While recent data like industrial production, consumer confidence and house prices offer hope that the UK economy may be through the worst of the crisis, the first half results from the big banks suggest that the second half of this year is still fraught with difficulty for businesses.

So far Barclays (BARC), Lloyds (LLOY) and NatWest (NWG), formerly Royal Bank of Scotland, have put aside a total of more than £10 billion of provisions for expected credit losses, and they expect to take up to half as much again in additional provisions by the end of 2020.

Government support

The importance of the Government’s decision to support firms through the furlough scheme, breaks on business rates and value-added tax and the Covid financing facility can’t be over-stated.

Extraordinary times call for extraordinary measures, and without this support it’s likely that a large number of small firms would have gone to the wall within weeks of the pandemic striking as economic activity went off a cliff.

Indeed, the number of firms filing for insolvency and being wound up through the courts is significantly down on last year, but there are fears that the true picture is being masked by state aid and the fact that the court system has barely functioned since lockdown.

Business advisory firm Begbies Traynor (BEG:AIM)  is predicting that ‘a dam of company financial distress’ is waiting to break this autumn as support is withdrawn, pushing what it calls ‘zombie’ companies which were just about clinging onto survival over the edge.

Potential losses

When trying to understand why the banks’ provisions for credit losses are so large, it’s important to look at how they reach these numbers.

Under the IFRS 9 reporting standard, which we looked at earlier this year, banks no longer make provisions for bad loans once a loss has been incurred.

Previously, when a payment was 30 days overdue the loan was classified as ‘doubtful’ and a small amount of cash was put aside to cover potential losses. When it was 90 days or more overdue,
it was classed as ‘bad’ and a larger amount was put aside.

The new accounting rule means that banks have to make provisions ahead of time based on the potential for those loans to go bad according to a range of economic forecasts.

In the case of NatWest, where credit loss provisions more than trebled from £800 million in the first quarter to £2.86 billion by the end of June, the increase reflected ‘the deterioration of the economic outlook’ and a central assumption that the percentage of its personal and corporate loans that would default would be 1.72% instead of 1.18%, or 45% more than it had previously forecast.

For personal loans the main loss drivers in all the banks’ calculations are expectations for the unemployment rate, house prices and the Bank of England base rate. For corporate loans, losses are forecast based on credit cycle indices which factor in specific economic drivers for each region and industry, on the assumption that losses on corporate loans tend to follow regular cycles.

Uncertain Times

The problem is that almost every individual and business has been negatively affected by the economic and social disruption caused by Covid, and given the severity of the economic shock and the lack of visibility over the outlook, forecasting losses accurately is almost impossible.

It may be that the level of provisioning in the first half is too much, but equally it may be too little as this is far from a ‘regular’ credit cycle. If forecasts for the economy – and in particular the unemployment rate – deteriorate this quarter, the banks will have to assume a higher default rate and put aside more provisions.

For the challenger banks, which tend to stick to deposit-taking rather than lending to individuals or businesses, the major concern for now isn’t credit losses but getting funding.

In the past, private and public markets were happy to support the new banks as they built ‘reach before revenue’ – the classic Amazon.com model – but the crisis has raised questions over valuations and even the durability of some new entrants.

Monzo is one of the more successful new entrants to the UK market, having increased customer numbers from 1.6 million to 3.9 million in the year to February, but its losses more than doubled to £114 million over the same period.

In its annual report, Monzo cautioned that since March its revenue streams had been ‘severely impacted by the pandemic and resulting economic uncertainty.’ It also warned that tighter regulation could mean fewer customers and a need for more capital.

The bank concluded that there was a ‘risk the group will not be able to execute its business plan’, including generating a profit and raising enough capital, and even went as far as to say there were ‘material uncertainties that cast significant doubt upon the group’s ability to continue as a going concern.’

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