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| In a COVID-19 scenario, are banks prepared for what's to come? |
The year 2020 is not even a quarter over, and it has been a rocky ride already. We haven't seen this since you pick it: (a) the 2008-09 mortgage and financial crisis, (b) the 1999-2001 crises related to dot-com bubbles bursting and the aftermath of Sept. 11, or (c) the Great Recession that followed the financial crisis of 2008.
In 2020, after the COVID-19 outbreak, we've experienced record-breaking volatility (depicted also in Wall Street's closely watched VIX trading index) in equity markets. We've observed uncertainty about liquidity and bond-market performance, and interest rates near zero. We now expect an immediate economic decline and a recession.
Are banks ready for what's coming in the months to come? Have they prepared for sudden shocks? Have they prepared for continued volatility of markets of all kinds (equities, fixed-come, currencies, commodities, etc.)? In the first days of this crisis, we saw extraordinary volatility in equity markets. Since then, we have seen unusual fluctuations in corporate and municipal bond markets.
Have banks prepared for higher expected losses in loan portfolios? Do they have sufficient liquidity to manage liabilities, funding and even operations over the next year?
Bank Stress Tests
The current environment (at least that of Mar., 2020) is characterized by stress that banks and regulators in theory have been using in projections and models after new rules required banks to either perform stress tests or be subject to them from by the Federal Reserve in the U.S.
One irony is that as we prepare for what might be "prolonged stress" (defined as nine quarters by regulators), regulators in the past year granted banks relief in requirements for stress tests. Federal Reserve-administered stress tests describe a specific scenario. From the scenario, it makes assumptions about economic indices and financial metrics and apply those assumptions to bank income statements and balance sheets.
The test performs specific calculations about how much a bank could lose in stress scenarios and in extreme-adverse scenarios: How impact will a 50% decline in equity markets have on banks? What impact will a 25-30% decline in the value of real estate have? GDP growth rates fall below 2% (on an annual basis)? The U.S. dollar appreciates versus other currencies? Unemployment climbs above 10%.
In its separate role, the FDIC, as a bank regulator, analyzes banks in phases:
(a) business as usual,
(b) under stress,
(c) recovery after periods of stress, and
(d) resolution, when it determines a bank is insolvent.
Just as the Federal Reserve examines how banks fare in clearly defined stress scenarios, the FDIC looks to see how banks will respond in each of its defined phases of deterioration and decline.
The Federal Reserve conducts its test and announces which banks would have passed or failed. Last year, it increased the threshold for which large banks would be subject to such tests from $50 billion in assets to $250 billion in assets, a form of regulatory relief that many banks applauded (to avert the pressure of such scrutiny and to reduce the administrative tasks to submit data to the Federal Reserve).
Under revised rules, other banks should still conduct these tests, based on their own models, and submit the results to regulators. The results of the 2020 tests for the top banks are scheduled to be announced before 2020's halfway point.
Big banks don't want the stigma or bad publicity that accompanies a failed test, so they have worked hard to ensure they pass these tests. In recent years, the familiar large banks (like JPMorgan Chase, Bank of America and Citigroup) have passed these tests, ensuring they could withstand billions in losses.
Keep in mind the stress tests aren't focused on assessing the stock value of banks, which have been slammed in recent weeks and are based on an assessment of bank earnings over the long term. Regulators would be concerned about "stock values" mostly when they assess whether a bank can issue new shares to the public to boost capital on the balance sheet, often to support loan growth or absorb other unforeseen risks. This all implies that a bank can satisfy requirements of a stress test and maintain adequate amounts of capital, while its stock price tumbles.
Yet as this crisis unfurls, just days ago the Federal Reserve granted banks another round of capital relief by deciding not to require big banks to be subject to what was called a "stress capital buffer" to ensure banks could pass annual stress tests sufficiently. On the table was a recommendation that those "too big to fail" banks should have additional "incremental capital surcharges" to ensure they have capital to pass tests. The "buffer" will not be required, but banks are expected to have excess capital to pass the Federal Reserve's test in any given year.
Such regulatory-administered stress tests have assumptions based on past events, although they are essentially theoretical scenarios. The current scenario, however, is real.
Where could banks be vulnerable?
Many of the new rules today (Basel III rules, U.S. Dodd-Frank regulation, etc.) were based on lessons learned from the financial crisis. And they focus on making sure banks can absorb losses and have sufficient liquidity (cash and liquid securities like U.S. Treasurys) to meet unexpected funds withdrawals. The losses can arise in three fundamental areas--from credit risks, market risks, and operational risks.
Liquidity requirements are assessed separately. There is no capital requirement; there is a requirement the bank has sufficient cash or cash-equivalents to manage unexpected cash outflows, particularly the outflows during a 2008-like stress scenario.
Despite cries new regulation has been a painful burden, U.S. banks have responded well to show they meet requirements across the board. Now we arrive where the requirements themselves will be put to test.
Most banks manage capital levels by ensuring they have excess capital to address all risks--regulatory risks and other risks regulators don't account for (legal risks, documentation risks, reputation risks, country risks, etc.). Most banks also have capital plans based on scenarios and assumptions more conservative then regulatory requirements-- at least to provide a comfortable cushion far in excess of regulatory expectations.
Credit Risks
Banks set aside loan-loss reserves to account for expected losses in the loan portfolio. They must maintain capital for unexpected losses.
In the current environment, banks will reassess their loan-loss reserves in a year when accounting rules required they increase reserves to account for long-term risks, not just short-term risks (subject to what is called the "CECL" rule "Current Expected Credit Loss"). Banks were already adapting to the new rules, which would have increased reserves and reduced earnings. Now they must reassess credit portfolios (consumer loans, corporate loans, letters of credit, credit commitments, counterparty-trading credit risks, etc.) to ensure reserves are still adequate.
Capital requirements account for unexpected losses (extreme-case losses) beyond expected losses (ongoing average losses in a portfolio).
In an economic decline, borrowers and counterparties will deteriorate in creditworthiness. That will lead to increases in loan-loss allowances (or reserves, as they sometimes called) and higher capital requirements, which are a function of the credit quality of the borrower or the counterparty.
As we learned from the financial crisis, banks must be prepared for other unforeseen risks. They examine the risk of each loan, each form of exposure, and each type of exposure. But crisis lessons taught us banks must examine the risk of the relationships among exposures. This leads to such risks as concentration risks and correlation risks, which must be addressed and accounted for.
Right now, risk and financial managers at banks are scoping credit portfolios to see where there are concentration risks and then decide what to do about it. Without doubt, oil and gas and energy portfolios are subject to scrutiny now because of the nose-dive drop in crude-oil prices this month.
But what other industries or consumer segments are vulnerable? Some industries and segments are less vulnerable than others, and risk managers are (or should be) identifying the most vulnerable. At the same time, they should be setting strategy in how to manage these risks.
Correlation risks (as banks learned from the crisis) arise from the likelihood that credit exposures in one industry or segment could be correlated or linked in some manner to the exposures in other industries and segments--effectively, a domino effect. Could problems in loans to retail-industry borrowers lead to, be correlated with, or could cause problems in loans to real-estate borrowers?
The financial crisis of 2008-09 presented today's risk managers a long laundry list of factors, risks and issues to review as we endure today's scenario.
If banks have been managing these risks shrewdly and have been performing and passing stress tests, then they should be prepared to weather a two-year downturn and remain solvent. Managing credit risks and ensuring there are adequate amounts of reserves and losses don't, however, address the fact that growth in loan portfolios and net-interest income (contributions to income) will be stifled for a few quarters.
In the short term, for banks with significant numbers of corporate relationships, the loan portfolio will grow. Many (if not most) corporate borrowers of all sizes have committed revolving-credit agreements with banks--some requiring exposure to be secured. Heretofore, large corporate borrowers (Fortune 500 names, notably) prefer to tap commercial paper and other cheap funding sources to fund operations (including working capital). They, as smaller corporate borrowers, have revolving-credit facilities for back-up or emergency purposes and for other various uses.
In the early days of this crisis, one by one corporate borrowers resorted to Plan A to ensure what could be weeks/months of hardship. Plan A stipulates they must have adequate liquidity, cash on hand to meet current obligations, current operating costs, or something unforeseen. Hence, they quickly drew down on the R/C arrangements, even when they often avoid usage or don't need funding. In a stress scenario, corporate CFOs and treasurers also understand if they wait to borrow, they may no longer qualify to access the funding (having breached "financial covenants") or risk the bank not being able to provide such funding easily.
Over time, with interest rates at historical lows, some borrowers (corporate and consumer) will consider refinancing outstanding debt. For now, it's likely most are focusing on operating performance over the next six months.
Market and Investment Risks
With anxiety swarming markets these days, banks are vulnerable. They have investment portfolios and, for the few large institutions, they have trading positions (securities and derivatives positions). Most banks are more likely vulnerable to interest-rate fluctuations than volatility in equity and commodity markets. Large, global banks (like Goldman Sachs and JPMorgan Chase) devote resources and capital to trading. For that group, vast market swings have impact on trading positions that exceed $100 billion. (They trade within the restrictive guidelines in the U.S. of the Volcker Rule, but will indeed have positions in equities, corporate bonds, municipal bonds, and derivatives of all sorts.)
Similar to credit risks and related stress testing, regulation is supposed to ensure they have a capital cushion to absorb unexpected losses. Banks compute regularly "Value at Risk" ("VaR") (a projection based on amounts of the maximum they could lose in a short period of time from trading and investments). They also go through countless "sensitivity" analyses, calculating the impact of equity-market declines, interest-rate changes, commodity-price increases/decreases, foreign currency fluctuation, etc.
(Citigroup reported a "VaR" calculation of $98 million for Dec. 31, 2018, which implies the greatest it can lose in one day (with 99% confidence) is $98 million or $308 million over 10 days. It uses Monte Carlo simulation to derive these figures.)
For these big banks, regulation tweaks the VaR calculations and requires banks to maintain capital to absorb these short-term market losses. (Smaller banks use different standards.) Hence, most banks will have had sufficient amounts of capital for these projected 10-day losses.
Analysts will question whether banks have sufficient amounts for "black swan" losses and losses that continue beyond two-week periods. "Black swan" losses refer to losses beyond these model-based worst-case calculations. New regulation (Basel III), not yet fully implemented, is supposed to account for "black swan" scenarios.
The more worrisome risk here may be "model risk," the risk that their models and approaches to computing worst-case losses are not adequate or don't account for factors that characterize the current crisis. In just a few weeks in March, we've seen volatility and near crashes in equity markets, disruption and uncertainty in corporate and municipal bond markets, sudden falls in crude-oil commodity prices, sharp increases in credit spreads in credit-default-swap derivatives, and increases in the dollar currency.
Banks in investment and trading portfolios might have large amounts in municipal bonds, corporate bonds, or mortgage-backed securities. While interest rates have declined, increased "credit spreads" on these positions lead to valuation declines, mostly because credit risk exists in these portfolios. Bank models should account for potential losses.
The challenge banks are already experiencing include
(a) many of the positions are hard to price (hard to find a true market value) in the current scenario and
(b) many of the positions may be hard to sell off (hard to find a buyer) if they choose to liquidate (customary liquidity risks that accompany market turmoil).
If they do need to sell assets, they may need to sell at deep discounts. Regulators push banks to account for these factors, as well, before the scenarios occur.
Accounting rules require banks to identify assets that might be difficult to sell by requiring they classify and sum up "Level 3" assets (assets for which prices are determined based on internal models and not on recent trades).
Interest-Rate Risks
March, 2020, has already featured the Federal Reserve (and central banks around the world) responding quickly by reducing interest rates sharply and quickly. Interest-rate reductions at the central bank lead to reductions in rates across the spectrum (across the yield curve).
Interest-rate declines can lead to fair-value or market gains in fixed-income portfolios. But they also lead to decreases in net-interest-earned on the loan portfolio, especially if large portions of the portfolio are floating-rate assets.
Bank regulation requires banks to compute the impact of a decline in interest rates on the loan portfolio. And they do so regularly and are expected to manage related risks. Basel III requirements stipulate banks must compute the impact of a specific decline in rates and determine how much net-interest-earned will fall, as a result. Most banks will compute based on parallel shifts in yield curves and other scenarios.
Hence, they should know the specific impact already of the decline in rates and should have had strategies for how they would respond (interest-rate hedging, reductions in funding costs, etc.).
Liquidity Risks
During periods of stress, banks must have liquid assets and cash to meet unexpected withdrawal of funding (deposits, especially). Basel III and Dodd-Frank regulation addressed liquidity risks conservatively--almost too strenuously in the views of many big banks. Banks must be prepared for the extreme cases when depositors and lenders (in repo markets, e.g.) want their money back without warning or delay.
Regulation today delineates line by line which fund-providers are likely to withdraw funding in a crisis. It's an extreme-case scenario.
In today's crisis, it is not yet clear how depositors, repo investors, commercial-paper investors, and other short-term lenders will respond. In 2008, the concern was the financial condition of the bank. In 2020, the issue might be that lenders and depositors have no other safe haven for funds--except federally insured banks.
In the current crisis, the Federal Reserve responded immediately, bringing forth some lessons from 2008. Big banks already maintain liquid balance sheets. (Citigroup, for example, maintains over $300 billion in "High Quality Liquid Assets"--the liquidity-regulation requirement.) But within days of when this crisis became a crisis, it implemented facilities to permit banks to tap funding from the Federal Reserve easily and without stigma (at its "window" and via repo markets). And the Federal Reserve has outlined plans to consider purchasing assets it normally doesn't (corporate bonds, e.g.).
Perhaps the greater concern for now might be "asset liquidity risk." Will assets that are normally liquid in a stable environment be liquid in a stress scenario? Those mortgage-backed securities that were easy to sell in December? Those AA-rated municipal bonds that were not difficult to find a market maker in November? Those structured notes a hedge fund might be willing to buy in October?
Will a bank be able to sell a New York State MTA bond in April that was easily convertible to cash in January? And if so, what discount must it sell it to get cash?
Liquidity risk managers are likely (or should be) reviewing securities positions to assess whether liquidity has diminished in select markets. A prominent 2008-09 lesson learned in that crisis was that mortgage-backed securities and other structured products were not nearly as easy to trade out of as expected or hoped, even if the security had an investment-grade rating.
Performance and earnings
Balance sheets, loan portfolios, market positions, liquidity and funding will garner much attention. Yet banks must tend to the bottom line. Operating revenues must be sufficient to meet operating expenses on an ongoing basis.
In good times, earnings and earnings growth contribute to higher capital bases, higher returns on capital, and higher stock prices. Banks across the country in 2018-19 experienced substantial gains in earnings (thanks partly to a robust economy, thanks also to new tax rules). (PNC Financial reported earnings above $5 billion in each of the past three years. US Bancorp has generated earnings of $7 billion the past two years). Returns on capital, often lagging below 10% for most banks, have begun to eclipse that threshold. At least until now.
In 2020, banks will focus on ensuring operating income is positive. Operating revenues in many categories will dip quickly: Asset management fees will fall if assets under management decline because markets have fallen. Investment-banking underwriting fees will fall if new stock and bond issues decline. Fees from mergers and acquisitions could disappear for a quarter or two. Net-interest income, because of declining interest rates, will decline, but might be offset by a temporarily larger loan portfolio.
Fees from deposit services, credit cards, funds transfer and cash management, if lucky, might remain stable.
Banks then will focus on operating expenses. This comes down to an assessment of fixed costs and variable costs. From 2009 until recent periods, U.S. banks had made remarkable strides in reducing, containing and managing costs. Ratio trends (operating expenses/net revenues) prove this.
In expenses, first up is always an assessment of employee-related expenses, typically the highest expense category at most banks. (At US Bancorp, employee expenses are 36% of total net revenues, 32% at JPMorgan Chase, 35% at Regions Financial.)
Does the bank reduce staff? Or for now, does it put a lid on growth in personnel? Does it proceed to hire and bring onboard the number of banking associates and analysts it had intended to do in January?
When analysts and ratings agencies assess bank liquidity, they seldom examine whether there is sufficient cash on the balance sheet for operating purposes. Liquidity is reviewed to evaluate whether it can manage expected and unforeseen withdrawal of funding.
If banks proceed through a period of negative operating income (and operating cash-flow deficits), then they will examine whether they have sufficient "operating cash" to ensure they can meet expenses over a defined period. They may determine that at all times they should have sufficient cash to meet six months of operating expenses.
Capital adequacy
By definition, bank regulation requires capital to absorb worst-case losses and expect banks to maintain capital at levels far above minimum requirements. This implies that all regulated banks are, in theory, supposed to have capital to absorb extreme-case losses arising from credit, market and operational risks.
Since the financial crisis, regulators have implemented countless other rules to help banks endure periods of stress and substantial losses. That includes the stress testing described above, but it also includes additional requirements--many of which have spurred big banks to silently protest as being too onerous. This includes, for example, the "capital surcharges" (incrementally higher requirements) for banks deemed "globally systemically import" (GSIBs, or "banks too big to fail"). This also includes other layers of capital cushion in the form of subordinated debt and senior long-term debt (Tier 2 capital, "TLAC" requirements, etc.).
So at least on paper, Basel III and Dodd-Frank regulation was intended to boost capital levels at all banks such that when stress occurs, they would be ready. Until recent events, in the U.S., banks were successfully lobbying to lawmakers to reduce some of the capital burden or at least recommending they make the computation of requirements easier and more consistent.
Regulation requires banks to show not only whether they are in compliance today, but require banks to prepare capital policy and present a capital plan for future periods. In 2020, regulators will likely nudge banks to polish these plans and articulate clearly how capital will be deployed or allocated in the new, still-uncertain environment.
Are banks adequately capitalized for the periods to come? The best answer for now is they are better capitalized and slightly better prepared for economic hardship than they had been in previous crises.
Rating Agencies
Rating agencies (Fitch, Moody's and S&P) have a role, too.
They analyze the largest banks continually, identify risks and issues, and assess banks in the form of a rating and an outlook and watchlist (an expectation of how ratings could change in the future). Today, many of the large, familiar U.S. banks have ratings in a BBB+ to A range. (Fitch Ratings, for example, at the beginning of the year had rated US Bancorp an AA- and Regions Financial a BBB+).
In a crisis period, investors, analysts and the general public will turn to rating agencies for guidance for how banks are faring and responding and for how they are prepared for downturns or uncertainty. In theory, the existing rating for a bank should reflect the rating agency's current view of how the bank can respond and get through a downturn or crisis scenario. They analyze operating performance, but they examine whether the bank has excess amounts of capital to survive challenging times or strong, sturdy balance sheets.
Since the financial crisis, the agencies are now supervised by regulators (the SEC in the U.S.) and are subject to standards for how they perform their roles and finalize their ratings. Supervisors don't expect or require the agencies to change, update and downgrade ratings every other minute in the way shareholders revalue stocks every other second. Thus, we wouldn't expect to see immediate downgrades across the board for large banks. At least not yet. Agencies downgraded banks during and after the financial crisis; however, downgrades are done in methodical, processed steps.
Agencies will, however, change the outlook quickly and warn investors and others when they say a bank is a candidate for a downgrade. That will happen just as swiftly in the current scenario.
Whether it was the financial crisis of 2008-09 or the current COVID-19 crisis, banks always tend to be at the center, partly because they are at the center of the financial system and because they themselves can be vulnerable.
Early signs indicate the Federal Reserve, having itself learned much from the crisis in the last decade, has stepped out quickly to make sure banks can perform trading, investing and lending duties within the system and will have sufficient funding sources to support balance-sheet activity.
Bank supervisors are relying on the constantly evolving regulation to make sure bank can get through this period while performing services, making loans, making markets in securities, all while maintaining solvency.
Tracy Williams
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