Credit contagion in a time of COVID-19

One of the enduring debates in banking over the last three decades is how to account for bad loans. Not those which are definitely duds – because the business has failed or the homeowner has defaulted – but those which might eventually go bad.

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Banks are not taking enough risk if no loans ever go bad – after all banks are in the business of providing risk capital at an appropriate price. But given a certain proportion of loans will go bad, how should banks provide for them in their accounts without knowing exactly which ones will tip over?

"Businesses which are losing money because the economy has been brought to a halt but can be expected to survive on the other side are being propped up.”

In this time of global pandemic, that is truly a multi-billion dollar question.

Back in the 1990s, after Australia’s last recession, the banks began to move towards “dynamic” or “expected loss” provisioning. Based on history and data modelling, they would set aside – provide – a certain percentage of the loan book to cover future bad loans even though those loans hadn’t yet failed.

That made sense: it meant reserves were stashed away for when they were needed. But this regime fell out of favour because of the view it could be used to sandbag future results. And, some argued, why should today’s shareholders pay for tomorrow’s – estimated - losses?

However, not providing for unknown but inevitable bad loans in advance meant bank profits were inflated in good times and plunged, pro-cyclically in bad.

Held aloft

The current accounting standards require two kinds of provisions to recognise this tension: individual provisions – for known bad loans – and general provisions– to account for the prevailing environment and the potential for bad loans in the future.

COVID-19 however is not surprisingly a major challenge for the system.

Loans which would be expected to fail are being held aloft by government support of business, prudential dispensation by regulators, deferrals by lenders and legal allowances for company directors.

From one perspective, this is sandbagging on an economy-wide scale. Surely, at some point in this dire recession a sizeable proportion of those loans will go bad?

Hopefully not. The intention of these measures is to support borrowers through what is currently a customer rather than insolvency crisis. Businesses which are losing money because the economy has been brought to a halt but can be expected to survive on the other side, when customers are allowed out, are being propped up.

Of course, not all will. This is a catastrophic recession and could yet – given the second and third waves of contagion around the world – become a depression.

Before the virus

The Reserve Bank of Australia’s (RBA) biannual Financial Stability Review warned business failures will rise – although they haven’t yet. Just as “excess mortality” data give us an insight into how many lives the coronavirus is ending prematurely, insolvency data show business life support is keeping an excess number of companies alive. Insolvencies recorded by the Australian Securities and Investments Commission (ASIC) are running around 75 per cent lower than for the comparable period last year – before the virus.

That may be changing: data show defaults rising 23 per cent in September, having been stable since May. Companies entering voluntary administration rose by 11 per cent over the same month, according to data from CreditorWatch.

“Business failures will increase, although there is a high degree of uncertainty about the magnitude and timing,” the RBA warned. “It will depend on the strength of the economic recovery, which will be influenced by the duration and severity of future COVID-19 related disruptions, and the timing and extent of the unwinding of the various support measures.

“Bankruptcies and insolvencies are currently very low because of the income support, loan repayment deferrals and temporary insolvency relief.”

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The RBA said COVID-19-linked government subsidies amounted to cash buffers of up to $A260 billion. The RBA estimated measures such as the temporary insolvency relief have cut business failures by about 4600 so far and would rescue more than 10,000 companies in total.

However, support measures are already rolling off and that will accelerate between January and March. According to the RBA, if the estimated 3 per cent fall in business revenue late in the fiscal year to June 30, 2020 fails to recover, annual business revenue would plunge a further 9.5 per cent in financial 2021. That would translate to an extra 5,200 company failures - on top of the typical 15,000 to 20,000 business closures each year in Australia (via insolvency and voluntary exits).

"Business failures will rise substantially when loan repayment deferrals and income support come to an end," the RBA said.

“Businesses failures are a key risk to the financial system for a few reasons. First, a higher rate of business failure means there will be larger loan losses, since insolvent firms hold debt (by definition). Second, an increase in the rate of business failures can pose indirect risks to the financial system if they lead to widespread job losses that put household finances at risk. Third, there can be adverse spillover effects if firms in financial trouble do not pay debts to other businesses in their supply chain. Finally, widespread business closures can lead to an increase in property fire sales, with flow-on effects to the prices of commercial properties, which are used as security for many business loans.”

Zombies lurching

With the health measures such as social distancing and lockdowns necessary for the acute medical emergency, the services sector, particularly live entertainment, dining, tourism and accommodation have suffered the most (with collateral excess damage to female employment).

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There are undoubtedly hordes of “zombie” companies lurching about in the business world. And zombies, when they finally die, leave a trail of bad loans across the finance sector.

The question then is what will be the final impact on banking profits and how should the banking sector be providing for them? The upcoming major bank reporting season in Australia won’t give us the answer as there remains insufficient certainty. General provisions are already being increased, however.

Commonwealth Bank, which has a June 30 as opposed to September 30 year end, reported a loan impairment expense of $A2.5 billion, up $A1.3 billion, including a $A1.5 billion “COVID-19 provision”. The percentage of lending covered by general provisions was increased to 1.44 per cent from 1.05 per cent.

That’s in keeping with accounting rules around individual – known – provisions and general – estimated – ones.

The uncertainty will not be resolved until at least the next reporting season, six months down the track. If then….

Essential stress testing

According to Fitch Ratings “we do not expect to resolve the Negative Outlook (on Australia’s major banks) until early to mid-2021, when there should be greater clarity on the banks' asset quality and other core financial metrics”.

Banking regulators are also uncertain.

The Bank for International Settlements (BIS) advises ongoing stress testing of financial systems, with the terms clearly articulated and tailored to different economies, are essential.

“Stress tests can, in the first instance, help gauge the system-wide impact of the pandemic on the banking sector,” the BIS said. “This can help authorities in comparing the economic impact of the pandemic against the capacity of the banking sector to continue supporting the real economy by providing credit to it. But, over time, it may be important to have a more granular view of the pandemic’s impact on individual banks.”

The upcoming bank reporting season will certainly provide new information but it won’t tell us definitely how the economy and the business sector will fare in the absence of life support. And that, ultimately, drives the credit cycle.

Andrew Cornell is managing editor of bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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