COVID- 19 is hitting us all hard. So hard, that regulators and governments are shifting the goalposts with regard to the financial system, in particular in relation to the banks.
Banking sector risks
Following the global financial crisis (GFC), the authorities vowed that it would never happen again, so rules were changed to strengthen bank balance sheets.
The first area addressed was capital. Before the GFC, banks had little capital, and of that relatively small amount, the only element that was used up when they fell into loss-making territory was their equity (the part of the capital structure owned by shareholders). After the crisis, the level of equity was immediately raised several fold, and other forms of capital were explicitly put at risk – AT1 coco bonds, tier 2 bonds and even some senior bonds. This has put a very meaningful firebreak around each bank to prevent systemic contagion should it get into trouble.
Secondly, liquidity was addressed. Liquidity is the cash, or other low-risk assets, such as UK government gilts, that are readily available to settle any claims made against the bank, such as deposit withdrawals or repayment of debt. Today, the UK banks have hundreds of billions of pounds on deposit at the Bank of England to cover this scenario.
With those two systemic risks covered, the other major hazard banks face is of course credit risk – the risk that their borrowers don’t pay back what they owe. This is the risk that the banks succumbed to in the GFC – a lot of sub-prime (less than pristine quality) borrowers defaulted in the US, and the aftermath rippled across the global banking system, leading to multiple failures here in the UK. That was understandable: the problem lay at the feet of the banks that had behaved recklessly, lending to customers that never really stood a chance of paying back their loans. As a result, banks and their shareholders paid a heavy price.
This time, however, it really is different. The cause of the current economic crash (and I deliberately avoid the term “recession,” because this is different) is a virus. Nobody is to blame, and most certainly, it is not a question of something that the banks have done wrong. Therefore, this isn’t a problem that the banks and their shareholders should have to pay for. That is why governments around the world are pledging trillions of dollars to support their economies, and the companies and individuals that make up those economies. They are doing this by issuing huge volumes of debt, the cost of which will be borne by society as a whole, rather than any one section of it.
This government action, and the simultaneous central bank response, is profoundly important as it means that the huge wave of redundancies and company failures that might have been expected will hopefully, at least to some degree, be avoided.
Together, the regulatory overhaul after the GFC and the quick response by governments to today’s crisis should alleviate the three major risks a banking system faces.
Avoiding a coronavirus credit crunch
As part of the disaster-avoidance package put forward to deal with the coronavirus outbreak, regulators have identified that some of the measures put in place since the GFC aren’t fit for purpose in a stressed environment, because they are highly pro-cyclical. By that, I mean that they progressively reduce a bank’s ability to increase lending as conditions deteriorate. That is exactly what regulators and authorities want to avoid – it’s called a credit crunch.
Thankfully this has been identified as a real potential problem before matters have deteriorated too far. A number of rules have changed, in accounting and also in the calculation of risk. This will help the banking system to continue to provide loans to the economy.
So, together, these packages and changes have made the banks far more resilient to a shock and as a long-term equity holder, this provides comfort that the investment case remains valid.
What about income?
While the banks are certainly more resilient today, what we are experiencing is still seismic, and purely as a precaution, a number of regulators around the world have asked (instructed) their banks to stop paying dividends to shareholders. The PRA in the UK was the latest to do this on the evening of 31 March – three days before Barclays was due to pay its final dividend of 6p per share for 2019.
The PRA stresses in its letter that this is not in order to shore up capital levels, but to increase the capacity to lend even further.
The UK banking industry is traditionally a large sector with high dividends, accounting for a significant proportion of investor income. This is now missing. But there is an alternative. As part of the regulatory response to the GFC, banks were allowed to issue a new form of capital, the Alternative Tier 1 bond, sometimes known as a coco (contingent convertible). These bonds pay coupons that are fixed, typically for five years from issue. After that, they are either called (repaid) by the bank, or their coupon is reset to the same spread above risk-free rates as when they were issued.
These bonds form a relatively small part of the capital of the bank, and the regulator has not asked banks to stop paying the coupons. Indeed, it is only dividends on ordinary shares that have been stopped.
The saving to a bank, and therefore the impact on its capital, of turning these coupons off is small. For example, for Lloyds, the ordinary dividends that would have been paid for 2019 were more than five times the total cost of all its coco bonds.
From our perspective, the coco offers a harbour in the storm. It pays a high yield in a time of dividend cuts across the market, with the relative security of investment grade issuers standing behind them, and huge government and regulatory support on all fronts.
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