U, V, OR W, WHAT SHAPE WILL THE RECOVERY BE?

In March, when it became evident that the COVID event was disrupting U.S. economic activity, the Federal Reserve (the Fed) conducted a sensitivity analysis (Assessment of Bank Capital during the Recent Coronavirus Event, June 2020), based on a set of scenarios that are more dire and stressful than were implied by then current economic and banking conditions.  For example, it projects a much deeper recession in the second quarter of 2020, greater contraction in GDP, and unemployment rates hovering over 16% to 19%.  They are also inexorably tied to the virus and the response to it.

Though it isn’t a forecast‐the Fed noted in the analysis‐it is a study to gauge the possible consequences of the disruption to the U. S. economic activity brought on by the COVID 19 pandemic.

Sensitivity Analysis

The scenarios used in the analysis are as follows:

• a V-shaped recession and recovery;
• a slower, U-shaped recession and recovery; and
• a W-shaped, double-dip recession.

The scenarios assume that the path of the economy depends on how U. S. deals with COVID.  In the case of U-shaped recovery, for example, it is consistent with the possibility of prolonged social distancing to combat ongoing outbreaks of the virus across the country; and for W-shaped recovery, a second COVID event begins in late 2020 and leads to a second increase in unemployment and drop in GDP.

In short, the results of the analysis can be characterized by depletion in capital due to an increase in loan loss.  Specifically, under the V-shaped downside scenario:

• The aggregate CET1 ratio (Common Equity Tier 1 ratio) declines from 12.0 percent to 9.9 percent (the CET1 ratio from a sample that consists of the 33 firms participating in DFAST 2020); and
• A loss rate of 8.2 percent that is partially offset by higher revenues owing to the stronger recovery and the benefits firms would get from the CARES Act.

The U-shaped and W-shaped alternative downside scenarios result in:

• Larger projected declines in capital driven by higher loan loss rates of 10.3 percent and 9.9 percent, respectively
• In the U-shaped downside scenario, the CET1 ratio declines to 8.2 percent after nine quarters.
• In the W-shaped downside scenario, the CET1 ratio declines to 7.7 percent after nine quarters.

The loan losses are the primary reason for capital declines across the various scenarios.  The analysis shows that the banks could experience similar sized loan losses stemming from the COVID event as during the Global Financial Crisis.  In addition, the composition and timing of losses are also worth noting:

• In the scenarios in which the unemployment rate remains elevated for a long period of time, losses on credit cards rise as well as other secured forms of consumer credit, like auto loans and mortgages, also take on material losses.
• In all scenarios, the results suggest that corporate credit and commercial real estate would take large losses.
• The analysis showed that the U-shaped downside scenario had the highest overall loan loss rate over the nine-quarter projection horizon; however, loan losses remain particularly elevated outside the projection horizon under the W-shaped downside scenario, which features a second COVID event.
• Those higher loan loss provisions in the W-shaped downside scenario result in lower net income and thus lower post-stress capital ratios than the U-shaped downside scenario.
• In short, a delay in the economic recovery as a result of a second COVID event could have significant negative effects on many banks’ capital levels.

What the Banks expect

The expectation, the one that is generally accepted in the market, is that a complete rebound to pre-crisis levels looks impossible until the virus is controlled. Especially for banks in the U. S., the prospect of mounting loan losses has given a reason for caution in thinking that a V-shaped recovery is ahead.

The uncertainty surrounding the timing and size of support to the economy complicates the challenges the banks have to face even more.  For example, it’s hard for banks to measure the resiliency of consumers because here again the response to the pandemic is the key to a recovery and some of the support in the form of disaster relief that the consumers have received and which have given a lifeline to the economy are set to run out soon (Krugman, NYT Jul. 16, 2020.)  In addition, loans to companies already have started to sour. Wells Fargo’s nonperforming assets jumped 22% from the first quarter, largely driven by loans to the oil and gas and commercial real estate industries. The bank boosted its reserve for credit losses by $8.4 billion in the period, with more than three-quarters of the increase coming on the commercial side. Citigroup’s “roughly $3.5 billion boost to wholesale lending reserves was partly driven by a slew of credit-rating downgrades.” (F Davis, Levitt and Surane, Bloomberg News, Jul. 14, 2020.)

For banks, the path to recovery might mean a series of ups and downs:  a slower one‐a combination of a hopeful but short-lived V, then a dragging U, and a scary W‐and as such, may be that much more painful.  Should it be the case, regardless of how inviting the prospect of an expedient recovery may appear, it would make sense to take care and strengthen the effort in monitoring and management of risk now‐using analytical and reporting tools such as the ones that VERMEG provides‐and to blunt the impact of adverse outcome.

PAUL BAIK
REGULATORY ENABLEMENT MANAGER – AMERICAS