Scope Ratings’ outlook on European banks continues to be biased to the downside in view of the magnitude of the COVID-19 crisis. The key question the ratings agency is asking is whether banks have de-risked enough to withstand the current cycle.
“Our main conclusion at the beginning of the lockdown in Europe was that the impact of the crisis on bank credit quality would need to be assessed on a case-by-case basis, taking account of the different starting position and franchise value of each bank at the outset of the crisis,” said Dierk Brandenburg, head of the financial institutions team at Scope Ratings and author of the report. “That conclusion remains intact. Our approach focuses on the relative strength of business models and their ability to deliver appropriate returns across the cycle. A temporary dip in earnings does not necessarily lead to increased credit risk.”
Despite the challenges, banking sector risk has not necessarily changed fundamentally at this point. Not all banks are riskier than before the crisis, especially if they are highly rated. A prolonged downturn and the emergence of excessive risk concentrations could change that view. Brandenburg expressed concern about concentrations in corporate and real estate portfolios where losses can be considerably larger than in diversified retail and commercial banking portfolios.
“For the larger, higher rated banks in our portfolio, this crisis will be the acid test for de-risking strategies of recent years and the value of geographical and sector diversification,” Brandenburg said. “The question is whether banks have de-risked enough to withstand the cycle. Banks with low capital and profitability buffers and more vulnerable business models are most likely to see downward rating migration in coming months.”
Regardless of the size and shape of the cyclical downturn, high costs and low returns remain the key structural issue facing many banks in our coverage universe. But while operating conditions for most banks are severe, regulators, central banks and governments are supportive, making it unlikely that a major bank will be pushed into distress at this stage of the crisis.
The reaction function of regulators and supervisors is a key driver of Scope’s credit assessment. “Our base case is that loan losses and RWA inflation will stop short of putting bank credit in jeopardy for most banks, especially for the more senior layers of banks’ capital structures,” Brandenburg said.
The likelihood of regulatory action to the detriment of bond holders is lower than before the crisis, though that is subject to change as the situation evolves. Once the damage is known, Scope expects regulators to mandate recapitalisation plans, which will again put pressure on banks that are lagging in the recovery.
“Given that EU authorities have shown a much more lenient stance towards non-banks in this crisis, we assume that this will be extended to the banks, provided their financial problems are caused by the coronavirus crisis and are not due to pre-existing conditions,” added Brandenburg.
The corporate picture
Meanwhile, research from Moody’s Investors Service has highlighted that the widespread coronavirus-driven actions by corporates show a differentiated approach by sector. Since 1 March, rating actions have been concentrated among companies in sectors such as auto manufacturers and suppliers; lodging; gaming and airlines, reflecting their high exposure to COVID-19. The rating actions for retailers highlight the relative resilience to a downturn of food versus nonfood retailers. Sectors with relatively little exposure, such as healthcare, defence and pharmaceuticals, have seen the least rating actions, and in some cases none at all.
Since the initial assessment by Moody’s in mid-March, the ratings agency has reclassified a number of companies and sectors in terms of their exposure. As a result, 22% of companies reviewed are deemed to have high exposure, versus 9% originally, as the effects of COVID-19 have become more apparent. In total, in the period under review, Moody’s took rating actions on 26% of the 929 companies that it assessed in its overall heat map.
There have been 11 fallen angels - bonds reduced to junk status - since 1 March. This is higher than the total annual number for most years since the financial crisis. However, the Moody’s research covers all of EMEA and many of these were in South Africa and followed the downgrade of the sovereign. Other fallen angels were in the retail, airlines and auto supplier sectors.
Apart from the fallen angels, there were 62 rating actions (26%) for companies that remained investment grade; and 171 actions (70%) for companies that remained speculative grade. Moody’s says that this exemplifies the fact that the latter are generally more vulnerable to an economic shock, either because of a weaker business profile, weaker credit metrics, or both. By contrast, the agency affirmed the ratings and changed the outlook to negative for a number global integrated oil and gas companies.
Finally, the Moody’s research notes that many rating reviews will need to be concluded in the coming months. More than 80 ratings remain under review, reflecting the high level of uncertainty in the current crisis, notably its duration, the level of state support that companies may receive and the measures companies can take to weather the downturn.
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