Description
Bank ratings from S&P Global reflect the long road ahead. Since the start of the pandemic, analysts have taken 236 negative rating actions on banks worldwide (as of November 9, 2020). Most of these were negative outlook revisions or placements on CreditWatch “negative” (77%), although nearly a quarter were downgrades (23%). Negative adjustments were made to approximately half of the 87 Banking Industry Country Risk Assessments (BICRA). This includes revisions to economic or industry trends, and in some cases, downward adjustments to the country risk assessment itself.
More than a year ago, before COVID-19 broke out, banks entered the new year relatively calmly. The scenario for banks moving into 2021 is in stark contrast. For many banking jurisdictions, experts forecast recovery to “pre-COVID” 2019 levels by 2023 or even later.
Shared Pain, But Different Paths to Normalization
The recovery of banks worldwide to “pre-COVID” 2019 levels will be slow, uncertain, and highly variable depending on geography. Analysts estimate that for 14 of the 20 leading jurisdictions, a return to pre-COVID-19 financial resilience levels will not occur until 2023 or later (see the study “Global Banking Recovery Will Stretch to 2023 and Beyond” from September 23, 2020).
Some emerging market banks face a difficult year, and many will struggle to recover quickly from the pandemic. China may be an exception, where banking sector recovery to “pre-COVID” financial resilience could occur earlier. Experts do not expect recovery even in jurisdictions that potentially emerged early from COVID-19, such as China, until the end of 2022 (see Chart 1).
S&P Global Ratings expects banks’ financial performance in many jurisdictions to deteriorate before economic recovery begins. Even then, credit portfolios will normalize with a lag as asset quality challenges are overcome. Experts estimate that for banks worldwide, the pandemic will result in credit losses of approximately $2.1 trillion by the end of 2021 (read “The $2 Trillion Question: What’s on the Horizon for Bank Credit Losses”). This will primarily be related to lending to the corporate and retail sectors.
Despite profitability remaining low in 2021, many banks are generally in better shape to withstand stress compared to 2009. They are better capitalized and have lower leverage, mainly due to stricter standards introduced after the global financial crisis, and have significant reserve levels to mitigate lower asset quality. Additionally, borrowing markets are stable. Nevertheless, analysts’ negative outlooks on approximately one-third of the world’s banking groups reflect the view of uncertainties and risks in 2021. S&P Global Ratings has identified 4 key risks to watch.
Key Risk #1 – Economic Crisis Due to COVID-19 Worsens or Lasts Longer
The base expectation is for a widely available vaccine by mid-2021 and confident economic recovery in 2021. While negative pressure on bank ratings will persist until meaningful and sustained economic recovery occurs, most banks’ ratings may remain at current levels if experts’ baseline scenario develops as planned. If the economic situation due to COVID-19 worsens further or extends beyond the baseline scenario (see the study “Global Leverage: Risks Are Rising, But Near-Term Crisis Is Unlikely”), one can confidently expect a negative jump in banks’ credit portfolio quality in 2021.
The health crisis and subsequent economic recovery will likely continue to differ by geographic region in 2021. Several notable differences are already evident heading into 2021 (see Chart 2). In some high-income countries (mainly in Asia), the virus is currently contained with zero (or near-zero) new infections and deaths; however, significant restrictions on borders, mobility, and gatherings will continue to hinder economic recovery. In some other high-income countries, particularly the US and Western Europe, the virus continues to spread.
Many emerging market economies face the challenge of containing the virus’s spread. Recovery of some banking systems to pre-pandemic levels is expected to be slow. Additionally, factors affecting banking credit quality in emerging markets on the path to recovery may be volatile.
Key Risk #2 – Short-Term Support for Banks and Borrowers May Lead to Extended Recovery
Government authorities acted quickly and decisively in response to COVID-19, providing unprecedented levels of fiscal support, as well as extensive financing and other support, particularly in developed economies (see Chart 3; and the study “Global Credit Conditions: K-Shaped Recovery”). Support measures have largely helped borrowers already in economic distress.
Well-designed and timely government actions will be crucial in 2021. If monetary and fiscal stimulus weakens too early, a prolonged recovery is likely. This could lead to greater damage to household and corporate balance sheets – and consequently to banks.
Authorities need to strike a delicate balance. Measures that benefit banks in the short term may contribute to excessive credit growth that would not be commercially acceptable in normal times, or create moral hazard by encouraging banks to lower borrower requirements or rates. Banks will likely face lower profitability for years due to compressed interest margins amid ultra-low interest rates.
Continued orderly funding and derivatives markets will be vital for banks to cope with the lingering effects of COVID-19. While not S&P Global Ratings’ baseline scenario, any serious disruptions in funding or derivatives markets would exacerbate problems for banks.
Key Risk #3 – Rising Leverage and Expected Increase in Corporate Defaults
Continued growth in corporate leverage and the expected higher level of corporate defaults in 2021 will create substantial risks for banks. While banks are constrained by prudential principles, including limits on their own leverage, experts expect potential adverse spillovers from large corporate borrowing both in the bond market and bank market at a time when profits in many industries are under enormous pressure. Additionally, some businesses may be less commercially viable in the post-pandemic world due to structural changes in consumer behavior. Many companies will need to substantially adjust their business models in the new business environment.
Global corporate debt is expected to rise to an average of 103% of GDP in 2020 (from 89% in 2019), while government debt will reach 97% of GDP (from 82% in 2019) before moderate deleveraging (see Chart 4). The increase in stress points to a baseline for the 12-month trailing speculative-grade corporate default rate, which analysts expect to double in the US (to 12.5% by June 2021, from 6.3% in September 2020) and Europe (to 8.5%, from 4.3%).
Bank asset quality and profitability (given high credit costs and low interest margins) are expected to remain under significant pressure in 2021. Despite the sharp increase in reserves in 2020, based on banks’ expectations of rising non-performing assets, experts see the risk that further reserve increases will be needed. Declining profitability will continue to reduce internal capital generation.
Higher levels of government debt may limit the future ability, if not willingness, of some sovereigns to provide extraordinary support to systemically important banks if needed. However, for banking jurisdictions where government support is currently factored into bank ratings, experts do not expect any significant reduction in support during 2021.
Key Risk #4 – Real Estate: Banking Credit’s Age-Old Nemesis
Moratoria on creditor payments, landlord forbearance in some jurisdictions, bank renegotiations with borrowers, and record-low interest rates may mask underlying asset quality problems. Experts believe this is especially true for real estate, where banks typically maintain high collateral levels and can handle short-term or temporary borrower difficulties. Additionally, COVID-19 is intensifying already existing threats in commercial real estate market segments, such as shopping centers threatened by online shopping. The office sector will face structural changes that may occur if work-from-home trends persist. There is a growing risk in 2021 related to commercial real estate, which could negatively impact banks’ asset quality.
Furthermore, in some markets, there is a risk that payment holidays and wage subsidies may delay problems that won’t manifest until support is reduced or terminated. This includes residential real estate assets of borrowers used as collateral for small business loans and investment purposes. One positive for banks is that residential real estate prices globally in many markets are stable, allaying some concerns about a significant price drop at the start of the pandemic. Additionally, credit availability for borrowers in 2021 will continue to be supported by low interest rates.
Understanding commercial mortgage-backed securities (CMBS) rating transactions provides some clarity, though modest. Stress in the commercial real estate sector related to rated pool transactions may indicate looming asset quality problems for banks with commercial real estate on their balance sheets. A recent review of US CMBS ratings resulted in 185 rating downgrades, including 88 single-asset/single-borrower (SASB) and large loan classes and 97 conduit classes. In European CMBS, after the COVID-19 outbreak, S&P Global Ratings took action on approximately 20% of rated transactions (see Charts 5-6; and the study “US and European CMBS COVID-19 Impact: Retail and Lodging Are the Hardest Hit”). Rating actions were most severe in the SASB subsector supported by shopping centers – a sector experiencing significant stress across multiple fronts.
Other Risks
While S&P Global Ratings highlights four critical risks, there are numerous other tests of banking creditworthiness in 2021 and beyond:
Emerging Market Vulnerabilities: Banking systems in emerging market countries are exposed to varying degrees to the local economy’s strong dependence on external financing, concentration in specific sectors (such as HoReCa, industrial exports, or service exports to developed countries), or commodities (e.g., oil or gas). Another vulnerability in some countries is the government’s lack of capacity to continue providing meaningful support. Additional obstacles include the impact of lower interest rates on interest margins and lower credit growth (given that interest margins are typically higher compared to developed markets), rising credit costs as regulatory measures are gradually removed, and potential external debt refinancing problems for some jurisdictions.
Digital Disruption: Digital technology prospects for traditional banks are increasing. Possible step-changes in digital technologies could profoundly impact how intermediation between depositors and investors, as well as government bodies and citizens, is conducted, and in other spheres. In turn, this could affect competitive dynamics – or other key risk factors – for banks. However, we emphasize that the digital sphere will open up many opportunities for banks to meet changing customer expectations while helping banks expand and diversify revenues and control costs. Investments in new technologies have enabled banks to offer customers quality services despite various containment measures. Experts noted that COVID-19 is accelerating innovation and digitalization in many banking markets.
ESG: Investors and their shareholders now demand more information on environmental, social, and governance (ESG) issues for decision-making. While key ESG considerations have always been an integral part of rating decision-making for banks, this trend will likely become even more widespread, leading to increased rating diversification. Like digitalization, ESG presents both advantages and risks for banks that can skillfully navigate the ESG sphere in 2021 and longer term.
Geopolitics: Economic nationalism and geopolitical tensions represent one of the major risks. The strategic confrontation between the US and China is important for banking credit quality in many countries, not just the US and China. This confrontation has implications for major global manufacturing economies and their banking sectors, such as Germany and Japan; as well as commodity-producing countries and mineral-exporting nations.
New Benchmark Rates: The planned introduction of new interest rate benchmarks in 2022 is another important development to watch as banks transition. Managing the associated operational, commercial, legal, and financial risks will be key.
