International Banker is joined by Mr. Giles Edwards, senior director of S&P Global Ratings, to discuss banking-market turmoil, ECB monetary policy and incorporating ESG factors into ratings.
Today, International Banker is joined by Giles Edwards, senior director of S&P Global Ratings, to discuss banking-market turmoil, ECB monetary policy and incorporating ESG factors into ratings.
Giles, very good to have you with us today. Now, I understand that Europe is your primary geographical focus within the financial-institution sector. How vulnerable is this region’s banking sector to another financial crisis, particularly in the wake of Credit Suisse’s trouble and the banking collapses in the United States? And can you provide insight into how you measure contagion risks?
Measuring contagion risks is a…it’s very hard to put a number on contagion risks. I think, clearly, it’s been very febrile, jittery markets in the last few months. It’s maybe eased off a bit. But certainly, March was a roller coaster. In terms of contagion, clearly, banks are highly leveraged. Confidence-sensitive institutions are always going to be vulnerable. And in some respects, the facts may not matter if the sentiment is against banks. Equally, the authorities, the Financial Stability [Board], are absolutely paramount. And they’ve stepped in to the extent they’ve felt they needed to, but, equally, not waded into it. And that reach in itself can cause question marks over what are people worried about. We think about contagion. Ultimately, there has to be a linkage; it has a domino effect, if you like. And the banks themselves are, when they face each other, collateralised these days rather than uncollateralised. A lot of exposure goes through either central banks in terms of lending and also clearinghouses. So, some of that connectivity continues to exist, but some of it has reduced over time. And if we think about other causes of contagion—you need the sort of similarity, I suppose, of business models. Particularly narrow business models lead to more vulnerability. Concentration kills banks ultimately—concentration, whether it’s credit concentration or business or funding. So, we’ve looked through the sector, the rated sector, at least the names we know, through March – April, and ultimately, we were happy that we couldn’t see the sort of type of vulnerabilities that have been showing up in the US. Equally, I mean there are clearly some banks that have some of those characteristics, but it’s very hard to find banks that tick more than one of those boxes.
Now, you recently commented on the banking crisis-management framework that followed the banking market’s turmoil in March, particularly, if you like, the future resolvability of global systematically important banks. Has this event caused S&P Global Ratings to re-evaluate its view on the bailout versus bail-in question?
Yeah, so maybe if I start by saying where we are. Since 2015, we’ve basically said government support for commercial banks, rather than policy institutions, commercial banks, is sort of uncertain. Which, never say never, but it’s, let’s say, unlikely or less likely than it used to be. And, therefore, we’ve been factoring resolution, loss-absorbing capacity, bail-in and so on as the sort of backstop in terms of whatever system a bank fails in. So, have we revisited that? The answer is no. Equally, even before March, there would have been plenty of investors around who would doubt that bailout has actually gone away. They’re still assuming that governments are there to backstop banks if it really comes to it. But when we looked at what happened in March, ultimately, we saw nothing there that’s really changed our minds. I mean, to policymakers, financial stability is paramount. Authorities have stepped in to preserve that. Governments’ providing liquidity backstops is, in a way, a good institutional framework. It’s not a bailout in the way that we think about it. So, we haven’t changed anything. Equally, is it, well, we do find it interesting that the Swiss authorities felt that resolution was not at all what they wished to use in those circumstances. It wouldn’t necessarily ensure financial stability, in their view, and that would have redoubled the existing doubts in the market about: Are they really serious about this? So, we’re keeping, in fact, a close eye in terms of the policy response. I mean, so far, it’s been relatively muted. Some discussion in the US and UK around deposit-guarantee schemes, maybe tweaks to that. The EU CMDI (crisis management and deposit insurance) package on crisis management plus insurance that’s been on the train for a long time, but the policy announcement has come out now. That’s ultimately a doubling down on making resolution work. So, there’s nothing really there that’s changing our minds. But it’s a dynamic situation, and ultimately, a lot of it’s down to behaviour. You can build the framework; a resolution framework is ultimately a toolkit. The question is: Will it be used when it comes to it?
So, it requires constant supervision, really, doesn’t it?
Yeah. And it requires, I think what it requires…a lot of it hasn’t been tested. I mean, sourcing out smaller institutions, even up to the size of Banco Popular around 2017, that’s been tried—selling failed banks to bigger banks. What’s not been tried is the bail-in of big systemic banks, no writing off tens of billions of debts, senior debt—forget the AT1 bonds and senior debt—that has not been tried yet. And what it takes, ultimately, for resolution to work is essentially that it shouldn’t be a surprise. And so, I think what we really look for is for policymakers to make sure that their intention is extra clear and to guide market expectations so that ultimately even the first bail-in will be a surprise to some parties, but it hopefully will be the smallest surprise possible.
Now, in January 2022, you were the primary credit analyst for S&P Global Ratings research “The top trend shaping European bank ratings in 2022”. And in that, one of the key forecasts was that at least 80 percent of the largest European banks had stable outlooks and that there would be substantial predictability for the sector’s profitability, asset quality, capitalisation and funding in 2022 amid an expected supportive economic backdrop and favourable financing conditions. Now, more than a year later, would you say this forecast has held up well? And how does 2023 look in terms of expectations and outlooks?
So, I had a look back last week at the rating actions we took last year, and we did have, we had more upgrades than downgrades by a long way. That’s not to say there were lots, but there were definitely more upgrades. And I think to some extent, that’s continued through this year. A rising-rating environment has been supportive for bank earnings, no question. There’s clearly a question mark about asset quality. We still see that as probably not a this-year thing, more next year in terms of rising nonperforming assets. And even through last year and this year, there’s still a story of recovery to some extent. Banks, peripheral banks, completing the job on nonperforming assets—legacy nonperforming assets—and getting their funding profiles right. Some banks have gone away and done some hard work on their business models, their structural profitability—the sort of the Deutsche Banks and the NatWests have now come back. Marcus as well. So, we’ve had, let’s say, idiosyncratic, a few trends, but idiosyncratic upgrades. As well as also the building of bail-in buffers naturally has supported our feeling for senior ratings.
Now, I’m turning to the European Central Bank (ECB). How aggressive do you predict their monetary policy will be for the rest of 2023? And how do you see this policy impacting the profitability and balance sheets of the eurozone financial institutions?
So, our economists are probably reasonably middle of the pack, in that they would expect another rate rise to 3-1/2 percent on the deposit rate around the middle of the year. I think there’s a question mark as to whether it then goes a little higher. Even then, they’re not expecting core inflation to come down into the ECB’s desired range for at least a further year after that. Now, but equally, the deposit rate is a fraction of the story. We’ve still got to wind down the TLTROs (targeted longer-term refinancing operations). We think that’s going to be seen through the quantitative tightening. That is, there are huge buffers of bonds that need to be unwound. Then there’s also sort of auctions of money, which is essentially limitless at the minute. It tells me that the ECB wants to bring that back. So, there’s a long road yet on monetary-policy normalisation. And then there’s also fiscal policy. Although there are next-gen EU funds still to be spent, I think the public authority is very mindful of the need to ensure that it has a close handle on fiscal policy as well and not overspending. Well, what that points to, ultimately, is constrained economic growth this year, maybe slightly improving next year, certainly as our economists would see it, but probably an end to that improving story of net interest margins for banks as we go through the back end of this year into next year. A bit more pressure on asset quality through next year. And also cost pressures on operating expenses. So, it may be, it’s very hard to generalise, but it may be that this year looks as good as it gets in terms of profitability for a number of banks. And there’s a bit more pressure, a bit less support on revenues next year. A bit more pressure on the other factors. It still wouldn’t be necessarily too bad, but, yeah, this could be as good as it gets for now.
Many would say that European banking was mired in a serious debt crisis around 10 years ago, particularly concentrated in Southern European economies. Are you confident today that this crisis has been sufficiently contained and alleviated?
Yeah, I think we saw huge progress over the last 10 years in the banking union. Ultimately, the banking union remains incomplete. There’s no EDIS, European deposit-insurance scheme, yet. It still seems like a distant notion. But the creation of the Single Supervisory Mechanism clearly has had a huge impact and added huge credibility, consistency and supervision, and standard setting as well. And the ECB has really driven the banks very hard over the last five years to clean up legacy nonperforming assets. And that’s what’s happened. A reasonably supportive economic environment has helped as well up until 2020 certainly, as well as some government schemes to take the bad assets off. So, it’s been a sort of joined-up effort. But one reason why we’ve upgraded Irish banks, some Spanish banks, Greek and so on over the last three years is exactly down to the progress that’s been made.
O.K., well let’s turn to Germany. How much optimism do you hold for its banking sector over the next few years, especially given the profitability challenges it’s faced in recent years and the highly publicised failings of its biggest lender?
I mean, Germany is a tough market. It’s a banking market. It’s got a very unusual structure to it, with the policy institutions, the two huge savings banks, corporate bank groups, mutual groups and then everybody else, all the other commercial banks. It’s a very hard market to make good margins. And there’s a lot of competition coming from outside Germany for German deposits. So, it’s unusual and one of the tougher markets in Europe to make good money for a bank. Equally, we’ve seen…we’ve actually put Deutsche Bank on a positive outlook recently. We’ve seen some progress in terms of the heavy lifting that they’ve done over the last few years. Commerzbank—we’ve got our eye on it as well, having brought their rating down in previous years. So, it’s long, hard work. It requires commercial banks to be structurally in a good place, to be working very hard in efficiency. And they are getting a bit more help now on revenues, particularly net interest margins, and that’s alleviating some of the pressure.
Now, how does S&P Global Ratings incorporate ESG factors into its ratings?
Yeah, so we get asked this question a lot: Now, where’s the ESG in the rating? I think, ultimately, from a rating perspective, ESG factors have to matter to the fundamental credit. And, really, nothing there really has changed. Poor governance, that’s always been there, right? Social failings, mis-selling, that kind of thing. That’s not a new thing either. I think the newest thing arguably is around the environmental side, green transition. So, we’ve worked to increase the transparency in terms of saying this rating action is linked to ESG factors. If you find ESG important, this bank has performed better than average on these sorts of factors or worse than average on these factors. So, we’ve worked to increase transparency, I suppose, in terms of how we actually analyze banks. We haven’t changed the methodology. What we have changed, of course, is we’re asking a lot more questions these days about green transitions, sustainable finance, looking at bank disclosures as well in terms of what they’re doing, looking at what regulators are expecting. But fundamentally, what’s really, for example, when ESG drives rating actions, it’s still, by and large, mainly driven down to governance, either poor governance slip-ups or occasionally also good governance.
Now, finally, what emerging risks are you seeing that could potentially impact the banking sector?
I mean, the green transition is clearly an emerging risk. It’s got a long way to run in terms of that story. There are going to be huge changes for economies and societies, and banks clearly will feel that as well and be part of the story. So, we’re keeping a very close eye in terms of what banks are doing there, the promises they’re making as well. I think cyber would be a second one. It’s, I would say, an emerged risk in that it’s been around for a long time as a source of vulnerability. I think the banks themselves have gotten pretty good track records, but fending off some of the pressure they’re under on cyber. They get attacked every day, and it’s a hard risk for us to judge. We like numbers. It’s very hard to measure exactly how good a bank is on cyber. But it is certainly a topic that we are asking bank managers about and trying to compare and contrast. So, I think those would be the main two. I mean, the final one, I suppose, would be shadow banks in that there’s been a big build-up of credit outside of the banking system over the last decade or so since the financial crisis. Understanding the linkages there in terms of where the risks lie and also the vulnerability that links back into the banking sector is, I think, an ongoing feat for policymakers as well as us, frankly. And it could yet be that problems in the shadow-banking sector yet come back, too, as monetary policy works its way through and could still cause a problem down the track.
And in many of these conversations, we talk about digital and digitalisation. One big telco company recently announced massive job reductions based on what they see as the role AI is going to play. Is that something you’re thinking about at the moment as well?
Yeah, so we’ve been publishing quite a lot on digitalisation and banking for the last four or five years, at least. It’s clear that a bank is essentially a regulated technology company, or at least they should be, because of such a key discipline as the organisational setup around technology and how that informs their costs of delivering also their products. So, it’s been a big topic for us with bank management for a long time. We’ve seen a lot of banks, some banks work very hard on their technology. We had big question marks about will some of these new entrants eat the banks’ lunch, particularly in some of the more juicy sort of fee-driven payment side of the market. That’s happened to a degree. Although with the size of the biggest banks and their budgets, as long as they’ve got the mindset to invest and to be forward-looking, I think, ultimately, they’ve been pretty successful at hanging on to their franchises and some of their strongest earnings so far.
Giles, thank you very much for your time today and for those insights as well.