Coronavirus' Effect on the Financial Sector
Volatility isn't always bad, and banks are better off now than they were in the financial crisis.
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Not many companies in the financial sector are immune to the coronavirus, but financial exchanges and data companies should be relatively stable. Market data is an essential purchase for many financial services companies, and higher market volatility should boost trading activity in equities and derivatives. The long-term impact is more difficult to assess, as a prolonged bear market may reduce investors’ risk appetite for an uncertain duration; turnover and liquidity may remain low despite a market recovery.
The benefit to other companies with material trading revenue, such as investment banks and retail brokerages, will probably be more than offset by a decline in other portions of their business. Fewer companies come public when markets are volatile, which will affect equity underwriting. Restructuring advisory will improve in a recession, but it won’t be enough to offset merger and acquisition advisory, which will likely be subdued until corporate executives gain more confidence in the economic outlook. Retail brokerages will have higher client trading activity; however, higher trading revenue will be more than offset by a decline in net interest income from the recent reduction in interest rates. The effect on insurers is also likely to be negative, with declining investment income and unusual liabilities associated with business disruption emerging.
If this bear market follows the same course as the 2008-09 financial crisis, then active asset managers with heavier exposures to money market funds and fixed income will see some benefit as investors park capital in perceived safe havens, with bond funds benefiting from inflows and market gains as bond prices rise in response to reduced rates and investor rotation into fixed income. For those with heavier active equity exposure, we’re likely to see the one-two hit of a decline in asset-based fees with the stock market rout and net outflows from investors seeking safety.
Increased volatility will separate the strong active managers from the weak and test whether active equity management can truly outperform during a downturn. If they do outperform, we would only expect to see a modest improvement in organic growth as investors generally need to be convinced that it is sustainable. Passive equity managers are likely to suffer more from market losses than net outflows, but redemptions could accelerate if the market continues to be volatile and falls further from here.
How Will Banks Fare Under Lower Rates and Higher Credit Costs?
Banks underperform during downturns, and we expect increasing pressure on credit quality in the short term. However, the COVID-19 pandemic does not overly change our long-term outlook, as banks are generally better positioned, in our view. Banks are inherently macro sensitive. While the impact of slower growth, lower interest rates, and higher credit costs is relatively well understood, the real key in our minds is whether banks are better positioned from a credit and capital standpoint, and we believe they are. Banks were hurt to an unusual degree during the global financial crisis, but there were systemic issues at play and capital levels were too low, causing the need for equity capital raises. Once a bank gets to the point of requiring capital infusions, permanent impairment of capital is occurring for shareholders. Currently, we don’t see a systemic financial crisis brewing, and as such, we don’t expect permanent impairments of capital to occur.
The good news for Japanese banks is that the Bank of Japan didn’t expand its negative interest-rate policy, which cratered share prices of local banks when it was first launched in early 2016. Instead, the BOJ’s actions were confined to measures that are unlikely to hurt banks’ profitability much and could help them navigate short-term stresses. These are (1) provision of additional U.S. dollar liquidity to banks at lower rates and for longer terms than previously; (2) a new operation to provide one-year loans at 0% against corporate debt as collateral, together with additional potential purchases by the central bank of commercial paper and corporate bonds; and (3) larger targets for the central bank’s ongoing purchases of stock index funds and real estate investment trusts.
Weaker net interest margins are likely for Asian banks, but the impact will vary. Most Asian banks are net lenders, and with the U.S. Federal Reserve making consecutive cuts to the federal-funds rate to 0%-0.25%, we expect lower interbank rates in Korea, Hong Kong, and Singapore to flow through to weaker net interest margins and profitability. The impact depends on the level of liquidity in the respective banking system and how this translates to interbank rates.
We lowered our forecasts for the four Korean banks we cover to incorporate even steeper erosion in net interest margins than we previously expected, as well as a sharp upturn in credit costs. We now expect net interest margins to fall 12-20 basis points in 2020 and another 5 basis points in 2021, roughly double our previous expectation. We also now expect credit costs to approximately double in 2020 compared with 2019 levels and remain elevated thereafter. We expect earnings for all the banks to decline more than 20% in 2020 due to increased credit costs and potential asset write-downs. Nevertheless, current valuations of around 0.3 times book value mean that the shares of the Korean banks we cover remain very attractive for long-term buyers, in our view.
From a sensitivity perspective, we estimate the impact of a 25-basis-point cut on net interest margin is 2-5 basis points for the Singapore banks and 3-5 basis points for the Hong Kong banks. In addition to the liquidity level within each banking system, we expect the banks to actively manage their asset yields and funding costs. For HSBC (HSBC)/(HSBA)/(00005) in Hong Kong, the bank held its prime rate (its best lending rate) unchanged, and this should support asset yield, in our view. On the liability side, fixed deposit rates were lowered, and we expect this to alleviate funding costs for the bank. Both measures are expected to minimize pressure on net interest margin, and other banks domestically should follow suit. Uncertainty remains high, given the diverse outcome of the coronavirus situation and the monetary responses by central banks.
In China, for instance, while we expect recent policy easing and slower growth to expedite the falling interest-rate trend in 2020, we believe the negative impact on earnings will be similar to 2015-16 for large banks. Here, the previous easing cycle saw a 165-basis-point decline in the lending benchmark rate and about 50% growth in credit costs from 2014’s level, leading to average net profit growth of 0.7% and 1.6% in 2015 and 2016, respectively. Now, the loan prime rate has declined roughly 26 basis points to 4.05%, and we anticipate the full rate-cut cycle to likely range from 50 to 100 basis points. However, we expect the magnitude of an interest-rate cut to be less than the 165 basis points we saw previously, as lower rates will largely be realized through an asymmetric rate cut to the loan prime rate. Besides, we expect fiscal stimulus, rather than credit easing, to play a leading role this time.
For large banks in China, we don’t expect credit costs to double like in 2008, when the economy was more reliant on exports. We believe banks have stronger capital and more sufficient provisions to buffer against the risks. Over the past seven years, banks have optimized their loan portfolios, adopted strict bad-debt classification standards, and lifted provision coverage loans under a more stringent financial regulatory framework. For the big four Chinese banks, the average provision coverage ratio of total overdue loans had improved from 121% at the end of 2015 to 207% as of mid-2019. Thus, we project an increase of 5-20 basis points in credit costs in the next two years and expect both net profits and dividends for the large banks to be flat in 2020 and 2021.
Our European banking coverage list has an average exposure to oil and gas equal to 33% of common equity Tier 1 capital. The sharp decline in oil prices has brought to the fore the risk faced by banks that have granted significant credit to oil and gas companies. Three banks with significant oil and gas exposure do boost the average significantly, however: Natixis , Credit Agricole (ACA), and ING (ING)/(INGA) have oil and gas exposure equal to 134%, 105%, and 82% of their respective common equity Tier 1 capital bases. At the other end of the spectrum, Julius Baer (BAER)/(JBAXY), Handelsbanken (SHB A), Intesa Sanpaolo (ISP)/(ISNPY), UBS (UBS)/(UBSG), Lloyds (LYG)/(LLOY), and KBC (KBC) have oil and gas exposure equal to less than 10% of their capital bases.
For the banks, dividend sustainability essentially comes down to two things: net income and capital levels. Banks need a certain level of capital to remain well capitalized, and they need a certain level of net income to maintain dividend payments. Credit losses can eat away at capital levels, presenting one risk to dividend sustainability. As capital is depleted, the bank will need to use its net income to rebuild capital, potentially putting dividend sustainability at risk. Net income is used to fund the dividends, so lower income, even without credit losses, also puts a strain on funding the dividend. If a bank suffers lower net income and big hits to capital levels, it is a double strain because it has to use a more limited net income stream to first fund its capital, and there isn't as much left over for a dividend. Any dividend payout that exceeds net income will reduce capital over time.
While it is tough to tell now what the fallout will be from the coronavirus outbreak, at the very least we can say that the banks are much better positioned today than they were during the financial crisis. Dividend payout ratios are generally lower than before, with most banks we cover at around 30% and several closer to 40%. Capital levels are also higher. Tangible equity/tangible asset levels are up more than 60% since 2007.
For dividends to come under threat, there would have to be a severe recession that caused net income to fall significantly for a sustained period and credit losses to increase by a significant amount. We believe it would have to be severe enough for net income to decrease roughly 40% or more, while credit losses would have to be large enough to eat up materially more than 40 basis points of common equity Tier 1 each year, likely at least 150 basis points more than 40 basis points. All the banks we cover have more than 150 basis points of cushion in their common equity Tier 1 ratios before they begin to reach certain minimum requirements, and in most cases they have more than 200 basis points of room. Right now, most excess cash has been used to make share repurchases, and the banks can easily stop these repurchases if earnings come under severe pressure. The severely adverse scenario we described could happen, but for now we would view it as very unlikely.
Johann Scholtz, Michael Wu, Michael Makdad, and Iris Tan contributed to this article.
Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.