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SUPERVISION NEWSLETTER

COVID-19 and vulnerable sectors: more work to be done

19 May 2021

COVID-19 and vulnerable sectors: more work to be done

As part of its coordinated coronavirus (COVID-19) credit risk strategy, ECB Banking Supervision launched a number of complementary projects to get a full picture of how banks are measuring and managing credit risk during the pandemic. This is the second article in our related series.

 

Corporate vulnerabilities have increased during the COVID-19 pandemic. Owing to a combination of uncertain profit prospects, high debt levels and current or potential capital losses, many companies in Europe are under financial stress. Larger corporates have tapped into capital markets to weather the pandemic storm. Smaller companies have received substantial support through government relief schemes in many countries, but could find themselves particularly exposed once this temporary support is withdrawn and the debt accumulated during the COVID-19 crisis falls due. Therefore, now more than ever, credit risk management needs to be a top priority for banks and banking supervisors.

In early 2021 ECB Banking Supervision adopted a targeted approach to the credit risk of its directly supervised banks that are exposed to vulnerable business sectors. This approach aims to evaluate the credit risk management practices of these larger banks to ensure that they engage with their borrowers promptly, identify balance sheet deterioration early, recognise distressed loans and make timely and adequate loan loss provisions. Banks should have sound policies, processes and systems in place that incorporate realistic and up-to-date information and assumptions to ensure that they are able to adequately identify, assess and measure credit risk, especially in the context of the pandemic. Early, targeted action by banks should help reduce potential cliff-edge effects, i.e. sharp increases in losses on loans to borrowers in vulnerable sectors once debt concessions and public support schemes come to an end.

Vulnerable sectors in the pandemic

Business sectors are considered vulnerable if borrowers in these sectors are sensitive to the pandemic shock and, as a result, could pose a material financial risk to banks. Sectors can become vulnerable owing to a number of factors, such as their size or materiality, country concentration, financial risk and the severity of the pandemic shock. Sectors can be further categorised based on whether the shock to their income is considered to be short or long lasting. Sectors which might only take a temporary hit include those that are heavily reliant on tourism and hospitality, such as the food and accommodation sector or aviation. While these have been constantly affected since the crisis began, as a result of multiple and protracted national restrictions, they may rebound as COVID-19 lockdowns are lifted. Other sectors might experience long-term and structural effects owing to changed customer behaviour once the pandemic is over. These sectors include commercial real estate (CRE) and the retail trade sector (excluding supermarkets). They were already facing structural changes, and these have potentially been accelerated by the pandemic.

In terms of volume, CRE represents the largest sectoral exposure across directly supervised banks. It accounts for 22% of total exposure to non-financial counterparties. The CRE sector is a prime example of a sector facing challenges from structural transformations that were ongoing before the pandemic struck but have since been accelerated. Many tenants of office buildings have successfully implemented large-scale remote working arrangements. Now, some are contemplating reducing their rent expenses and offering more flexible home working arrangements for large portions of their workforce on a permanent basis. Therefore, there is a risk that occupancy rates, which have in some instances fallen significantly during the crisis, fail to rebound as the pandemic abates. Substantial time and investment may be required to put former office buildings to alternative use. However, it may prove difficult to finance such investments and withstand prolonged vacancies given the high debt levels and declining returns in the CRE sector.

Tenants in the retail industry (excluding supermarkets), which is another vulnerable sector, may also be in decline. Lockdown measures have seriously challenged the liquidity and profit margins of many brick-and-mortar retail stores, whereas those operators with an online business model have flourished. Profit margins in retail were already squeezed before the crisis and could fall further in the post-pandemic period, speeding up the transformation of the city centre retail experience.

Targeted review of the food and accommodation sector

ECB Banking Supervision launched a targeted review of the food and accommodation sector in early 2021, focusing on a sample of directly supervised banks with relevant levels of loans to the sector. The review aimed to assess how banks were managing and addressing credit risk in relation to sector borrowers affected by the pandemic. Work and exchanges with the banks in the sample are still ongoing, but it is already apparent that some banks are deviating from the supervisory expectations set out in the ECB’s letter of 4 December 2020. The review also revealed that credit risk management practices vary across banks. Some banks’ early warning systems and procedures for assessing borrowers’ unlikeliness to pay are overly reliant on ineffective indicators, outdated ratings and backward-looking information. In many cases, these banks do not assess borrowers’ potential unlikeliness to pay or do not implement internal controls and risk indicators to challenge the effectiveness of their frameworks for the current crisis. Such systems are unable to anticipate deteriorations in credit quality, thus preventing proactive and timely engagement with clients. Moreover, not all banks have sufficiently adjusted their estimated default probabilities for borrowers in this sector to account for the current economic situation. In some instances, banks granted modifications for loans that do not meet the criteria for general payment moratoria but did not correctly flag such loans as forborne. This could potentially conceal the true risks in banks’ books.

Other issues identified related to banks’ policies and practices for assessing creditworthiness. Not all banks have well-structured and sound procedures that enable them to swiftly and effectively differentiate – by way of risk-based cashflow analysis and on a case-by-case basis, where appropriate – viable debtors from non-viable debtors.

The analysis revealed that approximately 68% of the sample banks’ exposure to the food and accommodation sector relates to small and medium-sized enterprises (SMEs). The review also helped the ECB to gauge the amount of new lending that was granted up to the end of December 2020. While continued lending by the banking sector throughout the crisis is welcome, it is important to consider that the increased indebtedness (+20%) of SME borrowers in this sector, over a relatively short period of nine months, could potentially have negative effects once government support starts to be withdrawn. If the pandemic ends up having a more permanent impact on these borrowers, it is less likely that they will be able to repay this debt, resulting in higher levels of default. Furthermore, the review showed that while many banks had developed enhanced borrower outreach programmes and had improved credit risk practices to deal with their large corporate clients, they appeared to be lagging behind for SMEs. These banks need to improve their credit management practices and tools to effectively assess and manage large volumes of potentially vulnerable SME borrowers. This should help them to actively mitigate associated cliff-edge effects in a timely manner.

Some banks have acknowledged that the food and accommodation sector is facing a bumpy path to recovery and the related loan portfolio has become significantly riskier. They reflected this increased risk by classifying more of the loans to this sector as Stage 2 under IFRS 9. However, other banks appear hesitant to follow suit. This was also the case for the level of credit loss provisions associated with Stage 2 loans – not all sampled banks seemed to make provisions in line with the observed risk increase. Some banks are keeping a significant portion of their accommodation and food services loans in a low-risk category or are not flagging that these loans are at risk of deterioration. This trend can be explained in part by banks’ strong sense of optimism, which is reflected in their economic outlooks and in their assessments of post-pandemic repayment capacity. Some banks expect a return to pre-crisis sales and occupancy levels by the middle to the end of 2021, which may turn out to be too optimistic given the delayed vaccination campaigns and the resurgence in infection rates across Europe.

The ECB will continue to focus on sectoral risks over the coming months. Its preliminary findings from the food and accommodation sector will be taken into account in upcoming reviews of other more structurally affected sectors. The findings from these off-site reviews will lead to targeted follow-up and remedial actions for banks. They will also help inform and shape future dedicated on-site campaigns and will be incorporated into the ECB’s regular supervisory work, including in the Supervisory Review and Evaluation Process, its annual assessment of the risks that banks face.

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