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European bank transformation: how to prepare now for a potential wave of Covid-19-induced write-downs

Christopher Sur, Gabriele Guggiola, and Gladiola Lilaj
November 9, 2021

Managing loan books to conserve capital once COVID-19’s impact on the real economy crystallizes is one of the most urgent challenges for Europe’s banks

European banks face a serious potential squeeze on their regulatory capital as state aid measures for the sector are withdrawn and the full impact on their loan books of COVID-19-related write-downs becomes clear.

With price to book valuations for Stoxx600 banks below the level of March 2009 – the nadir of the global financial crisis – European banks cannot hope to repair their balance sheets via equity issues. Their most pressing challenge, therefore, is to manage existing capital more effectively and defend their credit ratings. Achieving this will require a rigorous assessment of their assets and an active approach to managing them, based on a detailed recovery strategy. Banks that embark on this process early will be best placed to manage the expected increase in loans that no longer fit their strategic priorities as well as non-performing loans (NPLs).

Increasing pressure on their regulatory capital following the COVID-19 crisis is just one among a series of major strategic challenges facing Europe’s banks. They must also accelerate the digitization of front and back-office activities, respond to competition from new sources, and meet growing regulatory requirements on sustainability. Stabilizing and strengthening their loan books is vital if banks are to execute the far-reaching business transformation that these additional challenges will demand.

How to prepare now for a potential wave of Covid-19-induced write-downs

Balance sheets do not tell the whole story – yet

Although European banks’ profitability has suffered due to long-term pressure on their lending margins as a result of ultra-low interest rates, they entered the COVID-19 crisis much better capitalized than they were in 2008. In addition, NPL ratios had been improving in the years leading up to the pandemic and did not rise significantly during 2020, thanks to measures including state aid, temporary suspension of accounting rules, central bank liquidity, and flexibility from regulators.

However, these low reported levels of NPLs may obscure the true situation. Governments and regulators have protected banks from the full impact of the crisis on their Tier 1 equity capital. In particular, relief measures around accounting and provisioning enable banks to reduce the size of write-downs on problem loans and the associated provisions.

As these measures are scaled back, NPL levels are expected to rise this year and through 2022. Many borrowers have been affected by lockdowns imposed to tackle COVID-19 and forced to lay off employees and change the way they operate. But there will also be companies that were already in trouble and have been able to avoid bankruptcy thanks to COVID-19 support measures – so-called “zombie firms.” A backlog has therefore built up of troubled businesses that have so far managed to avoid default.

The effects of this uneven picture will also vary across the banking sector. Among the largest banking groups removal of relief measures will pose few problems since these institutions have well diversified operations and can draw on profits from other sources to cushion the impact of write-downs on their loan books.

However, smaller specialized lenders with more concentrated asset portfolios may face a difficult period. They cannot diversify or mitigate potential losses through the performance of other parts of their business in the way a large bank with an investment banking arm can. The big question is how well prepared they are to manage the impact on their assets as borrowers struggle to recover from the pandemic.

Additionally, supervisory authorities in EMEA, including ECB, are increasingly focusing on the quality of loan books as well as NPL volumes of the individual banks. Towards the time of post-COVID-19, we expect that this pressure will increase.

The looming mark-to-market challenge

The key danger area for these banks lies in the gap between the book value of their assets, which has remained relatively stable thanks to state aid measures and temporary relief from accounting and provisioning requirements, and their market value. Once banks are required to mark their loans to market, it is possible that a large proportion of their regulatory capital could be wiped out as loans to struggling borrowers are written down in value. The longer banks wait to address this risk, the more likely it is that the value gap will have grown to a point where it threatens their capital position.

This is a critical period for European banks, but one in which opportunities exist that were not apparent in the aftermath of the global financial crisis. Today, there are well-funded institutional buyers for NPL portfolios, although to date the predicted wave of COVID-19 impaired loan sales has failed to materialize as participants have waited to see how the situation develops. However, significant capital is available to provide exits and partial exits for banks from NPL portfolios.

A strategy for navigating the credit challenge

Even so, disposals will only ever be one part of a comprehensive strategy to stabilize and manage loan books. To meet the challenge of growing NPLs, banks need to concentrate on a series of priorities:

  • Transparency is key – banks must ensure they have detailed, loan-level data on their portfolios to monitor asset quality effectively and gain early warning of those loans most at risk.
  • This information will provide the raw material for robust, scenario-based analysis that will highlight the most significant risks to their asset quality.
  • Banks must ensure they have access to the right skills and can overcome any capacity constraints that could impede workout and restructuring programs for problem loans.
  • Clear and robust governance and decision-making are also vital, as is effective co-operation between front-office teams and banks’ workout and recovery units.

Actively prepare for capital generation or conservation

Even though portfolio sales may not ultimately prove the favored option, it is important to prepare the ground for options to be flexible if needed, by analyzing loans to establish their transferability, both legally and practically, and by ensuring that the bank has a good understanding of the buy-side’s thinking as well as the organizational capacity to structure transactions and manage the process. Equally, other capital conservation measures should be considered in parallel, including hedging strategies and alternative funding options such as partnerships with external investors.

Ultimately, the goal for banks must be to avoid damage to their capital base over the next two years that could severely constrain their lending activities. They must manage any stresses in their loan books as effectively as possible in order to conserve and recycle their capital quickly and profitably. Developing a robust and comprehensive strategy to achieve this – in the face of rising credit impairments and a lack of appetite to fund banks in equity capital markets – is the most urgent challenge for Europe’s mid-market and smaller banks.

Thorsten Egenolf also contributed to this article.

Contact us

Christopher Sur

Christopher Sur

Partner, PwC Germany

Gabriele Guggiola

Gabriele Guggiola

Partner, PwC Italy

Gladiola Lilaj

Gladiola Lilaj

Director, PwC Italy