The banking system is at the heart of government efforts to prop up economies as lockdowns are eased
The banking system is at the heart of government efforts to prop up economies as lockdowns are eased © Simon Dawson/Reuters

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How safe are the banks? It is a question that was asked during the financial crisis in 2008 and is again rearing its head as the economic cost of the coronavirus crisis becomes clearer. The banking system is at the heart of government efforts to prop up economies as lockdowns are eased. Banks are taking much of the strain, extending loans to businesses and consumers whose livelihoods have been taken away by the pandemic.

The concern is that many of these loans will never be repaid. A new report suggests that European banks could face loan losses of up to €800bn over the next three years. The figure is based on a worst-case scenario, including a severe second outbreak of the virus, but it is something to which regulators and bank chief executives need to be alert.

Second-quarter results in coming days, including from Deutsche Bank, will provide greater clarity. Switzerland’s UBS saw profits slip this week as higher provisions for bad loans offset a strong performance in its trading division. Buoyant trading revenues also dominated results from the five biggest Wall Street banks and overshadowed a combined $20bn of loan loss provisions for the quarter. But the cheer has proved shortlived, with JPMorgan’s Jamie Dimon already warning of a slowdown in the second half of the year.

Given the severity of today’s financial crisis regulators have relaxed audit rules to allow lenders greater freedom to trim loss-absorbing buffers. Such forbearance from regulators is inevitable over the short term, but the concern is some banks will try to avoid booking large provisions now. They should resist the urge to do so. First-quarter results already showed a wide range of reported loan provisions, underlining the delicate balancing act lenders are being forced into.

Banks today are more resilient than they were 12 years ago, with greater liquidity and higher capital levels. In the US, the Federal Reserve last month compared the buffers of large banks against the losses they might face in a range of coronavirus-based economic scenarios. In the worst-case outcome, the average loan-loss ratio rose to 10 per cent, indicating $700bn in total losses for the sector. This number may be high but even in such a situation, capital buffers at most lenders would not be wiped out; aggregate capital ratios would fall from 12 per cent in the fourth quarter of 2019 to 7.7 per cent.

Europe’s banks might fare less well. They are less profitable than their US peers — which benefit from their large investment banking arms in the current market — and many, in particular those in southern Europe, remain burdened by high levels of legacy debt. Timely loss recognition is critical. Research shows it allows regulators to intervene early if necessary and also helps to prevent excessive risk-taking.

So too, is a realistic approach to the thorny issue of how long restrictions on buybacks and dividend payouts should remain in place. In the US, the Fed told several banks as part of its stress test results that they had to preserve capital and should cap dividend payments and suspend share repurchases in the third quarter. The approach is sensible. In recent years, share repurchases have represented about 70 per cent of shareholder payouts from large US banks. European executives — and banking regulators — should take their lead from the Fed and proceed with similar caution.

Much better to bear the ire of bank executives and short-termist shareholders than run the risk of the pandemic turning into a threat to the stability of the financial system.

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