Common Equity Tier 1 capital buffers are close to all-time highs. Asset quality (measured by the percentage of nonperforming loans) is very robust. And balance sheet liquidity is exceptionally strong, boosted by a combination of unprecedented access to central bank funds (particularly in Europe), huge customer deposit inflows and muted loan growth.
Bank credit ratings have returned to pre–COVID-19 levels and there is potential for further upward rerating as agencies recalibrate their rating methodologies. Looking forward, we expect the banks will return some capital to shareholders, reducing balance sheet strength. Even so, we still think bank capital will remain buoyant—and highly supportive for bondholders.
Government Intervention Has Helped Enormously
The banks mostly entered the crisis in a financially strong position. The intervention of governments and their central banks has also been crucial. Massive support programs and stimulus packages have in many cases averted the worst-case outcomes from the impact of COVID-19 for businesses and individuals. That in turn has reduced the pressure on banks across the developed world.
On that basis, the large loan-loss provisions for COVID-19–related damage that the banks made in 2020 now look overly prudent, and some have already been written back. The banks appear to have fully provided for a potential increase in loan losses in 2022 and 2023. And if anything, they should have scope to reverse more of their provisions in the second half of this year as previous economic assumptions continue to be revised upward.
Bondholders Are Beneficiaries—but Face Some Threats Too
Although equity profitability remains muted—constrained by low rates, competition, the costs of digital capex and (in the short term) loan-loss provisions—the shift to a rising-rate environment should help boost banks’ profits. But for banks’ bondholders, profitability is not so important, except insofar as it affects banks’ ability to raise fresh equity capital. Their main concern is the strength of the equity buffers that protect them from capital losses. And the current very healthy state of bank balance sheets benefits the riskiest bonds—subordinated credits including contingent convertible bonds such as Additional Tier 1 (AT1) securities—the most.
Banks’ bondholders enjoy some further advantages in a post-COVID world. For instance, legacy issues such as GFC-era lawsuits are mostly resolved. More credible regulatory stress-testing (now including climate risks) gives more comfort than pre-GFC, and greater regulatory support for mergers and acquisitions (especially in Europe) should make for stronger banks and better-protected bondholders.
Also, bank business models are becoming better diversified, with a greater focus on fee-generating activities. And the worldwide transition to greener business models should create more opportunities for profitable lending.
But banks’ bondholders face some new threats too. Banks will now be looking to return what they deem to be excess capital to shareholders in the form of dividends and buybacks, with US banks likely the most aggressive. But although we expect CET1 buffers to weaken a little, we think regulators will stop the banks eroding them too close to the minimum requirements.
That said, the next crisis could prove harder to weather: governments have extended extraordinary levels of support during the pandemic but are unlikely to be able to respond to emergencies so generously in future. Also, technological advances can drive profits but may also fuel new competitors. The banks have done well to fend off challengers so far, but disruptive new entrants are still a risk. Lastly, the possibility of a major cyber incident remains a serious and unquantifiable threat (Display).
