During the coronavirus pandemic, and the economic shock caused by the restrictions introduced to protect people from it, banks are poised to be part of the solution, not part of the problem. What a change from the Great Financial Crisis of 2008, when the problem originated in the financial sector, where lax mortgage lending, over-marketing of repackaged mortgages, and over-ambitious banking conspired to cause the credit crunch!
The coronavirus crisis of 2020 has been completely different from 2008. An exogenous economic shock, the current crisis originated in a natural event from outside the human sphere altogether: an aggressively infectious microbe. The financial sector, for once, cannot be blamed. In 2020, a bug, not a banker, is the culprit.
As governments consider how quickly to allow businesses to reopen, they realise that banks are essential to the economic healing process. It is vital that banks’ balance sheets be in rude health. Only banks with healthy balance sheets can lend. Lockdown-hit companies will need bank fresh loans, and extensions of existing loans, to tide them through difficult – although in many cases, temporary – periods of falling revenues and vanishing profits. Many of the newly unemployed will need financial help from banks, too.
Banks could turn out to be some of the heroes of this crisis. Not that bankers will ever be as popular as nurses; but it is possible, if they do the right thing, that they will at least no longer be seen as quite so selfish. After all, many in our parents’ or grandparents’ generation saw banks as respectable and on the side of the good.
Instead of being admonished by governments, during this crisis bankers are being asked to help. They are a key transmission mechanism for the stimulus being provided by governments. Those stimulus measures are the most massive in living memory, including guarantees for loans, bailouts for certain industries, and central-bank backed credit facilities.
Suspend dividends, not coupons
When it comes to the coupons banks pay on contingent capital bonds (CoCos), regulators and banks are united, I believe, in drawing a line in the sand. European regulators have made it clear that banks should suspend dividend payments on their shares. By contrast, coupons on healthy banks’ CoCos are under no threat at all, in our view. Unsurprisingly, for an instrument marketed and sold to fixed income investors, CoCos should continue to pay distributions. Investors in CoCos expect a fixed income, and they are often the same institutions which lend to banks in huge size at a senior debt level, providing liquidity to the banking system at a time when it needs it most. Banks will therefore do all they can to keep these investors happy.
Bail-in danger put on ice
It has been no surprise to see bank bondholders further protected recently.
Under European rules put in place because of the Great Financial Crisis, if state aid were to be given to banks, subordinated bondholders and certain types of senior bondholders would have to be bailed-in, that is, have their bonds converted to equity and suffer a loss. The point of these rules was to protect taxpayers by shifting the risk to bondholders, who would have to participate in losses before the government stepped in to help a failing bank.
Well, these rules have been put on ice during the Covid-19 crisis. If a bank needs an equity injection from its government as a result of losses attributed to Covid-19, there is no longer a bail-in requirement, according to our understanding of the European Commission’s recent statements. A recent communication from the European Commission states that where a bank requires “extraordinary public financial support” due to Covid-19, such aid would not in fact be deemed extraordinary.
As CoCos investors, we have always taken care to select banks that were in a very healthy position anyway. It is therefore unthinkable to us that there could be bail-in of bondholders in these banks. This makes the prospect of losses for bank bondholders extremely remote, in our view. The regulator clearly recognises the importance of the funding markets for banks at this time, and is making the environment as supportive as possible. It is clear to us that the place to invest for high but safe returns at the moment is in the subordinated debt market, including CoCos issued by banks that were strong going into the pandemic. Yields of around 9% are currently to be had on such investments, which we view as highly attractive given our assessment of the risks.