The economic response to COVID-19 in Australia has largely focussed on reducing the impact on workers who have lost their jobs due to business shutdowns and also helping small businesses survive the crisis so they are in a position to re-open and re-employ workers in the future. Australian banks are specifically being asked (and to some degree compelled) to help by allowing both businesses and individuals affected by COVID-19 to defer principal and interest payments on their loans. In most cases the “voluntary” schemes put in place by each individual bank are that the bank no longer requires the borrower to make monthly payments for three to six months, but these payments are not “forgiven” rather they are capitalised as additional principal on the loan which needs to be paid with interest when payments resume.
There are a lot of unknowns as varying degrees of “lockdown” measures will have different potential impacts on the Australian economy (such as falls in Australian GDP, unemployment rates, the number of business failures etc). The outcomes are far too complex to accurately forecast; hence a more fruitful exercise is to consider how a range of increasingly adverse scenarios will likely affect the banks and the banking system in Australia.
In the short term, it is unlikely any ADI in Australia will fail, although we see the smaller unrated ADI’s as the most vulnerable. Outside the “neo-banks” an ADI will fail in the short term for liquidity reasons if it does not have sufficient high-quality assets to post as collateral with the RBA to access the RBA’s lending facilities. It is also possible there could be a “run” on some ADI’s where investors withdraw funds because they believe the ADI is most likely to fail, but this is less likely as retail investors have no need to fear a failure as all chequing and deposit accounts are protected by the Australian government’s guarantee up to $250,000. It is logical though to assume that however small the risk of failure is, it is greater for a smaller unrated ADI than it is for a Major Bank, with regional and mid-size ADI’s occupying a risk position between the two.
In the medium to longer term, the issue for Australian ADI’s will be one of solvency if business and home loans begin to sour. Clearly business loans are at risk through failing businesses, but for the SME market these loans are also often secured by the residential property of the business owners so most of the risks come back to residential property.
It would seem probable that unemployment is going to rise in both the rate and absolute numbers and that this will inevitably result in some residential mortgage holders being unable to meet repayments. Those still employed may be concerned for their jobs and therefore less willing to take out a large mortgage to purchase a house. Banks will be far more conservative in their lending and so there will be a tightening of credit. Low wage growth and perhaps even deflation in the medium term could occur as businesses will be desperate to sell and lower costs to make profits. Consumers will be financially constrained and looking for discounts and many people will be looking for any work they can find.
It is highly likely all these factors combined will lead to a fall in residential property prices through more sellers than buyers. Inevitably there will be foreclosures and likely loan losses for the lending ADI’s which may cause ADI failures if losses are large. Within the mutual sector the normal method of resolving a failing mutual is to have that ADI merge with a stronger mutual (which is in effect a takeover by the stronger mutual). This will become increasingly difficult if there are fewer stronger mutuals with excess capital to absorb weaker mutuals. Many of the “neobanks” may fail and this will set precedents for how small ADI failures are resolved in the crisis. There will likely be acquisitions of weaker listed banks by stronger ones (in the same manner CBA acquired Bankwest in the GFC).
In early April, Fitch Ratings Agency downgraded Australia’s Major Banks from AA- to A+ (negative outlook) due to a deterioration in the economic environment driven by the effects of measures taken to combat COVID-19. While S&P revised the outlook on its credit ratings for the Major Banks and Macquarie Bank from stable to negative. S&P’s revision followed a similar outlook revision on the Commonwealth of Australia from stable to negative reflecting the expected weakening the Sovereign’s fiscal profile due to the government’s large stimulus packages to support the economy. If the Australian government’s rating were to fall from “AAA” then this would cause a fall in the ratings of the Major Banks (and Macquarie) because the ratings of these banks are uplifted from their stand-alone ratings due the government’s perceived willingness and ability to support them in a crisis under S&P’s rating methodology. The ratings agencies will now progress with its assessment of other Australian banks. However these moderate movements in credit rating do not portend defaults of any ADI’s at this stage.
Despite recent credit ratings actions on Australian’s largest ADIs, the Major Banks remain the safest banks in a crisis as they have the best access to capital, are the most profitable (and can stop paying dividends to shareholders to boost capital as has been suggested as a prudent course of action by APRA recently), and also have the most sophisticated hybrid capital of preference shares and subordinated debt which can be written down to protect senior debt holders and depositors. A collapse of a Major Bank would cause the most damage to the financial system so the Australian government will be the most willing to support a major bank probably even allowing them to merge with each other in an extreme situation.
In conclusion, the threats to Australian ADI’s seem relatively minor in the short term as reflected in the recent ratings agencies actions, but there are clear signs of potential problems over the medium term depending on the levels of unemployment and negative GDP growth, reached as a result of the measures put in place to contain the COVID-19 virus and how these affect house prices. A prudent investment strategy would not be to make longer term investments in lesser or unrated ADI’s.