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Covid-19: an acid test for European banks’ diversification and de-risking strategies

Scope’s outlook on European banks continues to be biased to the downside in view of the magnitude of the Covid-19 crisis. The key question 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 a report out today. “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 is concerned 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,” Brandenburg said.

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