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Will UK banks catch the coronavirus?

Lenders’ capital reserves should insulate them – although dividends could be on the block
Will UK banks catch the coronavirus?

Since fears around the global spread of Covid-19 began to coalesce on 24 February, the FTSE 350 Banks Index (NMX8350) has fallen by a fifth, bringing the year-to-date declines to more than 28 per cent. That should be of little surprise to investors. By their nature, lenders are always highly exposed to fears around contracting economic activity.

But so far, much of the commentary has been confined to two well-understood aspects of the fallout.

The first concerns efforts by the largest lenders to keep operations going in the event of office shutdowns and containment measures. Inevitably, certain activities, such as investment banking, are likely to be hit by the current market turbulence, while home-working creates some logistical challenges for compliance. But banks’ contingency planning, supported by massive investments in digitising process wherever possible, has vastly improved since the financial crisis.

The second hit involves the renewed pain inflicted by further central bank pressure on interest rates. Last week’s decision by the Federal Reserve to cut the funds rate by 50 basis points set the tone for central banks to reduce the economic impact of the coronavirus through lower interest rates. On Wednesday, the Bank of England followed suit with its own 50 basis point cut. While unwelcome to commercial banks and their investors – as it reduces income-generating opportunities – ever-lower interest rates have been a mainstay since the financial crisis. Indeed, with interest rates already so low, there is a limited amount of further pain monetary policy can inflict on lenders, although analysts at Peel Hunt calculate that RBS (RBS) – with its already withered net interest margins – is the most interest-rate-sensitive of the banks, followed by Lloyds Banking Group (LLOY).

Other, potentially darker, clouds loom. Chief among these worries is the as-yet unquantifiable impact on lending and credit demand, as businesses and individuals put off investments and purchases amid the rising prospect of economic recession. In a sign that spending could already be falling, 28 per cent of UK adults surveyed by Barclaycard reported avoiding the high street and other busy places in February.

Second, there is the possibility of a rise in non-performing loans and cash flow issues among borrowers. Analysts at credit rating agency Moody’s expect small and medium-sized enterprises (SMEs) to pose the greatest risk to loan books, as they depend on an uninterrupted flow of global goods and are “particularly susceptible to operational disturbances”. But compared with smaller regional banks, and even some of their larger European peers, the UK’s largest lenders’ exposure is limited.

Emergency measures are already being rolled out, nonetheless. RBS has pledged £5bn of working capital support for SMEs during the outbreak, targeting businesses where “there is the greatest disruption and need”. Pledges to extend loan repayment holidays and fee-free temporary emergency loans were soon followed by plans to allow customers affected by the coronavirus outbreak to defer mortgage and loan repayments for up to three months. Lloyds has followed suit, offering £2bn of arrangement fee-free funding for small firms.

It remains to be seen whether lenders will need to extend rescue packages for oil and gas clients, who were this week rocked by the start of a crude price war between Russia and Saudi Arabia. Although far less exposed than their US peers, the energy teams at Barclays (BARC) and HSBC (HSBA) are likely to be working overtime. Rising loan losses and earnings downgrades look a surer bet for both HSBC and Standard Chartered (STAN), both of which derive greater proportions of their income from Asian markets.

Such a confluence of negative factors at least vindicates the regulatory push to force banks to dramatically boost their capital reserves since 2008. In December, the Bank of England’s stress tests found the UK’s seven largest lenders – Barclays, Lloyds and RBS among them – were sufficiently capitalised to handle the simultaneous effects of a scenario in which global gross domestic product falls by 2.6 per cent at the same time as the UK economy contracts by 4.7 per cent, interest rates balloon to 4 per cent, and unemployment more than doubles.

The other great unknown is what will happen to liquidity in short-term funding markets should economic conditions rapidly or suddenly deteriorate. Moody’s flagged that the increase in credit risk spreads – the price of corporate debt relative to interest rates – could raise the cost for banks to raise senior unsecured funds.