S and P: Outlooks revised on six UK banks on deepening COVID-19 downside risks
Until the start of March, UK banks were fully engaged with the same two key themes that have been paramount in recent years–harmonising balance sheet strength with solid investor returns, and identifying how to refine business and operating models in the face of the looming risks and opportunities of the digital era. For the short term at least, the COVID-19 pandemic has changed (almost) everything. In addition to the human cost, large parts of economic activity in the UK and much of the rest of Europe have ground to a halt. With isolation strategies still very much in force, our economists expect sharp economic contraction in the second quarter of 2020, followed by a rebound starting in the third quarter. However, they are now more cautious on the strength of recovery through end-2020 and into 2021, envisaging a 2.4% decline in global GDP in 2020; in the U.K. they assume a 6.5% GDP decline in 2020 before rebounding by 6% in 2021. Even under this base case, the effects of COVID-19 will be evident for long after the crisis subsides.
UK authorities, like others in the rest of Europe and elsewhere, have delivered unprecedented policy responses in the form of monetary, fiscal, and regulatory support to their economies. The better-capitalised, better-funded, more-liquid banks that have gradually emerged in the UK since the global financial crisis have played an instrumental role as a conduit of the expansion of low cost credit to affected households and businesses. However, while we expect banks in the UK and across Europe to remain resilient in the face of this short-term cyclical shock, we expect that it will have a meaningful impact on asset quality, revenues, profitability, liquidity and, potentially, capitalisation. We expect few of these negative trends to be strongly evident in UK banks’ first-quarter results, but consider that they would become increasingly evident through the course of 2020 and persist into 2021. Bank asset quality will be key to this outcome.
We are acutely mindful that this base case remains subject to significant downside risks. Even under our economic base case, the policy responses taken in the UK may be less than totally successful in avoiding permanent economic damage later. We note also that a significant component of the fiscal support package comprises additional indebtedness–for the sovereign, some households, and many businesses. At best, the easing of physical isolation will likely not start for some weeks, is likely to be slow, and could be subject to setbacks. The longer the delay in the recovery of economic activity, the less sustainable this extra debt will be.
Across the UK banking sector, we have affirmed bank ratings in view of the resilience that we expect them to demonstrate in the face of this short-term cyclical event. Negative outlooks tend to reflect the significant downside risks that we see, and our expectation that we could lower ratings on one or several banks if the economic rebound is delayed or fiscal countermeasures prove ineffective. We overlay this broad assessment with our view on the idiosyncratic features of individual banks, variously reflecting aspects such as pre-existing positive and negative rating pressures, their asset and funding profiles, and our view of their potential to absorb setbacks within earnings and so avoid significant capital depletion.
We expect systemwide domestic loan losses to be a key indicator of the evolution of the negative trend that we now assign to economic risk within our UK banking industry country risk assessment (BICRA).
Specifically, we estimate that the domestic loan loss rate could rise to 100 basis points (bps) in 2020, which would be around five times the level we have observed in each of the past six years. In 2021, on the back of the economic recovery, we assume that the systemwide loss rate would fall to around 67bps, which we judge to be closer to, but still slightly above, the long-run UK average. We form these estimates, after taking into account the UK’s fiscal and monetary countermeasures, by balancing our economic forecasts with Bank of England stress test data and actual stressed loss data that we have observed over the past 30 years. While the loan loss rate is an important indicator of asset quality stress in the banking system, we will also take into account the pace and strength of the economic recovery, among other factors.
If we were ultimately to revise down our assessment of UK economic risk then the anchor, or starting point for rating a domestically focused bank, would fall to ‘bbb’ from ‘bbb+’, hence the negative outlooks we have assigned to selected UK banks.
We will shortly be publishing separate research updates on each affected UK banking group.
