S&P: Bank loan losses to double

Credit Losses To Double In 2020

We estimate that COVID-19 will contribute to the Australian banks’ credit losses nearly doubling in 2020–to about 30 basis points of gross loans and advances–from historic lows in 2019. Nevertheless, in our view the credit losses should remain low compared with international peers as well as our expected long-term averages.

Furthermore, we consider the profitability of the Australian banks should remain adequate to absorb increased credit losses notwithstanding headwinds from low and declining interest rates, a likely further decrease in demand for credit, and continuing customer remediation costs in relation to governance lapses in recent years. We believe that Australian banks retain headroom in their earnings to absorb a rise in credit losses even beyond our revised forecasts, without posing significant risks to their creditworthiness.

Business Loans Will Lead Initial Losses

We expect that business loans will contribute to most of the initial increase in credit losses for the Australian banks, with the travel, hospitality, retail-services, and transport related sectors likely to be among the more severely hit. The coronavirus outbreak follows several major natural disasters in Australia, such as bushfires and storms, the combined effect of which will further curb already subdued consumer sentiment and business confidence, with likely second-order effects on the economy and the banking system–for example, due to job losses and underemployment.

Nevertheless, we expect the impact on the Australian banking system to be relatively small in the short term on the back of sound long-term economic prospects and our forecast rebound in economic growth as this event passes. We also expect that fiscal stimulus from the Australian government should somewhat support short-term economic outcomes.

Banks’ Preparedness And Central Bank Support Should Fend Off Funding Squeeze

We believe that the Australian major banks are adequately placed to contend with a temporary disruption in their access to offshore wholesale funding, on which these banks materially rely. Spreads on Australian bank debt have widened in recent weeks following the outbreak of COVID-19. We also note that a large part of the banks’ offshore borrowings remains short term in nature, the refinancing of which is more sensitive to financial market sentiment and increase in spreads. Nevertheless, we believe that these banks have significantly completed their wholesale term-funding for the financial year.

The major Australian banks have headroom and capacity to issue covered bonds to supplement their funding, if needed. In addition, the banks hold a good level of liquid assets on their balance sheets. The banks have access to the Reserve Bank of Australia’s (RBA) Committed Liquidity Facility, which was set up following the global financial crisis to help Australian banks meet unforeseen liquidity needs. Also, we note that the RBA has indicated its preparedness to support the liquidity of the secondary bond markets in Australia as well as its plan to conduct longer-term repurchase operations of six-months maturity or longer at least weekly, as long as market conditions warrant. Furthermore, we expect that many Australia-based fund managers are likely to choose debt issued by Australian banks in preference to offshore investments because of geographic proximity and likely better understanding of local operating conditions. We also expect that a larger proportion of new savings will accrue to the Australian banks in the form of customer deposits as the impact of the outbreak continues, with retail customers likely to become more risk averse. These developments should at least partly offset the impact from a disruption in the Australian banks’ access to offshore borrowings.

Banks Likely To Show Forbearance To Borrower Hardships

We expect that Australian banks would show forbearance to the temporary strain placed on household and business borrowers. More broadly, we expect that the Australian banks would aim to “do the right thing” by their customers and broader society to meet community expectations. For example, we note that all four major banks passed the recent interest rate cut by the RBA in full through to their borrowers despite persistent pressures on their interest margins and earnings headwinds.

Market Dislocation Has Affected Some Hybrid Issuance

Two Australian banks have exercised calls on their regulatory tier-1 capital instruments but have deferred plans to replace these issues in view of the dislocated financial markets. Nevertheless, we remain confident that the regulatory tier-1 capital instruments issued by the Australian banks will remain outstanding for a sufficiently long term due to four factors: i) we understand that these banks intended to replace the called hybrid instruments with new capital but then deferred their plans due to market dislocation; ii) we understand that the banks require regulatory approval to reduce their capital bases; iii) we expect that such regulatory approval would generally indicate that the respective bank is maintaining its regulatory capital ratios well above the regulatory minimums (including the buffers required by the regulator), and; iv) in our view, the contraction in the respective banks’ capital bases is relatively small, and does not weaken their overall capital strength.

Banks Will Suffer More Pain If Outbreak Fails To Subside As Forecast

While uncertainty over the rate of spread and timing of the peak of the COVID-19 disease remains high, modeling by academics with expertise in epidemiology indicates a likely range for the peak of up to June 2020. For the purpose of assessing the economic and credit implications, we assume the global outbreak will subside during the second quarter 2020, consistent with our report, “Global Credit Conditions: COVID-19’s Darkening Shadow,” published on March 3, 2020. As the situation evolves, we will update our assumptions and estimates accordingly.

Notwithstanding our relatively benign outlook on the Australian banks, we expect that a longer lasting and more severe impact than our revised base case could precipitate significant problems for the Australian banking system from two channels. First, the Australian banks would be challenged in accessing offshore wholesale funding if the global financial markets remain dislocated or if the Australian economy significantly deteriorates. A prolonged disruption in that access is also likely to weaken the banks’ ability to meet the demand for credit in the Australian economy. Second, a significant drop in economic activity–in conjunction with weak business and consumer confidence–could add to the triggers for a rapid rise in unemployment and a drop in property prices. We note that property prices in Sydney and Melbourne–the two most populous cities of Australia–have risen sharply in recent months following an orderly correction in the past two years. Consequently, we expect that such a scenario would likely result in a sharp rise in the banks’ credit losses, well above those that we currently forecast, and significantly weaker earnings.

Australia will be locked down to October. The assumptions are wrong, as always.