The key chart
The key message
The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.
The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD.
The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.”
Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. However, estimates by my colleagues at zeb consulting suggest that the average CET1 ratio of the largest 50 banks will remain on a sufficient level. More importantly, their analysis highlights significant differences among the sample banks. They find no statistically significant patterns regarding specific business models or country/regional exposure.
Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders remains subordinate to other priorities.
Six charts that matter
The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.
The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Across advanced economies, banks’ dividend yields had recovered from the low levels that accompanied the rebuilding of capital after the GFC.
Euro area (EA) banks increased their shareholders’ yields via dividends but also tended to raise capital by issuing new shares. In contrast, the recovery in yields for US banks was more modest, as US banks have returned more cash through share buybacks instead. ECB analysis suggests that US and Nordic banks were the most generous in terms of shareholder remuneration recently, ahead of their UK, Swiss and EA peers (see graph below).
Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD. In previous posts, I have (1) explained that the macro building blocks that are required for a sustained improvement in banks’ profitability and share price performance have been missing, (2) highlighted that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic, and (3) questioned the conviction of previous sector rallies. Despite a 2% recovery over the past month, the SX7E index has fallen 42% YTD and underperformed the wider SXXE index by 34%.
The 60% underperformance of EA banks over the past five years supports a central theme in CMMP analysis. The true value in analysing developments in the financial sector lies less in considering investments in banks and more in the understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.
The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. It is important to note that the implementation of post-GFC standards had improved the capitalisation of global banks and that the introduction of capital buffers also helped them to withstand stressed situations such as the current pandemic. When these buffers are drawn down to pre-determined levels, Basel standards place automatic limits on dividends, share buybacks and bonus payments. However, given the scale of the potential losses that might arise from the pandemic, supervisors moved to halt dividends and buybacks even if pre-identified capital limits had not been breached.
In the case of EA banks, Yves Mersch, a member of the Executive Board of the ECB and Vice Chair of its Supervisory Board, explained last month that “while prudent capital planning is the order of the day, the current economic uncertainty means that banks are simply unable to forecast their medium-term capital needs accurately. Such an unorthodox move was therefore justified by our ultimate goal to counteract procyclical developments and support banks’ capacity to absorb losses during the crisis without compromising their ability to continue lending to the real economy.”
Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.” Mersch also acknowledged that, “under normal conditions, profitable and healthy banks should not be prevented from remunerating their shareholders. Restricting dividends can increase banks’ funding costs, have an impact on their access to capital markets and make them less competitive than their international peers.”
Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. Estimates from my colleagues at zeb consulting suggest that ELs could rise to between EUR 543-632bn in 2021 and EUR 611-833bn in 2022. Combined with a rise in RWAs, this would result in a drop in average CET1 ratios to between 11.4% and 12.3% in 2021 and 11.4% and 12.6% in 2022. In other words, the average CET1 ratio of the largest 50 banks in Europe is expected to remain sufficient despite higher ELs and RWAs.
Their analysis highlights significant differences among the sample banks. In several cases, banks are expected to consume their pre-Covid-19 capital cushions and will be forced to use the capital buffers release by regulators. In the “zeb base case”, eight of the top 50 European banks fall into this category. This number increases to 18 in their more “severe scenario”. However, none of the banks will end up with CET1 ratios below the reduced post-Covid-19 requirements.
More importantly in the context of the current debate, they find no statistically significant patterns regarding specific business models or country/regional exposure.
Conclusion
Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. Yes, European banks remain dependent on government support for private and corporate customers and regulatory easing regarding capital ratios and banks, regulators and governments also need to continue to work together to prevent future credit or liquidity crunches. ECB representatives are also correct to highlight the real challenges faced by banks in forecasting medium-term capital needs accurately and the argument that they and the IMF put forward in terms of the benefits of flexibility is valid (eg, additional capital preserved could be distributed to shareholders should it prove unnecessary).
Nonetheless, the significant differences that exist between European banks and the lack of significant patterns at the business model, country or regional exposure levels suggests that the case for a blanket approach to restrictions of banks capital distributions is much weaker now that it was at the start of the pandemic. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders is subordinated below other objectives and I conclude with the words of Andrea Enria, the Chair of the ECB’s Supervisory Board from a recent interview with Handlesblatt:
The ban on dividends is an exceptional measure. We do not intend to make it a regular supervisory tool. It was introduced when governments, the ECB and ECB Banking Supervision announced a major support package to deal with the fallout of the pandemic. The ECB has calculated that the full use of government guarantee schemes might reduce banks’ loan losses by between 15 to 20 per cent in the euro area. The package was intended to allow banks to grant loans to households and companies, not to compensate shareholders. The pandemic led to factory and school closures, and some of us were locked down for months. Why should dividends, of all things, be the only sacrosanct element in our societies?
Andrea Enria, Interview with Handlesblatt (12 October 2020)
Please note that the summary comments and charts above are abstracts from more detailed CMMP and zeb consulting analysis that is available separately.