"The banks are not in the eye of the storm this time, but they must prepare for it: shocks to the real economy become shocks to the financial sector."
The German banking market in the COVID-19 crisis: rising risks, falling revenues
Our approach for how banks can deal with uncertainty and the consequences for their business
The world has been rocked by the coronavirus pandemic and the unfolding economic crisis. The German banking industry, too, is feeling the effects: depending on how the recession progresses, a massive drop in revenues can be expected. In the negative but not unlikely scenario of a profound recession, operating results could take a hit of up to 50 percent through 2021. Given the extreme uncertainty over exactly how the crisis will pan out, banks must now develop scenarios that weigh the impact on their institution and come up with measures to ensure they can remain profitable in the long run and emerge stronger for the future.
"This crisis is different - Comparing the coronavirs crisis with the financial crash" – this is the title of a recently published Roland Berger analysis of the economic impact of COVID-19. And indeed, in its overall impact, the current crisis has no historical precedent in the last 50 years. It is a black swan, an event of extreme rarity and severe economic impact that is impossible to predict.
The global lockdown of large parts of society and business activity has enormous negative consequences for the real economy. Even if the banks are not in the eye of the storm this time, they are certain to be severely affected: shocks to macroeconomic supply and demand very often turn into shocks to the financial sector. Among the first indications of this are the banks' loan loss provisions, which are already significantly raised at this stage of the crisis. In a worst case scenario, this could result in a prolonged downward spiral of mutually reinforcing circumstances.
The longer and deeper the recession, the weightier the consequences for the banking industry
Even though some of the consequences of the coronavirus crisis will only become evident in the medium term as the full effects take some time to filter through, one thing is for sure: the longer and more severe the impact on the real economy is, the harder German banks and their balance sheets will be hit. The reasons for this are manifold: increasing insolvencies, worsening credit ratings, reduced willingness to invest among corporates, lower personal income and assets, and lower budgets for consumer spending among private individuals to name but a few of the influencing factors.
Governments are also currently taking the long view and have no idea when the crisis will come to an end. Nobody can predict when and in what order the political measures to contain the pandemic will eventually be withdrawn, or whether there will be a 2nd or even 3rd wave of infection that will make recent restrictions necessary again.
Uncertainty makes scenario planning indispensable
Against this backdrop, a scenario-based approach is the right way to go about mapping possible developments and drawing conclusions for how to deal with the crisis. Roland Berger has developed two macroeconomic scenarios and used them as a basis for calculating the impact of COVID-19 on the German banking market, as illustrated below.
The "delayed cure" scenario is still considered to reflect the most likely course of events currently. In this scenario, the economic shutdown lasts for about 12 weeks and leads to a significant drop in GDP growth of about 7% in 2020 followed by a recovery in 2021 (about 4% up on 2020). However, the economy is not expected to recover to pre-crisis levels until 2022 at the earliest.
In the second scenario, "profound recession", the disruption to the economy is more severe and lasts several months. This results in an increased number of bankruptcies and a sharp rise in unemployment. In this case, a return to pre-crisis levels is not expected before 2025.
The impact on banks is substantial. In a "delayed cure" scenario, (operating) revenues are expected to fall as much as 6% by 2021. At the same time, there will be a need for significantly higher loan loss provisions. In some individual cases, banks may now require more than 10 times the level of provisions, which have been at historic lows in recent years. In addition, substantial write-downs and impairment losses may have to be recognized on assets and collateral.
Without cost reductions, the threat of reduced earnings is real
These two factors have a huge impact on a bank's operating result. In the absence of significant countermeasures on the cost side, operating result (before risks, write-downs and impairment losses) will fall by as much as 25% in 2020 (or even 30% in 2021). In the "profound recession" scenario, a decline of up to 40% in 2020 (or as much as 50% in 2021) can be expected. To be proactive in addressing this eventuality, banks must make themselves fit for the future now. Undertaking a systematic review of the loan portfolio and preparing to increase the number of restructuring and liquidation units is just as important as active cost management here. If they want to achieve a cost-income ratio at the pre-crisis level of around 72 percent, banks will have to make savings of a good EUR 11 billion in the "delayed cure" scenario. That's around 13% of their current cost base.
Precise situation analysis is necessary to know what actions to take
In order to address the current uncertainties and work out the consequences of the COVID-19 pandemic for any given bank, an individual scenario analysis will need to be carried out to determine just how the crisis will impact the P&L, balance sheet and operating model of the respective institution. In addition, the bank's loan portfolio must be actively reviewed and appropriate measures taken to mitigate risk. Specific short-, medium- and long-term savings potential and measures can then be identified on that basis. Tools such as the Roland Berger Efficiency Booster can be useful here. A modular and standardized method, our Efficiency Booster determines the implications of the various scenarios for a bank's individual situation and defines concrete, realizable savings potential. It also examines the implications for the bank's business model.
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