Look who’s jumped on the bad bank coverage ratio bandwagon — Goldman Sachs.
In a note out today, GS analysts, are also looking at how falling coverage of non-performing loans (NPLs) has fueled this year’s profits among European banks. As a reminder coverage ratios are loan loss reserves divided by NPLs — so basically how much a bank has covered its bad debts.
On aggregate NPLs among Europe’s banks increased from €315bn at the end of last year to €443bn at the end of the first-half of 2009, or 41 per cent, according to GS. During the same period loan loss reserves increased 27 per cent, from €197bn to €251bn, meaning the aggregate coverage ratio fell from 62 per cent to 57 per cent — or 5 percentage points. (You can see a table of the individual European banks’ NPLs and coverage ratios here).
Why do we care about the coverage ratio falling a measly 5 percentage points? As the Goldman analysts highlight, that 5 percentage-point reduction helped boost the European banking industry to a collective profit in the first-half of the year. They note that:
A flat coverage ratio on 2008 would have wiped out 1H2009 PBT for the sector. In aggregate, the banks under our coverage reported €19 bn of pre-tax profits in 1H2009. If we assume flat NPL coverage on 2008, this profit swings into a €9 bn pre-tax loss. Bank sector profitability in 1H2009 is therefore, to an overwhelming extent, a function of thinner reserves.
The most dramatic swings occurred in banks heavily exposed to central and eastern Europe — names like Raffeisen, EFG Eurobank and Erste Bank. At Raffeisen for instance, a flat loan loss provision would have turned the bank’s reported H1 profit before tax of €154m into a loss of €697m. At Erste, a €203 PBT would have become a loss of €378m. Erste’s profits would have fallen by 66 per cent.
Also heavily impacted would have been Italian banks — notably Intesa SanPaolo, where €2.2bn in PBT would have turned to a loss of €95m, and BMP, where €216m turns into a loss of €178m. Every domestic Spanish bank bar Banco Pastor would also have become loss-making.
In fact with a flat coverage ratio, banks’ H1 2009 results would have looked like the below, GS says. Click to enlarge:
The big question here is what will happen with non-performing loans. If NPLs stay the same or even fall during the rest of this year, then banks largely don’t have to worry about adding to their loan loss reserves — their coverage ratio will increase automatically (CR = LLR/NPL). That will mean banks’ bad debts are better covered, but it will also mean an end to the lower-coverage ratio profit boost. It’s also, as Goldman notes, a big bet on the future of NPL formation:
By definition a decline in coverage [in H1 2009] represents an increase in bank risk. In our view, aggregate coverage declines are premature and include a fair amount of wishful thinking. Reduced values – and liquidity – of key collateral markets and elevated levels of NPL formation drivers suggest credit quality will remain under pressure. Looking into 2H2009 we make the following points.
• Coverage should not fall further. Another PBT boost, similar in magnitude to that in 1H2009, is therefore extremely unlikely, in our view. In particular, this is true of banks that currently exhibit below average (and falling) coverage ratios.
• Slower NPL formation could well happen; partly this is a function of better macro conditions. More importantly, the interest rate environment remains low, allowing banks to pre-empt problematic loans through restructuring.
Related link:
Good banks, bad banks – FT Alphaville