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    EBA Examines Impact of COVID Crisis on Banking Sector in EU

    May 25, 2020

    EBA published thematic note presenting a preliminary assessment of the impact of COVID-19 outbreak on the banking sector in EU. The assessment concludes that COVID-19 outbreak is placing unprecedented challenges on EU banks. It highlights that banks have entered the COVID-19 crisis with strong capital and liquidity buffers and have managed the pressure on operational capacities. However, this crisis will have a negative impact on the asset quality of banks while the operational resilience of banks is under pressure. Banks have significantly increased their reliance on central bank funding and are expected to continue using their liquidity buffers in the coming months.

    Banks have built material capital and liquidity buffers, not least driven by the post global financial crisis regulation. Although profitability remains subdued and nonperforming are still high in some countries, regulatory reforms applied over the past few years have allowed banks to enter this crisis with ample capital and liquidity cushions and a healthier funding mix. High liquidity coverage ratios and central bank support have allowed banks to weather the first months of the COVID-19 crisis without major liquidity concerns. Nonetheless, once banks restart the process to build up their Minimum Requirement for own funds and Eligible Liabilities, or MREL, they might face higher costs than in the pre-COVID-19 days, which will further increase pressure on profitability of banks. The following are the key conclusions of the EBA assessment:

    • Asset quality. In the medium term, asset quality is expected to deteriorate significantly. The cost of risk has already started to rise and nonperforming loans are likely to surge by the end of the year. Banks have already started to book higher provisions in their first quarter financial statements. A sensitivity analysis considering transition rates from the 2018 EU stress test shows that the increase in credit risk could have an average impact of about –380 basis points in common equity tier 1 (CET1) ratio. The EBA Guidelines on loan moratoria set criteria aimed to avoid the automatic reclassification of affected loans as forborne or defaulted. However, banks will still need to carefully track asset quality, in particular of loans exiting the moratoria status. They should also identify any need for forbearance measures as quickly as possible and prevent unnecessary moves of performing exposures to non-performing status. State guarantees for loans, introduced in many jurisdictions, might soften the impact on balance sheets of asset quality deterioration.
    • Capital levels. Although banks could face significant losses, capital buffers built prior to the pandemic and the relief provided by regulators and supervisors allow banks to provide relevant coverage for the rise in cost of risk and to maintain their important financing to the real economy. Even if 380 basis points of CET1 is depleted by credit risk-related losses, banks would, on average, retain a management buffer of nearly 1.1 percentage point above the overall capital requirement . Once this crisis is over, banks will have to rebuild capital buffers. Given their low market valuations, doing so inorganically might result in a high dilution for existing shareholders. The extent to which banks will be affected by the crisis is expected to differ widely, depending on, for instance, starting capital levels and operational efficiency as well as levels of exposure to the sectors more affected by the crisis. Competent authorities should quickly address any idiosyncratic weaknesses that could be exacerbated by the current crisis.
    • Profitability. Profitability might remain subdued for an even longer period. Lending margins are likely to remain low as a result of  the monetary stimulus by central banks. The expected credit quality deterioration will result in an increase in impairments. In addition, as many clients are now getting much more used to online banking, branch overcapacity might increase, pushing banks to embark on even more ambitious digitalization strategies. These can also be favored by the recent EC proposal to front-load the non-deduction of prudently valued software assets. Further pressure on profitability and faster digitalization might also stress the need to address overcapacity and for consolidation in the sector, at national or EU levels.

     

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    Keywords: Europe, EU, Banking, COVID-19, MREL, Credit Risk, Liquidity Risk, Basel, Regulatory Capital, Operational Risk, EBA

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