This is an abridged version of a more in-depth note attached below.

The initial shock from COVID-19

The banking system has weathered the first phase of the COVID-19 economic shock, despite the initial severity with which it affected financial markets. Early interventions by regulators and central banks, including cuts in interest rates and coordinated action on dollar liquidity, eased stresses on the system. However, the economic turbulence is not entirely behind us, and further stresses to bank liquidity and funding remain distinct possibilities, with the wider real-economy impact of the pandemic only now beginning to emerge.

There are a number of steps banks can take to prepare for this. Active management of capital and liquidity structures, deeper stress testing, and enhanced collateral management are all vital. We anticipate in particular that liquidity management will be a crucial area of focus, with liquidity allocation set to become as important as capital allocation.

Risk and challenges

We see several areas in which challenges could emerge:

  • Regulatory ratios: Liquidity coverage ratios look strong, in many cases having increased as a result of an influx of deposits from customers wanting to retain easy access to cash. However, the LCR is a volatile ratio, and buffers built up through increased deposit volumes are not guaranteed to remain in place given that customers may need to withdraw cash to meet their own obligations.
  • Collateral quality: Banks’ management of collateral has developed considerably since the last financial crisis, and banks have substantial volumes of collateral positioned to enable access to BoE liquidity facilities. However, deteriorations in asset quality will shrink the pool of eligible assets and increase haircuts, creating pro-cyclical pressures.
  • Revolving credit facilities: Continued high corporate use of RCFs may reduce banks’ capacity to deploy their balance sheet strength elsewhere, and banks may face difficult decisions over where to channel what liquidity they do have available.
  • Credit ratings: The majority of banks have been on negative ratings outlook since April, and although generally lower than in the last financial crisis, ratings-sensitive wholesale funding volumes are by no means negligible. Furthermore, given the current corporate preference for depositing funds at short tenors, ratings downgrades could trigger abrupt movements in corporate deposits.
  • Bail-in-able debt: With many banks in the process of issuing bail-in-able debt buffers (‘MREL’ or ‘TLAC’), the cost of continued issuance could offset reductions in funding costs arising elsewhere, particularly for challenger banks and other smaller players.

Planning ahead

Precise and granular management of liquidity: It is vital that banks focus rigorously on liquidity and funding, with detailed analysis of current financial resources, as well as more sophisticated tracking and forecasting of key metrics such as the LCR and NSFR. Management of LCR volatility will be critical, as LCRs could conceivably dip as quickly as they rose in the first half of the year. Banks should conduct both short-term and long-term stress tests with detail on a wide-range of risk factors, including intra-group dependencies, currency-specific issues, the potential for tenor mismatches between loan and deposit books, and more.

The case for capital issuance: Concentrated credit losses with a material capital impact are likely to translate into liquidity pressures. Banks’ capital positions generally remain strong, and the BoE’s view is that buffers remain sufficient to absorb the aggregate credit losses projected under its central scenarios [1]. However, banks will need to rebuild capital levels in time, and the sector must grapple with how best to do this given ongoing pressure to continue to lend and the poor outlook for profitability. One possibility is early, pre-emptive capital issuance which would, among other things, help alleviate liquidity and funding pressures. We explore the case for recapitalisation and other recovery actions more fully in our recent paper A stress event like no other.

The end of the beginning

Experience teaches that even if banks have been able to navigate some of the near-term challenges of the market-wide stress, the continuing pressures generated by a large economic contraction will bite further down the line. Future pressures are more likely to be concentrated on individual banks as bank-specific information becomes available, as opposed to the type of market-wide stress witnessed in recent months. While banks undoubtedly entered the pandemic from a position of balance sheet strength, we have only reached the “end of the beginning” of what is likely to be a prolonged period of economic pressure. As such, banks should work to ensure that their financial resources and their capacity to manage them are sufficient for all eventualities.

[1] Bank of England, Financial Stability Report, August 2020. Available online at https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2020/may-2020.pdf