On 25 May 2020, the European Banking Authority (EBA) published a Thematic Note setting out its preliminary analysis on the impact of the COVID-19 pandemic on the EU banking sector (Thematic Note). The EBA’s assessment is mainly based on supervisory reporting data (particularly Q4 2019 data) submitted by a sample of EU banks, excluding UK banks.
The overall analysis suggests that the EU banking sector is generally resilient and able to withstand the shock, despite the unprecedented challenges the global economy is facing due to the coronavirus crisis.
State of the EU Banking Industry
According to the Thematic Note, EU banks are better prepared, in terms of both capital and liquidity levels, compared to previous crises. Banks now hold larger capital and liquidity buffers, compared for example to the global financial crisis in 2008-2009.
For instance, the Common Equity Tier 1 (CET1) ratio has increased from 9% in 2009 to approximately 15% in Q4 2019, which is well above the regulatory requirements. In a similar vein, banks’ overall Liquidity Coverage Ratio (LCR) was around 150% in Q1 2020, which is also above the regulatory minimum.
The Thematic Note does say however that a number of vulnerabilities persist. Since the end of 2019, the profitability levels of banks have remained low and many banks struggle to earn their cost of equity. In addition, the low interest rate environment, which already existed before the crisis, is expected to continue for an even longer period of time.
Impact of COVID-19
The Thematic Note highlights that a key concern is that the COVID-19 pandemic is expected to have an adverse impact on asset quality. In the last few years, EU banks have generally increased their exposures towards more risky borrowers, such as Small and Medium-sized Enterprises (SMEs) or consumers. The Thematic Note states that it is anticipated that banks will face growing Non-Performing Loan (NPL) volumes, as a result of the COVID-19 pandemic, which could potentially reach levels similar to those recorded following the sovereign debt crisis. The fall in asset quality could be accompanied by increased Risk-Weighted Assets (RWAs).
On the basis of a sensitivity analysis performed, taking into account the 2018 EBA stress test results, it is estimated that credit risk losses could reach up to 3.8% of RWAs. This means that the EU banking sector would on average have enough capital to address potential losses under the most severe credit risk shock.
Measures taken to mitigate the economic effects of the COVID-19 crisis, such as the provision of state-guarantees, could potentially soften the negative impact of the pandemic. In addition, the EBA guidelines on loan moratoria will prevent the automatic classification of affected exposures as e having increased credit risk or having defaulted. It is expected, however, that the impact of the pandemic will differ among banks. For example, banks with idiosyncratic weaknesses or with large exposures to affected sectors will be most impacted by the COVID-19 crisis.
The Thematic Note also points out that funding conditions have deteriorated significantly due to the COVID-19 crisis. Spreads have widened significantly since February 2020 and new unsecured debt issuances have nearly come to a halt in the period to mid-April. In addition, approximately 20% of securities issued by banks will mature in the following 6 months, while an additional 10% will mature within 1 year. As a result, banks have been relying increasingly on central bank funding. They have also been using their liquidity buffers and are expected to continue to do so in the next months.
Lastly, according to the Thematic Note, EU banks are facing pressure in terms of operational resilience. Since the wake of the pandemic, banks have been implementing their contingency plans in order to be able to keep their core functions unaffected, to the extent possible. This has included, for example, setting-up ad-hoc crisis and remote units and the extension of teleworking. However, the need to handle large volumes of applications for debt moratoria and guaranteed loans has put additional pressure on banks. Moreover, it was observed that some banks’ offshore units were not sufficiently prepared to work remotely.