As we start to emerge from the COVID-19 pandemic in the UK, we have taken a look back at the economic consequences that the pandemic has had on major UK banks’ performance and Expected Credit Losses (ECL) over the past year, and the initial steps to recovery that we are starting to see in Q1 21.
Looking back – FY 20
2020 was a challenging year for UK banks. Although five of the six major UK banks managed to remain profitable, return on tangible equity fell by an average of 70 percent from 2019:
- ECL charges surged by 209 percent, with stage 2 exposures increasing by 79 percent (Wholesale exposures doubled), and ECL coverage ratios increasing by 43 percent.
- Operating income decreased, with net interest margin falling by 10 percent.
This performance was to be expected in the context of deteriorating macroeconomic outlook, coloured by interest rate cuts and significant uncertainty, which were captured in banks’ ECL models and post-model adjustments (PMAs).
Banks responded by pivoting to fee-based business e.g. corporate advisory and wealth management, cutting costs through digitalisation and adjusting their funding mix to bolster profitability.
Here and now – Q1 21
The rapid vaccine rollout, easing of Brexit-related trade frictions and government intervention such as the extended job retention scheme are contributing to a rosier macroeconomic outlook as of Q1 21. This, coupled with banks’ efforts to bolster profitability, drove improved performance in the first quarter – a tenfold increase in return on tangible equity from Q4 20:
- ECL charges fell by 132 percent, with three major UK banks even releasing ECL. Stage 2 exposures fell with marginal decrease in coverage ratios.
- Operating income increased, with net interest margin improving marginally by 1 percent.
What is apparent, though, is that government support measures and regulatory reliefs have softened the impact of the pandemic to date – we are yet to see the full extent of the economic fallout:
- Government support measures such as payment holidays and furlough schemes prevented a significant increase in defaults. We observed only a small increase in stage 3 exposures in FY 20, and again in Q1 21.
- Government-backed lending sustained banks’ lending books, and little ECL was recognised against these given the 80 percent or 100 percent guarantee. With repayments still in their early phase, it is too soon to tell what success banks will have recovering the loans before invoking government guarantees.
- Regulatory reliefs allowed for an increase in CET1 ratios in spite of decreased profitability in FY 20. These have come down marginally in Q1 21 only as some reliefs cease and banks buy back own shares.
Road to recovery
While we are not yet back to pre-COVID levels, it is clear that we are on the way. Here is a snapshot of the key trends we are seeing.
- Reflection of the more positive macroeconomic outlook in banks’ forecasts, reducing ECL.
- Resurgence in trading, capital markets and advisory activities, which are propping up operating income.
- Focus on cost reduction through process improvements and digitalisation, with some banks managing to meet targets in spite of the pandemic.
- Continuing reliance on PMAs and high downside scenario weightings carried forward from FY 20 to address ongoing uncertainty, together with prudent ECL assessments of exposures to particularly impacted industry sectors e.g. Aviation and Hospitality.
As we move forward into the second half of 2021, banks’ performance is expected to continue to improve. Although some uncertainty remains, indicators show that the economy in general is on the road to recovery.
As cliff effects may emerge from delayed defaults once government support measures are withdrawn, banks must continue to exercise significant judgement in setting appropriate loan loss provisions.
CFOs should focus on managing downward pressure on CET1 ratios from tapering capital relief by building capital strength and optimising RWAs, to support sustainable dividends to shareholders.
Our full report “COVID-19 economic impact on Expected Credit Losses” analyses the movement in financial performance and ECL of six major UK banks from last year to the first quarter of 2021, and explores the evolving trends when considering macroeconomic outlook, governmental and regulatory developments, and banks’ targeted response.