8 minute read 1 Jun 2020
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How banks will be vital in recapitalizing viable firms

Authors
Ajay Rawal

EY Global Banking & Capital Markets Restructuring Leader; Financial Services Leader for Central, Eastern and Southern Europe and Central Asia Strategy and Transactions

Advisor to European authorities, banks and investors on bank restructuring and loan sales.

Tom Groom

EY Global Client Service Partner

Corporate finance professional. Enjoys running. Father of three wonderful children.

8 minute read 1 Jun 2020

Banking industry needs systemic solutions to address the expected severe overhang from the impact of the pandemic.

Economists and historians will study at length the monetary, fiscal and regulatory changes announced in the last few weeks. They have been designed to ensure there is a wave of stimulus that washes over all parts of the economy, from individuals to large corporates. And at the heart of turning this stimulus into the real economy will be the banking industry. In sharp contrast to 2008 they are now being cast as key components in helping businesses and individuals get through the next few weeks and months.

Yet both the banking industry and the authorities should start planning for the medium and long term. We will need systemic solutions to address the expected severe overhang from the impact of the pandemic. Despite the unprecedented scale of the stimulus authorities will likely have to deal with large-scale defaults and insolvencies. There will also be a stark increase in companies that will need restructuring or to be resolved. European or national solutions will be needed for the growth in non-performing loans (NPL)s within the banking system.

While debate rages over the type of recovery we will see, it is becoming clear that some companies are facing failure. This is especially true of those with high leverage and in vulnerable sectors, such as travel, hospitality and construction. Banks will have to model and calculate how fast and how far we start to see non-performing loans rise. For regulators and investors, there will be increased efforts to get a holistic view of individual banks exposures to vulnerable sectors. With the new accounting standard IFRS9 in place, which compels banks to recognise expected losses, we may see provisioning increase greatly in upcoming quarters as corporate defaults rise rapidly.

Stopping this becoming a banking crisis

High levels of NPLs in the banking system could see the health crisis turn into a banking crisis via the economic downturn. The initial focus has been on limiting the economic damage. Despite best endeavours, the volume of non-performing exposures (NPEs) and non-performing loans (NPLs) that will materialise in the next couple of quarters is likely to be very high. All countries will experience growth, but the profile will once again vary given the different starting points and differences in COVID 19 impact.

While it’s still too early to estimate, if NPLs “only” reached the highs of the last crisis, around 8% of all loans (reached in 2013). It would severely reduce the return on equity (ROE) for banks. It will mean banks will struggle to build up capital organically, and adds a significant restraint on a sector that was already facing profitability pressures as we entered 2020. More worryingly, it would also severely hamper banks’ ability to fund credit, which will be vital in any recovery.

So the problem coming our way is clear. Here are three systemic solutions - the first which is needed urgently - that could help the authorities manage the wave of defaults, stabilise the banking system and importantly allow banks to lend to support the real economy over the medium and longer term.

1. Recapitalization of companies

Companies will emerge from lockdowns with weaker balance sheets and greater debt. Unfortunately, a number of these will need some form of recapitalization or rescue financing. The instrument could take a number of different forms from the introduction of mezzanine instruments to the provision of senior financing which have an equity conversion element.

Insolvency frameworks around Europe are not uniformly facilitative of the provision of rescue financing. One idea which could help the region would be the facilitation of a form of ‘debtor in possession’ financing. This could take the form of junior mezzanine debt, which is a hybrid of debt and equity financing that would give the lenders the right to convert to an equity interest or roll forward the finance. This has the advantage of helping provide liquidity immediately with a repayment schedule over several years, which could include equity.

It also reflects that few corporates want to give up equity upfront now given the very low valuations, at the moment. As we see in Chapter 11 bankruptcy cases in the U.S, this would also provide finance to companies that have effectively failed, allowing them time and space to continue to operate and hopefully preserve jobs and salvage some level of recovery.

Ideally, such finance would be customised to deal with the range of cases it is likely to deal with, from highly leveraged and complex distressed to firms with no leverage but in highly impacted sectors. Both initial and subsequent drawdowns would need to be purpose built and could be tailored to the level of business size and complexity. For the initial drawdowns, the loans would need to be ranked super senior, taking priority over all other debt and claims. In terms of maturity, they should be very short term, up to 4-12 weeks, subject to risk and operational flow smoothing. 

Subsequent drawdowns would also be super senior. In terms of maturity they would be extended for a slightly longer term, up to 6-12 months. As part of the structure, companies would have an interest incentive for early repayment and firms that manage to survive and then thrive could repay their debt to be able to stand on their own two feet again.

2. Asset Protection Schemes (APS)

Asset Protection Schemes could be another instrument that could become useful in stabilising the financial sector and supporting the banks resume lending. These have also proven useful in the 2008–2009 financial crisis, yet they come along with certain costs and a need to protect the public interest.

In essence, an APS is a risk sharing scheme, through which the government provides the banks with protection against losses on a pool of assets deemed eligible. The structuring is usually designed to include a first loss retention by the banks participating, with no compensation being paid for the losses up to the first per cent of the agreed value of the loan pool. Once the first loss level is reached, further losses are effectively insured for the rest of the value on the entire asset pool.

However, in order to continue the diligent management of the loan portfolio, after the first loss threshold is exceeded, the banks should still cover a fraction of further losses for appropriate incentive alignment. There are many variants on such insurance schemes that can be tailored to the situation.

The assets continue to be managed by the bank and remain on the banks’ balance sheets. However, this is subject to certain controls and restrictions, even possibly having an independent manager appointed. Additionally, banks may be asked to provide commitments to increasing funding to the rest of the economy.

3. Asset Management Companies (AMC)

Following the crisis there will be a surge of non-performing exposures in the bank’s balance sheets. Banks would need to have available options with sufficient government support to swiftly dispose of NPLs and resume their lending.

Governments across Europe could set up and own an Asset Management Company (AMC), which can free banks from NPLs and with sufficient state support can also provide adequate solutions to the underlying borrowers. As we saw post 2008, those countries that dealt quickly with NPLs and saw their banks have cleaner balance sheets allowing quicker resumption of lending.

The AMC will be more complex than historical examples as it will include not only real estate backed loans but a whole range. Given the scale of the potential range of debt that may end up there, it will require careful planning and calibration, but it would strengthen banks as well as lower the risk to deposits and deposit guarantee schemes.

Tackling the economic impact of COVID 19 requires action to both reduce the hit to the economy to save companies and jobs. Lending and rescue financing aims to do just this. However, at a future step there will be a need to look at ways to resolve the debt overhang. As we move to the next phase we need the frameworks to be able to achieve both. This will require approaches that deal with the thorny issues of state aid and bank resolution.

We may see some countries take a lead in these schemes if they feel their banking system is more exposed or fragile. We are more likely to see more systemic solutions, at a later date.

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Summary

Banks have done well in dealing with the immediate needs of the economy and the call for action from the authorities to support stimulus. However, there is only a small window before the next and beyond challenges hit hard. We need to ensure banks are supported in dealing with the upcoming wave of bad loans. This will allow them to continue to lend and to avoid a health and economic crisis becoming a banking one.

About this article

Authors
Ajay Rawal

EY Global Banking & Capital Markets Restructuring Leader; Financial Services Leader for Central, Eastern and Southern Europe and Central Asia Strategy and Transactions

Advisor to European authorities, banks and investors on bank restructuring and loan sales.

Tom Groom

EY Global Client Service Partner

Corporate finance professional. Enjoys running. Father of three wonderful children.