Reasons to be fearful: bank second-quarter results

With the second quarter of 2020 drawing to a close and all the new alternative data footfall trackers showing economic activity picking up in the US and Europe, investors are starting to look forward to the undoubted highlight of their summer.

No, not Wimbledon. That’s still cancelled. So, too, is Glastonbury.

All the excitement this year will be for banks’ second-quarter results.

They told us back in April, when banks ramped up reserves against looming loan losses in the grip of lockdown, that by the time they reported again in July they would have a much better handle on the impact of the pandemic on economies and on borrowers.

Anticipation

With the anticipation already building even before the three months was up, some helpful bank chief executives and chief financial officers were persuaded to share thoughts with investors and bank analysts, almost as if they were offering to guide a nervous and volatile stock market.

What are we learning?

From June 10-12, Goldman Sachs hosted its 24th annual European financials conference in the now familiar virtual format. Its bank analysts presented a disappointing summary for any investors expecting illumination in the next round of results calls.

There’s been just one reason to own bank stocks: dividends. These are now suspended.

This crisis is unusual, the Goldman analysts concluded, in that all key stake holders – investors, bank managements and policymakers – operate with the same set of information. No one has an information advantage.

“In this sense, bank management guidance for credit losses is abstract and premised on two assumptions – no second wave, and a V-shaped recovery.”

This might turn out to be accurate, but it is by no means a given.

While restrictions on movement eased in continental Europe and even in the far worse hit UK in June, they were being re-imposed in China.

The Oxford University Covid-19 government response tracker measures 17 criteria for 160 countries, across economic support measures, health system capacity and containment and closure policies. It scores the strength of each from 1 to 100.

China of course, moved first and fastest in January, going from 0 to 70 on lockdown stringency before Europe and the US even got started.

China hit 80 in March, but by early April had relaxed to 58.

Fast forward to mid June, and with the US at a 73 score for lockdown stringency, and the European average for Italy, Spain, France and Germany already down to 55 from a high of 86 in early May, China had gone back up to 83.

Hello, second wave.

More assumptions

European bank executives may appear confident that they can handle loan losses, but that is based on two other assumptions: the success of large official-sector support measures for markets and economies, and regulatory forbearance.

UBS bank analysts point to the package of some helpful measures relaxing regulatory impositions on bank capital that the European Parliament confirmed on June 8.

These include an allowance to add back to capital any mark-to-market losses on sovereign bonds, the exclusion of central bank reserves from leverage ratio calculations and, most importantly, an allowance to phase in over five years the second-order, dynamic component of IFRS 9 life-time losses on loans that hit problems after January 1, 2020.

That’s nice, the UBS analysts suggest, but hardly the stuff to reinforce investor confidence. Regulations being relaxed is another sign of the coming stress that it is still hard to measure.

UBS says: “At 2Q20 earnings, we don’t think banks will know much more on customer defaults than they did at 1Q given the delayed loss emergence which government furlough schemes (now employing more than half of French workers, for example) and bank loan forbearance combine to deliver.”

Policy measures will delay and may even flatten the curve of defaults. They will also reduce net interest income, of course.

Thank goodness for those banks smart enough to maintain diverse business portfolios that still have revenues coming in through high volume trading in volatile debt, equity and currency markets.

Investors have regarded such profits as low-quality in recent years. They still boost capital, though.

Bank volatility

Few sectors have been more volatile than back stocks, which were hit hard going into the lockdown and recovered strongly on big-ticket government economic support measures. Forget the up-to-the moment trackers on this one and consider the long view.

If you index the European bank equity sector at 100 back at its foundation in 1986, it has delivered less than nothing. In capital appreciation terms, you would have lost 7% of your money.

There’s been just one reason to own bank stocks: dividends. These are now suspended.

Presumably banks will be re-assuring us on their second-quarter earnings calls that they will have a much better handle on the impact of the pandemic when they report their third quarters in October.

Keep an eye on those footfall and economic activity trackers. Listen to the earnings calls, by all means. But watch out for any indication from banking regulators that they may introduce any differentiation in blanket dividend proscriptions and allow stronger lenders to reward shareholders.

Why should regulators do this?

Because the time will eventually come when banks need to consolidate and recapitalize. And if the dividend ban persists, the question becomes which investors will be left for them to tap.