Sideways: Banks get to mark their own balance sheet homework

Deutsche Bank became the latest firm to warn that it will miss capital targets due to provisions and an expanded balance sheet, in a pre-announcement of its first-quarter earnings on Sunday April 26.

The big surprise in the release was that Deutsche will actually turn a profit for the first quarter. Revenue will be a higher than expected €6.4 billion and pre-tax profit €206 million – when many analysts had expected a loss of at least that amount.

Deutsche said that its capital may fall “modestly and temporarily” below its common equity ratio target of at least 12.5%, adding: “this revised outlook acknowledges that credit extension to support clients at this time could increase risk weighted assets for several quarters”.

Before the coronavirus crisis hit markets, the RWAs of banks with big trading operations were closely monitored by investors. Steps to cut RWAs – or at least to mitigate growth caused by market movements that affect derivative valuations – were detailed by bank executives on earnings calls and tested for plausibility by analysts.

Now the urgent need to ensure that credit flows to the real economy and the difficulty in accurately forecasting the impact of the crisis is leading to a suspension of scrutiny.

Deutsche’s first-quarter credit provision of €500 million looks at first glance like a round number that might be on the low side for a firm that had a balance sheet of around €1 trillion at the end of last year.

The current management team at Deutsche has more credibility than recent incumbents, however, and investors marked its stock price up by 10% the day after its pre-announcement of first-quarter earnings.

Unprecedented challenge

Investors may be taking a cue from regulators, who seem to have formed the collective view that now is not the time to pull up banks over the details of their planning for an unprecedented economic challenge.

There are differences between accounting conventions for credit provisions in the US and Europe – and a stark contrast between the health of the banking sectors in the two regions.

This is leading European regulators to signal to banks that they should be generous when marking their own homework, in the form of making credit provisions.

The Bank of England’s Prudential Regulation Authority has reportedly advised British banks not to make high first-quarter provisions that could affect their reported capital levels and in turn reduce their lending ability, for example.

The European Banking Authority (EBA) had already indicated that implementation of accounting standard IFRS9 for impairment evaluation is at the discretion of European Union banks for now.

There are differences between accounting conventions for credit provisions in the US and Europe – and a stark contrast between the health of the banking sectors in the two regions 

“Institutions are expected to use a certain degree of judgement and distinguish between borrowers whose credit standing would not be significantly affected by the current situation in the long term, and those who would be unlikely to restore their creditworthiness,” the EBA said on March 25.

Once European banks have followed their US counterparts in completing their first-quarter earnings announcements by early May, and provided further detail on credit provisions, stock prices will supply an evaluation of the relative strength of the two sectors by investors.

This will be accompanied by a less easily observable analysis of relative value in banking by policy setters at the national level.

Big US firms such as JPMorgan (which saw its balance sheet swell to over $3 trillion by the end of the first quarter) and Citigroup have come to dominate investment banking in Europe as well as their domestic market.

If there any signs that US firms are pulling back from providing financing to Europe, then policymakers in the region may feel that they need to take further steps to bolster local banks.

That won’t be as simple as promoting national banking champions to channel state-sponsored investment, however, given that some bank chief executives still cling to the hope of cross-border acquisitions within Europe. 

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