The ECB recently published its Financial Stability Review (the "Review") which highlights how Europe's economic and financial policymakers have, where possible, attempted to reduce the near-term economic damage caused by the COVID-19 pandemic, while also attempting to minimise medium to long-term damage and assist in a speedier European economic recovery as the virus recedes.
A preliminary scenario analysis carried out by the ECB suggests a decrease in GDP this year in the euro zone of between 5% and 12%. This contraction reflects the impact of the public health measures used to contain the spread of the Coronavirus, which has curtailed demand and production globally. To counteract extensive negative effects to the public and to businesses, two of the measures that the European Commission undertook was the launch of a support scheme by way of a pan-European guarantee fund to support SMEs via the European Investment Bank and separately, pandemic crisis supports for Member States via the European Stability Mechanism.
The Banks – Money in, money out
According to the Review, nearly 20% of European GDP has already been committed to loan guarantee schemes through a variety of schemes which will have the knock-on effect of reducing banks' credit risk. The pricing of these emergency loan guarantees generally starts at 0.0025% for one-year SME guarantees and 0.005% for one-year corporate guarantees. This rises on average to 1% and 2% respectively for four and six-year maturities. This type of cheap and hastened financing will continue to decrease the likelihood of any downward spirals in European Member States. Eligible companies should be able to use the guarantees to obtain bridge financing that increases their cash buffers and extends the horizon over which these firms will continue servicing their liabilities, even with reduced cash flows. This has been the first real-world test of the macro-prudential lessons learned following the 2008 financial crisis.
Operational challenges for banks may arise in the near and long-term stemming from the need to assess the creditworthiness of a potentially large number of applications in what is likely to be a challenging economic environment where new applications may also coincide with numerous requests for debt moratoria. The Review suggests that the digitalisation of platforms to assist with the adoption of these liquidity measures may provide significant cost-saving opportunities for banks, at least in the medium-to-long term.
The ECB intends to purchase more than €1 trillion of private and public sector securities by the end of 2020 as part of its pandemic emergency purchase programme, which should assist with providing additional liquidity into the markets. Additionally for European banks, a large expansion of targeted longer-term refinancing operations (the TLTRO III programme) offers liquidity to banks at a rate that, depending on banks' lending performance, can be as low as -1%.
This in turn means that both banks and corporate clients should have access to cheaper and expedited financing where the cause of the need for new financing is COVID 19-related and it provides all parties space to navigate their way through the current crisis. Lending institutions who digitalise their operations in order to process the influx of new credit requests would likely reap the benefits of introducing these systems in years to come.
A Lifeline for Household Debt Sustainability?
Prior to the pandemic, household indebtedness had been declining across Europe, with some exceptions mostly in countries featuring buoyant housing markets. Due to the recent economic slowdown effecting household incomes and causing an increase in unemployment, these factors may contribute to a sharp correction in some countries' property markets. Loan repayment holidays which have been offered in a number of countries (such as Ireland) should help mitigate the short-term effects and help reduce the negative consequences for those who would otherwise have suffered more so due to the unforeseen impact of this crisis. The true impact on household indebtedness however remains to be seen as these repayment holidays come to an end and with the global economic slowdown set to continue.
Stability for Businesses?
A large share of European companies were forced to stop production for a period of time during the first half of 2020 which will inevitably cause substantial revenue losses and a requirement for an injection of liquidity in many cases. Certain business models where the close contact of people is essential could be hampered for a longer period than initially forecast depending on the duration and extent of the containment measures. The worsened outlook for specific companies has unsurprisingly led to a number of them being downgraded by ratings agencies as rates of default by corporates on a European level are expected to increase. It has not helped that a high percentage of these companies have already experienced liquidity shortages and have had to draw down further on credit lines, thereby increasing their leverage. The Review notes that this uptake in leveraging increased by about €120 billion in March 2020 to the highest monthly level on record. The majority of these loans were provided with one year maturity dates. This in turn means that for those companies that survive the global downturn and have availed of the additional credit, they will have to (1) repay in full the emergency funding, (2) restructure or refinance their existing obligations, or (3) default in a year's time.
From a governmental perspective, the proportion of corporate sector guarantees required will depend on the depth and length of the recession and such calls will increase a government's financing needs, hence budget deficits and governmental debt levels are projected to increase, especially in the near-term. For banks, it makes it less likely that defaults will occur in the short term, however additional resources will no doubt be required to deal with proposed restructurings and foreclosures.
The Review highlights that current financing conditions are likely to support near-term demand for residential real estate ("RRE"). However, the cumulative negative impact to renters' confidence, household disposable income and the possible negative repercussions on employment levels could strengthen the envisaged deceleration of the euro area housing cycle, both in terms of prices and properties going to market. Concurrently, it would seem that there would inevitably be a housing shortage resulting from delays in construction (due to the absence of workers) and the fact that intentions to buy and renovate properties could remain at fairly elevated levels which could equally lead to upward price pressures. Due to the shortage of households on the market, prices might increase but banks may also have a situation where they are unable to lend to a number of buyers due to their respective credit policies and a potential buyer's COVID 19-related work freeze.
Separately, the commercial real estate ("CRE") space tends to be sensitive to economic activity and reacts strongly to global slowdowns due to the lower profits of non-financial corporations leading to a decreased demand for commercially leased properties. As a number of companies have either reduced or temporarily stopped their rental payments with a number of employees working from home, it is understandable to expect this to cause liquidity problems for property owners which inevitably leads to increased discussions with landlords / lenders to either break leases or renegotiate rental repayments. The Review notes that the CRE sector has been affected by the shock faster than the RRE sector and may face structural changes over the longer term.
Against this background, the financial sector may be exposed to risks originating from RRE and CRE price corrections, in particular where real estate exposures are significant, debt levels are elevated or prices are overvalued. Corporate investors and lenders in real estate will undoubtedly be watching this space closely.
The Review provides a useful overview of the financial impact of COVID-19 and outlines what we can expect to see over the coming months and years. It is evident a lot was learned in the aftermath of the 2008 financial crisis and the Review highlights that global financial institutions were ready to react to the shock to the system in a much more appropriate and damage-reducing manner this time around.
As the pandemic shows no immediate signs of retreating, companies will need to continue to receive assistance. Having access to cheap, but more importantly, quick financing and refinancing options, is not only beneficial to businesses but should allow the banks to provide liquidity to the market.
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