As a typical “black swan” event, COVID-19 took the world by complete surprise. Financial institutions, as the moderator and a lagging factor of the overall economy, their performance and operations have significant impacted by the pandemic, however there are a few things to consider when it comes to the assessment of a particular bank’s well-being.
Introduction to Banks (Just for context, skip if needed)
Financial Institutions are a little bit tricky under this pandemic. A bank consists of different divisions and each division is independent yet impacted severely by the COVID-19 in various aspect. So let’s take a look of the Goldman Sachs portfolio. Investment Banking performance varies with merger & acquisition volume, which are impacted drastically by the economic outlook and debt financing interest rate. Global Market refers to “Capital Market” where most banks make the most of their money from — by borrowing money to businesses whom require external financing. Global Market varies with the interest rate, default rate and the economic outlook. Asset Management refers to portfolio management when asset managers managed investors money into investments like public equity and securities, it varies by the financial market entirely. Consumer & Wealth Management, is the only B2C operation arm of the bank, it varies by the deposit volume and the demand for financial advisory.
Given current macroeconomic condition where interest rate is as low as 0.5%, unemployment rate has risen to 4.2%, with $2 trillion fiscal package injecting into the economy, consumer spending remained slow and virus cases started to peak in several countries in the world.
Money is going to worth less than it used to, the economy is not going to recover until the pandemic is over, before that jobless people are going to stay jobless. However, to financial institutions, their performance is always a lagging factor followed after the overall well-being of the economy.
Two things to consider when it comes to a bank’s prospects under COVID-19
- Borrower’s Cash Flow
Borrower’s liquidity determines their ability to payback their principal and interest, since most non-essential businesses are required to freeze operation in addition to fewer demand for goods & services.
Retail along with tourism, hospitality, entertainment and air transportation services which operates in a Business to Consumer (B2C) model are going to be hit the hardest, as they are barely generating any sales because non-essential businesses are not permitted to open. Moody has downgraded most retail businesses for example J.C Penny, Pier 1, J.C Crew to the lowest grade, Caa1/Caa2. Indicating a 9.99% to 50% chance of filing for bankruptcy.
The liquidity problem is a little more than just negative working capital due to the operation cease. PwC has reported that another major issue could be supply chain disruption, which could imply a chain effect that one supply chain could affect numerous retail and food service businesses.
Moody’s analytics tool model, Expected Default Frequency (EDF) highlighted a company’s probability to default by taking its capital structure, stock price and credit rating into consideration. Currently, it is believed we are sitting at 2008’s January level and it is expected increase when economy turns into a downfall.
The j-curve of default risk has increased exponentially, factors of the effectiveness of government policy, healthcare capacity, overall industry leverage positions are taken into effect and has increased along with the spread of coronavirus. In average the global default risk has risen as least 125% since the beginning of 2020.
Therefore it could hurt the banks a lot, as the default rate increases their profit margins from corporate banking are going to decrease and yet they might have to transfer the losses by upping the loan interest rate, therefore hurting other businesses whom need to refinance to sustain operations.
- Interest Rate Modifications
Interest rate would affect interest rate as well as fixed-income securities. For example a bond with a coupon rate of 3%, the value of holding the bond increases if interest rate decreases because the return of 3% is more attractive and rare to find now. Therefore, traditional public financial institutions have pretty much offset their equity losses by the increased fixed-income securities sales. However, it is not going to sustain because interest rate is not going to continue to slump. Therefore most gains the banks have recorded in first quarter in FICC is not anticipated to sustain in the next few months.
The real question for financial institution is — will interest rate return to previous level when economy enters a recovery stage of cycle. The interest rate offered by financial institution is determined by the Central bank who imposes monetary and fiscal policy to monitor the economy. Variables that pushes interest rate to all-time low is the Debt-to-GDP ratio, treasury yield control, economic prospect and public/private spendings and savings.
It is not likely that interest rate is going to bump back to previous level because while the public sector is dissaving (running a deficit), the private sector is likely to save more capital in the future.
As the graph illustrates, this also happened after the previous four recessions, with the response particularly large after the 2008 Financial Crisis. Following this current recession, we expect consumers will increase precautionary savings, particularly in the form of cash and bonds. Thus, increased private sector saving should provide a powerful offset to higher public sector deficits.
Financial institutions tend to react a little slower than typical companies that are directly reflected by their performance. Financial institutions performance rely on their borrower’s capability to payback, interest rate modifications, market activities volume and so on. The outlook of the economy is generally bad but the discount public has onto financial institutions might be a little higher than the reality.