Expect the worst and hope for the best Guest contribution published in the Frankfurter Allgemeinen Zeitung

Since the onset of the pandemic, loan losses have hardly been any higher than usual so far in Germany. But still, policymakers, supervisors and researchers have been relentless in flagging the heavy losses that lie ahead. How do these two statements fit together? What makes defaults so difficult to predict? And what action do banks now need to take?

Credit default rates have been at a record low of late, including so far this year. Remarkable, perhaps, but only at first glance. That is because the typical storyline of a crisis only sees borrowers defaulting on loans once their revenues have dried up for months on end, their reserves have been depleted, and the bills start piling up. In an effort to obstruct this normal chain of events and thus prevent a wave of corporate insolvencies and credit defaults for now, the government put together a large package of measures, comprising loans from the KfW, guarantees, a deferral of insolvency deadlines and payment moratoria. This response was absolutely crucial to stabilise the economy.

Banks, however, sense that this package offers them no more than temporary relief, and they used the first half of 2020 not only to accumulate €2 billion in additional capital but also to recognise loss allowances as a precautionary measure – the 21 large “significant” German institutions alone have set aside a total of €4.4 billion. These measures shrank their pre-tax profits by almost half on the year, even though 2020 turned out to be a better year for some banks’ core operating business. Clearly, then, the pandemic is already flaring up on bank balance sheets.

Welcome as these precautions may be, they won’t be enough in some cases. This is the conclusion made by a variety of studies which approach this topic from very different angles. For all their differences and uncertainties, though, it’s striking that all these studies agree on one point: As long as the situation does not deteriorate dramatically from here, the buffers built up since the financial crisis ought to be enough to absorb the expected losses in overall terms. The same cannot be said at the individual-institution level, however.

Take the situation in Germany, for instance. A baseline scenario we use in the Bundesbank’s Financial Stability Review assumes that €13 billion in loss allowances will be needed for exposures to domestic enterprises. In a moderate stress scenario, and looking at the loan book as a whole, a number of studies indicate that German banks even face loan losses of up to 1.5 percentage point of their common equity tier 1 ratio – that would be just over €45 billion in common equity tier 1 capital. Forecasts by the Bundesbank and the ECB also consider a very unfavourable scenario in which the effects simulated in the moderate stress scenario would be almost twice as severe.

Bearing this in mind, it is all the more gratifying that German credit institutions have a comfortable capital base to draw on – not least thanks to the stricter regulatory requirements adopted since the last crisis. Above and beyond the minimum requirements, German banks also hold just under €255 billion in the form of capital buffers and unallocated capital.

As regards the ratio of non-performing loans (NPLs), we are still quite some distance from worrying levels. Germany’s significant institutions had an NPL ratio of 1.2% on average in the second quarter, which is quite low both over time and in a cross-comparison. The rate came to 2.9% in the euro area. This is an area where German institutions are benefiting from their relatively conservative loan books.

Overall, then, banks are well equipped as they enter a period that will probably see a sharp rise in corporate insolvencies and the resulting loan losses. Looking at the studies in their entirety, it is reasonable to believe that the financial system as a whole will be able to cope with the loan losses. But no one knows for sure what the future holds, so the question facing individual banks is, what can they do now?

Admittedly, there’s only so much a credit institution can do right now to make its house weatherproof. But it would also be wrong for a bank to just stare like a rabbit at the oncoming headlights.

These are my words of advice for individual institutions. First, it is crucial for institutions now to retain capital so that they can digest the accounting impact of credit losses. This was also the thinking behind the recommendation by supervisors that no dividends should be paid out until the end of the year. This significant encroachment on the rights of bank owners wasn’t an easy move for supervisors, and it must remain a crisis-related exception. Once there is greater clarity, this blanket recommendation will need to be replaced by a nuanced risk-oriented recommended course of action for each individual bank.

Second, banks should go ahead and use their scope to supply credit, and thus do justice to the role they play in the economy as a whole. Supervisors already gave institutions permission to use their capital and liquidity buffers for this purpose back in March and, in return, will give them sufficient time to replenish the buffers.

Third, banks will still need to scrutinise and monitor their borrowers’ creditworthiness, however. This applies first of all to new business. Building up new risks benefits no one at this point in time. Banks may need to adjust their risk policies. It is also important for them to monitor their legacy exposures so that they can counteract problems early on. Institutions should be as conservative and prudent as ever when it comes to numbers. Now is not the time to turn a blind eye. This is a point on which banking supervisors have never yielded an inch.

That said, supervisors have a role to play, too. The easing measures won’t be withdrawn all at once, and it won’t happen unannounced. Supervisors will exercise caution, all the more so given the uncertainty surrounding future pandemic infection rates. The name of the game for banks, and for supervisors, too, is to prepare for the worst and hope for th