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COVID-19 has generated significant instability and high volatility in global capital markets. While the full impact is yet to be determined, it’s expected that the adverse impact are likely to continue from the virus’ knock-on effects. As part of our Global banking M&A outlook H2 2020 report, we explore the areas of the overall banking sector most likely to be impacted, including valuation and profitability.

The areas that are likely to be most impacted by COVID-19 are:

Profitability and credit management/cost of risk

The low interest rate scenario, along with the significant impact of the COVID-19, is reducing the core banking profitability in mature markets. Financial institutions are thus shifting towards commission-based income from the likes of payments and tech businesses.

One of the immediate effects of the health emergency on the real global economy is the increased credit risk of corporate and retail clients of the banks. In order to continue financing the real economy and support its recovery, banks are called to distinguish between purely temporary phenomena, destined to be reabsorbed in a short time, and longer lasting impacts which would require actions of management and reclassification.

The primary aspects to be considered are:

  1. the forward-looking information update -- in particular, the way in which new information must be incorporated into risk parameters needs to be carefully analyzed, given the peculiar nature of COVID-19. This may last for a lesser time than cyclical downturns induced by economic -financial causes;
  2. the update of the 'default rates' which needs to take into account any waivers granted by the authorities in relation to only temporary phenomena of expiry of the creditworthiness;
  3. the definition of the most appropriate timescales for updating the 'recovery rates' in order to be able to factor in the positive effects -- albeit inevitably in the medium term -- deriving from the credit recovery policies which could introduce forms of deferred payments or agreements on longer maturities (restructuring debt, etc.);

The contraction in economic activity is having adverse consequences on credit quality as banks are increasing loan loss provisions. A few European banks, have already posted significant losses in Q1'20 (Jan-Mar) to face a potential surge in bad loans.

Securitization landscape

  • The corrective actions of governments aims to mitigate the risk profiles through further incentives for disposals.
  • It is likely that the future market of synthetic securitizations may require a revitalization after recent developments and important economic impacts that could come as a result.
  • Over the past few years, several European banks have finalized important disposal operations of impaired loans, contributing to a significant reduction of the NPL ratio. Among the prominent evolutionary trends in the market, it is possible to identify the strong interest on the unlikely-to- pay (UTP) loans, the birth of a fervent secondary market for bad debts and the amalgamation of homogeneous large-ticket asset classes in the construction of portfolios intended for the market i.e., so-called single names.

Customer relationship and commercial models

  • Although COVID-19 may lead to a crisis in the real economy, the impact on the banking system and on the bank -customer relationship can also be defined as a 'positive discontinuity' for the purpose of digitization of the sector and the ability to offer an excellent customer experience.
  • Banks, even the most territorial and branch-centric ones, are forced to encourage the use of channels that have never been their strategic priority. This phase would be particularly complex, which banks need to address by demonstrating real proximity with their customers.
  • The clear understanding by banking operators of their gap in the provision of services, becoming more tangible than ever before with COVID-19, could make them even more inclined to accelerate the digital transformation path through partnerships and collaborations within the fintech community.

Operational resilience and business continuity management

  • The provision of technological innovation can play an important role in guaranteeing the business continuity of the banks: the activation and enhancement of robotics solutions or artificial intelligence (e.g., Advanced BOTs that support the processes of adoption of the technologies displayed on the channels direct) and mobility (e.g., platforms for the management of promoters and systems authorizations), if applied to critical processes, would allow for an easier protection in case of absence of staff.
  • Given the necessity to have an unpredictable availability of infrastructural resources, there is a clear opportunity also for the financial sector to evaluate the benefits of applicable Cloud technologies.

High volatility in stock markets depressed banks' valuation…

COVID-19 has generated significant instability and high volatility in global capital markets. The financial sector has been one of the most affected, with bank valuations dropping in all countries around the world (P/NAV multiple experienced a severe downfall from 1.00x on 31 December 2019 to 0.69x on 30 April 2020). At the regional level, North American banks are still trading at P/NAV equal to an average 1.15x, while Asian and European banks (with the exception of the Nordics) are currently trading at significant discount levels (with average P/NAV at 0.56x and 0.52x, respectively).

Banking stocks were impacted during COVID-19. In the period from 01 December 2019 to 30 April 2020 -- most banks saw a price slump in mid-March. European banks were adversely impacted as the Euro STOXX banks index saw a massive decline of 40.18 percent followed by STOXX North America 600 banks index (31.23 percent) and STOXX Asia/Pacific 600 Banks Index (26.09 percent) for the given period.

Price-to-tangible book value multiple (x) of the top banks, by region

…whilst keeping a strong correlation with profitability

A strong correlation between bank valuation and profitability is envisaged by the regression analysis. North American banks in particular are experiencing higher valuations due to a relatively higher profitability, mainly driven by the diversification of the business activity (e.g. investment banking services), with RONAV equal to 11.4 percent on average, compared with 10.9 percent and 7.5 percent in Asian and European banks, respectively. At a regional level, assuming a RONAV equal to 10 percent, the implied P/RONAV is equal to 1.0x, 0.8x and 0.5x in North America, Europe and Asia respectively.

Regression RONAV ’21 — P/NAV: North America
Regression RONAV ’21 — P/NAV: Asia