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Could COVID-19 Trigger a European Banking Crisis?

Analysis

Will COVID-19 be the trigger that takes us from a health crisis to a financial meltdown? Les Nemethy and Nicolas Beguin investigate.

Forecasts for GDP decrease within the European Union in 2020 run as high as 13%, even after taking into account massive stimulation by governments, according to NPL Markets, “Forecasting NPL Ratios after COVID-19.”

This is likely to trigger many bankruptcies and even more non-performing loans (an “NPL” is a loan where a borrower has a high probability of default or is actually in default).

NPL’s lead to the question: will COVID-19 lead to failure of one or more European banks? In this article we will talk about capital adequacy of the European banking sector; non-performing loans in the European banking sector; give a brief analysis of several weaker European banks; and some concluding comments as to the likelihood of bank failure or default.

Capital Adequacy

The European banking system has considerably improved capital to asset ratios since the Lehman Brothers crisis, with a 6% annual growth rate over the past 10 years.

This growth in capitalization was driven by the application of Basel II and III rules, which impose requirements for capital, liquidity and ability to absorb shocks. Some of these requirements include:

•    Common Equity Tier 1 ratio (CET1), which refers to the most basic and liquid core equity capital of a bank. Basel III has decreed that, since 2019, CET1 must exceed 4.5% for European banks; no dividends or employee bonuses may be paid in the event of losses unless CET1 has been topped up;

•    Minimum Tier 1 capital must be at least 10.5% (e.g. capital requirement that must be met in order for a bank to stay in business);

•    Minimum Tier 2 capital at 2% (e.g. additional capital that must be available to satisfy liquidation).

Tier 1 and 2 are percentages related to so-called risk weighted assets, creating a disincentive to hold highly risky assets, be they loans or derivatives. The Basel Committee has also introduced additional legislation for what it identifies as “Systemically Important Financial Institutions” (SIFI), e.g. banks that are “too big to fail.”

Fortunately, as of Q3 2019, European banks had a resilient CET1 capital ratio of 14.78%, according to ECB supervisory statistics, compared to the 4.5% threshold set by Basel III.

Non-performing Loans

Chart One provides an overview of historic and most recent NPL ratios in the European Union, as well as a so-called “worst case” forecast taking into account COVID-19.

COVID-19 will have massive effect on NPL’s, particularly in Italy and Spain, where the NPL ratio could exceed 20% and 10% respectively.

Selected Weak European Banks

Deutsche Bank has been on the regulators’ watch list for many years. While capitalization has come into line with Basel requirements, its profitability remains a concern. In 2019, it clocked a whopping -9.5% return on equity, albeit in the context of a restructuring exercise. A continued negative or low return could jeopardize financial stability.

On April 23, 2020, S&P lowered its outlook for Deutsche Bank to negative from stable and cut Commerzbank’s credit rating by a notch. S&P expects bank earnings, asset quality, and in some cases, capitalization, to weaken meaningfully through yearend 2020 and into 2021, according to Reuters.

Likelihood of Bank Default

We can breathe a sigh of relief that European banks met their Basel III requirements on schedule in 2019, just in time for COVID-19. Even the credit ratings of weaker banks, as mentioned above, seem to be within the range of acceptability.

Much stress has also been taken off the banking sector by massive government bailouts and guarantees. For example, in Italy, both the Italian government and the European Commission have provided guarantees on emergency loans given by Italian banks.

However, the NPL projections above are based on IMF calculations which assume a one quarter shock, and the virus will subside in the second half of 2020 (see the IMF’s “World Economic Outlook, April 2020: The Great Lockdown”).

But what if there are subsequent waves of virus, or worse, a severe mutation? What if no vaccine is found? What about the current crisis triggering as-of-yet unforeseen domino effects, which may range from supply chain breakdowns to war? Some pundits are suggesting that COVID-19 may even trigger the dissolution of the European Union.

In the end, runs on banks are seldom triggered by capitalization levels, but by depositor panics.

We should count our blessings that Basel III has been implemented, that we do not seem to be facing an immediate crisis; but we are far from being out of the woods.

Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.

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