Thursday 15 October 2020 6:38 am

Beware the risk to economic stability if banks are asked to shoulder the full burden of Covid-19

James Worsnip is a banking expert and managing director at global consultancy AlixPartners

The economic cost of Covid-19 has been — and will continue to be — immense. 

As the Bank of England publishes its surveys on bank liabilities and credit conditions today, it is a reminder that much of that cost will fall on the financial sector, and within that, on the larger banks. But how that burden lands requires some thought. 

If there was ever a time when we needed a resilient and healthy banking system, it is now.

Read more: Goldman Sachs profit surges, Bank of America and Wells Fargo hit by loss provisions

So how healthy is the UK’s banking system?

The banking sector entered the pandemic with healthy levels of capital, which the Bank of England considers will be adequate to maintain the viability of firms in the sector.

Yet in the short and medium term, the costs stemming from Covid-19 and the government’s response to the pandemic will inevitably harm the economy, and therefore bank profitability. Regulators need to be mindful of the capital rebuild that will be required and the ability of banks to attract the capital needed to support the essential services they provide. 

The banks’ role in funding the economy through CBILS and Bounce Back Loans has allowed businesses that might otherwise have failed to continue. Forbearance — the decision not to enforce rights against troubled borrowers — across many credit markets has also enabled businesses and consumers to avoid insolvency — or has, at least, given them more time to adapt. 

But with businesses and individuals alike struggling to avoid the economic impact and financial distress that the pandemic has brought, the banking sector has reported additional loan losses. These amount to £18bn for the first half of 2020 alone, while the Bank of England estimated (in its May 2020 central case) that Covid-related loan losses may tally up to as much as £80bn. 

Any notion that the banks can simply absorb these losses needs to consider the links between the interests of government, customers, and shareholders. Should these losses continue, the sector as a whole faces the risk of entering into a spiral of depressed profits, poor shareholder returns, and an inability to raise capital. 

Depressed shareholder returns will, in turn, reduce the banks’ ability to provide the volume of lending required to fund the recovery and growth that customers seek. This is not a welcome conclusion for an economy trying to address the twin threats of the pandemic and Brexit.

So how can the burden of Covid-19 be shifted to lighten the load for the banking sector, while protecting society and maintaining the economy?

The banks certainly need to act to mitigate loan losses: price in the additional risk (and capital charge); offset the squeeze on the net interest margins; and begin to think about how they will ultimately restore capital levels to those expected by regulators. 

However, there is also a crucial role for regulators and the Treasury to play in balancing the burden.

First, regulators should be stepping back and rethinking the objectives, policy hierarchy, and supporting regulatory structure for consumer and SME banking at a minimum. Greater regulatory coordination and alignment are more crucial than ever, across all interfaces between government and the banks.

Additional regulatory initiatives also need to be carefully considered, in the context of the overall burden and impact on the ability of the banks to attract capital and keep lending at levels that the economy needs. The notion that banks can absorb additional costs driven by these initiatives without onward implications is misplaced: eroded profits affect the ability to lend and meet the needs of customers and, at this time in particular, the wider economy.

The impact of measures designed to increase competition also needs to be considered against these broader pressures. It is precisely at times of economic stress like this that the value of competition in relationship banking can be seen for the wider economy.

It is with this in mind, that the FCA’s competition duty must look to recognise the wider impacts of interventions on the sources of competitive pressure in the market. Measures that have a disproportionate effect may undermine important elements of competition and severely constrain the ability of mainstream lenders to provide adequate levels of lending.

Ministers have spoken about the banking sector “returning the favour” of taxpayer support through the financial crisis over the course of this pandemic. It may well be right that better outcomes can be achieved through a coordinated response, but this is not the same as saying that incumbent banks should carry a disproportionate share of the burden. 

The Treasury and the regulators will need to be mindful of the need to encourage competition in the banking sector and balance regulatory banking initiatives through the crisis and beyond if we are to maintain the country’s economic resilience through these challenging times.

Read more: Bank of England asks UK banks about readiness for negative rates

Main image credit: Getty

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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