The European Banking Authority (EBA) published yesterday a preliminary assessment of the impact of COVID-19 on the EU banking sector. With the global economy facing unprecedented challenges, banks entered the health crisis with strong capital and liquidity buffers and managed the pressure on operational capacities activating their contingency plans. The crisis is expected to affect asset quality and, thus, profitability of banks going forward. Nonetheless, the capital accumulated by banks during the past years along with the capital relief provided by regulators amounts on average to 5p.p. above their overall capital requirements (OCR). This capital buffer should allow banks to withstand the potential credit risk losses derived from a sensitivity analysis based on the 2018 stress test.
Banks have entered the COVID-19 crisis more capitalised and with better liquidity compared to previous crises. In contrast to the Global Financial Crisis (GFC) in 2008-2009, banks now hold larger capital and liquidity buffers. The common equity tier 1 (CET1) ratio rose from 9% in 2009 to nearly 15% as of Q4 2019, including a management buffer above overall capital requirements and Pillar 2 Guidance (P2G) of on average about 3% of risk weighted assets (RWAs). In addition to the ample management buffers, the capital related measures put in place by EU regulators to mitigate the effects of the crisis will free up roughly 2% of RWAs. Similarly, prior to the pandemic outbreak, banks’ liquidity coverage ratios (LCR) were on average close to 150%, significantly above the regulatory minimum.
The COVID-19 crisis will have a negative impact on asset quality. As the crisis develops, banks are likely to face growing non-performing loan (NPL) volumes, which can reach levels similar to those recorded in the aftermath of the sovereign debt crisis. A sensitivity analysis based on the 2018 EBA stress test suggests credit risk losses could amount up to 3.8% of RWAs. Hence, the banking sector would on average count on enough capital to cover potential losses under the most severe credit risk shock while maintaining a buffer equivalent to 1.1p.p. of RWAs above their OCR. State-guarantees introduced in many jurisdictions might soften this impact while the EBA Guidelines on loan moratoria will avoid the automatic classification of affected exposures as forborne or defaulted. Nonetheless, banks should assure that proper risk assessment continues to be performed. The extent to which banks will be affected by the crisis is expected to differ widely, depending on how the crisis evolves, the starting capital level of each bank and the magnitude of their exposures to the most affected sectors. Competent authorities should address quickly any idiosyncratic weaknesses that could be exacerbated by the current crisis.
Banks have been using their liquidity buffers and are expected to continue using them in the coming months. Since February 2020, funding market conditions have significantly deteriorated, with spreads widening substantially and new unsecured debt issuances almost coming to a halt until mid-April. Under these circumstances, banks have increased significantly their reliance on central bank funding. Banks are also expected to make some use of their ample liquidity buffers in the months to come.
Banks’ operational resilience is under pressure. Following the outbreak of the pandemic, banks have activated their contingency plans, which have allowed them to keep their core functions broadly unaffected. However, the handling of large volumes of applications for debt moratoria and guaranteed loans, and the insufficient preparation of some offshore units to work remotely added some pressure on their operational capacities.