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Profitability Paradigm : Capital Compression - Balance Sheet Story

Tracing the evolving banking scenario in and around the pandemic, through the lens of  “shrunken transactions” a harbinger in many ways. The intensity of the impact may vary, but both individuals and businesses of all sizes and shapes have been thrown into a vortex. Last blog* I touched upon margin compression and  its  impact on P & L books of the bank, due to shrunken business (reduction in both consumption and Trade), lowering interest rates and flattened yield curve.

This blog explores the effect on Capital. Lower repayments of Loans, lower net new deposits and volatility in the markets impacting  investment and treasury operations have all contributed to shrunken transactions (Value & Volume). Lower business volumes  are symptomatic of the upcoming challenges. The capital buffers built, thanks to the regulatory guidelines, will stand banks in good stead in the near term. It is  in the medium term, market volatility, asset quality deterioration, rising risk weighted assets, increasing cost of risk and surge in NPLs leading to higher provisions will require razor sharp attention and nimble response to protect capital and margins.

Most banks world over, entered the current crisis with strong capital base - US banks with a CET 1 ratio of 12% and EU Banks with  15% (Q4 2019). The problem though, is of assessing the potential impact. Uncertainty of the crisis both severity and length, the resultant breadth and depth of recession as well as the speed of recovery is unclear at this point. Both Credit Risk & Market Risk will be negatively impacted resulting in higher RWA with higher capital requirement. The combined effect of high mark to market losses, higher credit losses (both actual and deferred), higher provisions necessitated by IFRS 9/CECL due to Covid 19 will affect capital as well as play truant with cash flow projections impacting funding and lending decisions.

Credit recovery alone will be a sizeable stress as banks see multiple year credit losses with Retail segment hit, SME or commercial segment reeling under losses (In North America, it is anticipated that about 20% of small businesses may declare bankruptcy – a representative global trend) and corporates in some industries staring at being downgraded by rating agencies. The challenge is heightened particularly for those banks, as EBA points out, that are exposed to the sectors more effected by the pandemic and do not have enough capital buffer to weather the storm.

Some data points

Europe - First insights from EBA (Thematic Note – EBA/REP/2020/17) show that banks went in with a resilient position both on capital (CET 1 rose from 9% in 2009 to almost 15% in Q4 2019) and liquidity buffers with LCR close to 150%. However, the exposure of banks to riskier portfolios (SMEs & Consumer Financing) will result in growing NPA. “A sensitivity analysis around the 2018 EBA stress test scenario indicates that the impact of credit risk losses on CET1 ratios ranges between around 230 basis points (bps) and 380 bps,”

North America – Per study by McKinsey  team (Stability in the storm) the Credit Losses could be in the range of $400 Billion to $1 Trillion over the period 2020 to 2024 depending on the evolving scenarios. This could lead to a decline of capital from 1% to 4%.

India & APAC – News reports indicate that banks in India are likely to witness a spike in the NPA ratio by 1.9% and credit cost ratio by 130 basis points in 2020. For Asia-Pacific Banks, COVID-19 crisis could add “USD 300 Billion to Credit Costs" and about “$600 Billion estimated rise in non- performing assets” in 2020, per S&P Global Ratings.

The above data, points to a global phenomenon highlighting two underlying themes a) Capital compression likely to be in the range of 2% to 4%  b) Credit losses will be in hundreds of billions of dollars.  Balance Sheet depth to handle the situation is the question, not in the short term but medium to long term. The real test will be the ability of banks to manage capital while supporting customers. A lesson history has taught us is that capital cushion is critical for survival – During the previous crisis six major institutions that experienced a capital erosion of 3% or more, no longer exist as independent entities. Today is different as banks have built in capital buffers but need to be aware that it is a finite reserve.

This is the time for banks to focus on building flexibility and resilience into their balance sheet, as well  look at their P&L book closely. A positive P & L adds to the Capital. It is a fact that typically, only 20 to 25% of the business is profitable and subsidizes the rest of the business, specially the 30% business that is loss making. By deep diving  and acting on the loss-making business, banks can enhance their profitability substantially and shore up capital. My next blog “Lens on Profitability & Value Creation” explores this theme.

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