The main stakeholders of the European banking sector, being governments, regulators, central and domestic banks, are currently primarily focused on bridging liquidity needs to limit the collateral damage of lockdown on European corporates. In a complete reversal to the global financial crisis, this time banks are seen as part of the solution, and not the problem. The importance of banks lies in being a key element of the transmission mechanism. Ironically, taxpayers need to be supported by banks that have to grow their balance sheet and become even more systemic, as the leverage throughout financial markets increases.

On the regulatory front, capital rules have been relaxed, making full use of the flexibility embedded within the existing framework. Every element that could be changed in order to free up capital, to make sure regulation does not come in the way of a bank financing the economy has been changed.

The objective all along has been to support banks in continuing to provide credit to households and to viable small businesses and corporations hardest hit by the current economic fallout. A number of measures introduced include dividend bans, waiver on state aid rules, ability to breach capital requirements in various forms, mitigating the IFRS9 impact and modifying the leverage exposure calculation.

On the fiscal front, member states have individually announced guarantee schemes, taking a substantial part of the increased credit risk as a result of the lockdown/social-distancing measures. In essence, the way these guarantee schemes work is that loans are being originated through the banking system with the majority of the risk being assumed by the state.

In most schemes the state assumes around 80 per cent to 90 per cent of the credit risk. Banks only need to provide capital for the part of the loan on which they assume the credit risk. The guaranteed part will be treated as a sovereign or quasi-sovereign exposure requiring a very small amount of capital from the bank. Ironically, once again European banks will have to increase their exposure to sovereign risk as they did during the European sovereign crisis.

The third prong is on the monetary front, where we expect a significant ramp up in effective measures to come into force in June due to the relaxation of collateral rules and improvement of the terms of refinancing operations – Targeted Longer-Term Refinancing Operations (TLTRO).

To maximise banks’ take up in the different refinancing operations, the European Central Bank (ECB) has eased collateral measures in two different decisions on April 7 and 22. The first announcement was regarding collateral easing measures and the second announcement focused on alleviating the effects of potential rating downgrades on collateral availability.

The ECB has added two LTROs – a “bridge” LTRO and a “pandemic” LTRO (PELTRO) as well as revisiting the conditions for the upcoming TLTRO III. A comparison of the three facilities suggests the PELTRO is the most expensive option and implicitly the least favoured. The general expectation is for banks to favour a substantial take-up at the revised TLTRO III, which is now - one per cent compared to - 0.5 per cent for the bridge LTRO and - 0.25 per cent for the PELTRO facilities.

In the layman’s terms, the borrowing costs for banks will be even cheaper, creating more favourable lending conditions at better margins. Collectively, the market across various asset classes has rewarded the measures being taken to limit the damage being done to economies worldwide, with a strong recovery in prices from the March lows.

As economies re-open it remains to be seen how quickly activity can bounce back to pre-crisis levels. Ongoing national and supra-national support remains crucial to navigate the crisis successfully, and stakeholders can be comforted by the fact that concrete actions are being taken.

Disclaimer: This article was issued by Simon Psaila, investment manager at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.