13 May Why Banks Need to Get Ahead of the COVID-19 Economy
By Leonard J. DeRoma, Invictus Group Director of Liquidity Analytics
The one thing we know about the future economic impact of COVID-19 is that we do not know what it will be. The internal optimist in all of us hopes that the lockdowns start to unwind, the economy quickly returns to business as usual, and loan losses are modest because the modifications and Paycheck Protection Program (PPP) loans worked.
However, such a scenario is becoming less plausible as time passes. Even a phased approach toward reopening the economy will present significant challenges to community banks, both in the near and longer term. In the near term, deferral periods will end on modified loans and many borrowers are likely to struggle with their normal debt service obligations. Over the longer term, structural changes to the economy will affect the business of community banking.
Using baseball as an analogy, we are now in about the bottom of the second inning and the rest of the game has yet to be played. Those banks that manage the early innings well will put themselves in the best position for the later innings, where the game is almost always won.
Luckily banks entered the game in early 2020 in good economic shape. Every depository institution, every credit union, every platform lender, and every non-bank lender will see problems moving forward. More than 36 million had filed for unemployment as of May and the majority of consumer-based businesses are closed. Consider:
- Hardship mortgage modification applications are increasing by the week. Since most real estate companies keep only a few months’ worth of operating cash, we expect to see CRE of all types—whether it’s hotels, strip malls, or high-end malls—beginning to feel the pressure and push on their banks for relief. REITs will be forced to cut dividends.
- Short-term working capital C&I loans, particularly those against work-in-progress inventories might become worthless if factories don’t reopen. Longer-term capital expenditure or structural credits will become underwater quickly if factories and businesses are slow to reopen.
- On the liability side, we’ve seen cash and deposit buildups from committed facility draw-downs, the Small Business Administration PPP deposits, and other cash saving from corporations and individuals.
- Business closings will put enormous pressure on many state and local governments, particularly in areas where profligate spending and poor fiscal control already contributed to a fragile municipal equilibrium.
- Potential significant credit downgrades for corporations and municipalities could make accessing the capital markets much more difficult, if even possible.
- All banks are coping with learning to operate remotely, even though financial services employees are considered essential workers. Large banks have large IT budgets and experience in remote operations. Most community banks do not.
Before a bank acts, it must understand the potential implications of its actions so management can design tactics that will produce a competent defense. You want to keep every advantage you can. How can you do this? The answer is a well-designed stress test that must have a harsher economic impact than the Federal Reserve’s CCAR severely adverse case scenario, published in February.
Just as in baseball, you need to assess what capability you have to defend against your opponent (in this case, the economy). And since there is no equivalent or history to reference, anyone who tells you to run a stress test based on regression or using canned software is providing bad advice. That first stress test needs to be done now, and it should be based on 2019Q4 or latest 2020Q1. This will give you a clearer view into the vulnerability and capital risks for your existing loan book. The information you get out of this will form a baseline. It should tell you where your risks are, what your capital levels will be under severe stress, and hopefully provide information to let you employ some short-term tactics.
What is clear is that you can’t let the game get away from you in the early innings. If you shut down clients, you may lose them if they survive. Conversely if you don’t move quickly enough, you can find yourself left with severely marked-down collateral and behind in the later innings. The well-designed stress test will give you that perspective.
The middle innings
This is the heart of the game. Here’s what you might expect:
Different states will re-open at different times, attempting to balance public health and economic factors. If there was ever a time that community banks are prisoners of their footprints it will be the result of staggered openings of the commercial entities in their areas and the redeployment of an unemployed workforce.
- The timing of incremental commercial activity will have a greater impact on the quality of the loan portfolio than your underwriting standards.
- Reopening businesses in your state or county may still not happen as quickly as might be thought, particularly if these businesses are dependent on raw material shipments or retail outlets in states that haven’t yet opened. Look for rapidly changing conditions.
- Bright spots can quickly dim as some businesses try to get back their markets but fail due to other factors or events (or lack thereof) in other states. As states open at different times, the relative market position of competitors can and will change. If both state A and state B have widget manufacturers and state A opens first, the widget manufacturer in State A will have a competitive advantage. It will try to gain as much market share of the State B widget manufacturer that it can.
- The SBA’s PPP program will have been exhausted. This is the time that hard numbers will start to reveal the devastation. The economy may look like the post-Gettysburg battlefield with bodies of dead businesses and bankrupt or near bankrupt individuals as far as the eye can see. Look for significantly increasing defaults.
- Early inning modifications may come back to haunt you. Refinancing consumer loans will reduce their cash outflow, but if the jobs don’t come back, even the assistance of lower rates will not be able to offset worsening consumer and commercial credit prospects.
- Deposits will begin to disappear as the loan drawdowns and “rainy day” funds are exhausted.
- Lawsuits will proliferate, whether it’s consumers suing businesses for refunds, employees suing for work safety rules, or businesses suing insurers for business interruption claims.
Again, we have no history to see how this might evolve. The only way to look at your position is with a stress test. In the middle innings you’re not only stressing what was on the books at the beginning of the crisis, but now you also have to stress loan modifications, committed draw-downs, the cloudy economic recovery picture, and secondary effects such as an open business with a broken supply chain.
A well-designed stress test will give clarity to senior management about whether tactics employed in the early and beginning of the middle innings is working.
Structural changes to the environment will start to become more apparent. This is when a community bank’s strategy can begin to emerge, though steps taken in the earlier innings will boost its pathways to success.
- Crises are often said to accelerate trends that have already been in place.
- Brick-and-mortar retailers have been giving way to on-line shopping so future bankruptcies of big chains like Neiman Marcus should come as no surprise.
- Remote work environments have been increasing. This will have massive impacts to geographic dispersion of the workforce, urban flight, transportation, commercial real estate occupancy, leisure pursuits and more.
- The incremental opening of states and businesses does not mean these businesses return to profitability immediately. Look at the restaurant business as an example.
- In the best of times, 60 percent of restaurants close within 3 years of opening. If seating is reduced by 50 percent or more, it will be almost impossible for both casual and high-end restaurants to generate profitability. If diners are happier with take-out, then restaurants may lose most of the higher margin alcohol business.
- Supply chain disruptions can cause restaurants to not be able to offer their signature dishes (one in five Wendy’s franchises was out of beef in May).
- Municipalities will likely see major problems.
- Reduced sales tax revenue.
- Lack of income tax collections
- Most municipalities haven’t laid off employees, so they are still spending.
- Lower interest rates and a volatile stock market will put pressure on unfunded pension liabilities.
The economy may come back stronger than before, but it will be different. Winners and losers will become more apparent. Banks that have weathered the early and middle innings may see opportunities. Your customers will be doing things differently. So will you.
Don’t forget your own cost structure. Companies will be doing more with less—employees, travel, entertainment, real estate. Will your branch structure still make sense? How much can move over to technology?
The late innings will determine if you win or lose the game and get to go to the playoffs. Understanding what’s happening in your footprint, given your lending and deposit bases, will suggest your ongoing strategy. The structural shift will be unprecedented. The only way to see through it is with stress testing. All this needs to be custom designed for your bank. No off-the-shelf computer software will give you the depth or capability to see the big picture and apply it to your bank’s unique situation. Stress testing is not just for your regulators. Most importantly it’s for management to define strategy and tactics.
One enormous unknown will be the interest rate environment: both the absolute level and shape/slope of the yield curve. The Federal government is going to have to borrow massive/records amount of money in the 2nd and 3rd quarters of this year—considerably more than in the aftermath of the 2008 crisis. While the Federal Reserve can take in some of this paper through the QE program, the market will have to absorb the rest. This could mean a classical capital market “crowding out” environment in which corporate and municipal borrowers either pay a lot or just don’t have capital available. We don’t know what that will do to rates, and further we don’t know how that will affect inflation in the later years. But for sure, both inflation and rates will have an enormous impact on community banks and their customers.
The well-developed stress test for the late innings is going to be crucial for strategy. It will determine if the tactics employed in the early innings will leave you competitive, or if you need to change course.
The end of the game
To complete our analogy: a baseball game doesn’t have a time frame like basketball or football. Innings can be short or long. We don’t know how long each of the above phases is going to last or how long it’s going to take to complete the game. Be prepared for extra innings.
You need to be stressing your bank at every step along the way. You don’t want to reach the eighth inning and realize that you should have pulled your pitcher in the fourth. And conversely you don’t want to use up all your relief pitchers too early.