit loss of €937M increasing provisions by 62%. Bank of Ireland explains this significant rise is a prudent approach, outlining that COVID-19 has impacted its IFRS 9 staging profile. The application of updated forward-looking information, as well as individually assessed risk ratings, has resulted in a material migration of loans from Stage 1 (performing loan without substantial increase of credit risk) to Stage 2 (Loan showing a significant increase in credit risk). Ultimately, this approach led in Bank of Ireland to a rise in its coverage rate from 1.6% to 2.7%.
AIB posted a significant increase of expected credit losses at the end of June 2020 (+€924M, +90%) almost doubling the coverage rate from 2.0% to 3.9%. AIB consider that COVID-19 short term modifications (e.g. payment breaks) have been identified as requiring a temporary ECL post model adjustment due to the heightened risk of downward stage migration on the expiry of payment breaks. It reflects the risk that on expiry of the temporary payment breaks, some of these loans will require further support, e.g. forbearance, as these borrowers would otherwise be unable to return to their prior contractual loan repayments. Therefore, the ECL post model adjustment allows for the early recognition of anticipated downward stage migration on expiry of the temporary COVID-19 modifications.
In conclusion, the evolution of the scale of provision for expected credit losses shows without surprise that banks are expecting tough times in the months and years ahead concerning the performance of their loan books. On a positive note, the analysis of overall earnings doesn’t highlight significant failure signals in Europe compared to what we have seen in the past. The results published for the six months to June 2020, still must be the first assessment. The long-term impact of the pandemic is still highly unpredictable, especially in the actual uncertain environment (risk of a second wave of the pandemic, success of support measures provided by governments, etc.). In this respect, the next reporting period will be scrutinised according to the evolution of the situation.
For more information please contact the authors Michael Tuohy or Willie Oppermann.