Financial service providers should not ignore the risk of loan defaults - Part 1 - Banking blog

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The COVID-19 crisis is not a financial crisis and so it has had less of an impact on the financial sector than on many other sectors. Most financial service providers are well prepared for crises and well capitalised. However, the crisis is not yet over: the second wave of the pandemic is upon us, and a mass vaccination programme still some way off. The longer the crisis continues, the more the risk of loan defaults grows, so banks need now to be monitoring their capitalisation more closely, expanding their stress-testing tools, taking short, medium and long-term steps to boost their capital resources, and optimising monitoring of their loan portfolio.

Financial service providers less affected so far

Detailed analysis by the current swissVR Monitor shows that, by comparison with other sectors, financial service providers have proven well equipped to tackle the crisis, have experienced little direct impact and have not generally had to put crisis measures in place.

As Chart 1 shows, the financial services sector was more likely than most to have crisis management plans in place before the start of the pandemic. Ninety-two per cent of companies in the sector report that they had a business continuity management strategy in place, while 56% say they had carried out pandemic planning. Both figures are almost twice the average across the economy.

Chart 1. Measures taken before the start of the COVID-19 crisis, by sector

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Our survey of measures put in place following the start of the pandemic shows that financial services companies are substantially less likely than other sectors to have had to react with measures to tackle the crisis (Chart 2). The sector has therefore `had a good crisis’ and been spared the worst impact of the pandemic – so far.

Chart 2. Financial measures introduced during the COVID-19 crisis, by sector

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Regulatory measures taken in the wake of the 2008 financial crisis to strengthen the capital base have proven invaluable. For example, statistics published by the Swiss National Bank (SNB) indicate that the Common Equity Tier 1 (CET1) ratio rose from 16% to 18.35% between 2013 and 2019. The SNB Governing Board Chairman, Thomas Jordan, recently used a speech to confirm that both domestic and foreign-oriented banks were well capitalised overall.

On average, banks have therefore been well prepared both organisationally and in terms of their capitalisation. But, as good as their preparation has been, vigilance is crucial because it is increasingly likely that banks will need to fall back on their crisis plans.

The longer the crisis continues, the greater the risks – especially of loan defaults

Not even the best preparation can completely eliminate risks.  If the economic crisis continues, the risk to financial service providers will increase, especially in their loans business. Government measures have so far cushioned them. Automatic stabilisers such as unemployment benefit have at least temporarily mitigated the negative impact of the crisis on consumer spending, while specific COVID-19 measures, such as greater use of short-time working, are helping to stave off unemployment. Stabilising consumer spending helps sustain demand for financial products – especially in the retail sector – and demand for goods and services, boosting financial service providers’ B2B business. Government coronavirus loans have also had a stabilising effect, with banks playing an active part in tackling the crisis by making these loans rapidly available.

The measures taken by the Federal Council have been successful but can – and must – be only temporary. The longer the economic crisis continues, the more companies will go out of business because they cannot see light at the end of the tunnel and government support will become less effective. Meanwhile, unintended consequences of the government support have begun to bubble up. Fundamentally unproductive companies are being kept on life support, and the longer the government props them up, the greater the risk of ‘zombification’, which is not just expensive but also an impediment to essential structural change. Propped up zombie companies risk undermining the success of more productive ones and thereby create the risk of further zombification. It is unclear to what extent this has already occurred in Switzerland.

The intensity of Federal Council measures has waned since the summer, and some of the measures have been revised under new COVID-19 legislation. No new COVID-19 credits are being granted, and many special regulations governing short-time working have now expired, as have more detailed insolvency regulations. Other measures will remain in place until summer 2021, including income support measures. Further measures are under discussion, including hardship support for companies that have been particularly badly affected.

There are no simple answers to the dilemma of what support measures to put in place, and the problem has been exacerbated by the second wave of the pandemic.

Short-time working has fallen from the record levels seen in the spring, but the most recent State Secretariat for Economic Affairs (SECO) statistics indicate that around 300,000 employees were still affected by short-time working arrangements this summer. In July, a total of around 16 million fewer hours were worked than usual, about three times the drop in output recorded at the height of the financial crisis in 2008. That means that real unemployment remains higher than the official figure, which itself has risen: the rate of unemployment was 3.2% in October, one percentage point higher than a year previously.

Companies are continuing to rely on short-time working as a response to patchy and partial improvements in their business volume and order books. The current Swiss CFO Survey finds that a majority of companies do not expect revenues to return to pre-crisis levels until Q3 2021. Individual sectors including tourism, hospitality, retail and automotive component production have been particularly hard hit, prompting the president of the Swiss Credit Reform Association, Raoul Egeli, to warn of a wave of insolvencies in November.

The risk of the housing market overheating is also increasing – and with it, that of a slump which could jeopardise the sustainability of mortgages, particularly if unemployment rises. For the first time, the latest UBS Global Real Estate Bubble Index includes Zurich in the seven international cities with a housing bubble, with prices also overheating in Geneva. And while the supply of rental properties is expanding, the owner-occupied market in the booming regions has largely dried up.

From the perspective of the banks, personal loans, corporate borrowing and mortgages now all pose increasing risks. These risks are interlinked and may exacerbate one other. For example, an increase in corporate insolvency may drive up unemployment, with individuals then less able to meet their mortgage repayments.

The Swiss Financial Market Supervisory Authority (FINMA) includes both corrections to the housing market and, for the first time, corporate (foreign) loan defaults as major risks in its 2020 Risk Monitor. And FINMA says the COVID-19 crisis has heightened both these risks.

Initial estimates of the impact of the crisis on the EU suggest, for example, that a higher rate of loan defaults could see the Common Equity Tier 1 (CET1) of the 50 largest European banks falling from 14.4% to 12.6% in 2021, with the most negative scenario putting it at 11.4%. Aggregated credit losses could meanwhile more than double by 2022, and if there were a second hard lockdown, this could double, taking the default rate from below 4% to as much as 10%.

In the second part of the blog post next week, we examine the initial reaction from banks and summarise what they could do to be crisis-proof in the future.

Many thanks to Marco Kaeser for his valuable input to this article. Please reach out to our authors for any questions.

 

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Marc Grueter - Partner, Risk Advisory

Marc is a Partner in Deloitte’s Risk Advisory practice and a member of the Financial Services leadership team at Deloitte in Switzerland. Within Deloitte Switzerland he is in charge of Risk, Regulatory, Compliance and Transformation topics for Financial Services. Marc holds a PhD degree in Bank Management, Finance, Risk & Regulatory Management from the University of Basel. He has over 18 years of experience in the global Financial Services sector, as well as a solid background in Strategy and Management which he gained from working at a number of leading global Consulting firms.

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Florain Munz

Florian Munz - Senior Manager, Risk Advisory

Florian has over fourteen years’ experience in the areas of strategy, finance, risk and regulation for financial services companies. With his project portfolio, he focuses on – AQRs, comprehensive loan book reviews, (regulatory) stress testing exercises and scenario modelling; large-scale regulatory transformation initiatives in cooperation with supervisory authorities; and strategic transformation initiatives of the CRO Function towards increased effectiveness and efficiency.

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Eric

Eric Gutzwiller - Senior Manager, Risk Advisory

Eric is a Senior Manager at Deloitte for the Financial Services industry, especially focused on leading process optimization and digitalization as well as strategic TOM design projects in credit and credit risk management (Mortgage, Lombard, Corporate, SME, Consumer lending), Finance and Risk. He brings over 8 years of strategy consulting experience for both, globally leading institutions and developing players, as well as central banks and regulators, in several established (Switzerland, UK, US, Hong-Kong, Germany) and also emerging markets (CEE, Middle East).

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Dennis

Dennis Brandes - Manager, Research

Dennis is a Research Manager at Deloitte Insight Switzerland in Zurich, specializing on the Swiss economy, the Swiss CFO Survey and the financial services industry. He joined Deloitte in December 2010 after 5 years in the research department of one of the largest Swiss banks, where he had focused on the international aspects of the Swiss economy. Dennis holds a Master Degree in Economics from the University of Basel.

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