There is now little doubt that the coronavirus will spread globally and will cause more supply and demand shocks in the market. While economic activity will slow, the amount and duration of the slowdown are big unknowns. Community banks may not have exposure to Chinese markets and may not have significant exposure to the energy sector. Community banks may even operate in areas where the virus is absent; nonetheless, the economic costs and dampened consumer and business activity will have some effect on all community banks throughout the country. Community banks face some challenges but must also identify opportunities at these uncertain times.
Risks Have Risen
One of the most sensitive gauges of credit stress in the commercial market is the credit-default swap index of investment-grade companies (CDX IG). This index measures market participants’ required compensation to protect from the default on 125 investment-grade companies in 6 sub-indices (consumer, energy, financials, high volatility, industrial, and technology & telecom). In the last few days, the CDX IG quickly spiked higher (see graph below). This graph indicates that credit risks have risen, and the market expects shocks to materially affect US corporations’ ability to repay debt.
Community Bank - Opportunities and Threats
- Sectors – Many economists are lowering baseline growth for the US to below 2% for 2020, and conditions are ripe for self-sustaining recessionary dynamics (negative sentiment begets negative economic results). The basecase may be for a technical recession in 2020, but not all sectors will experience the same pullback. Community banks should be mainly focused on exposure to the following industries: energy, airlines, travel, tourism, and hotels. Currently, credit default rates have crept higher, driven almost entirely by energy companies. However, as the economic scenario unfolds, companies that rely on travelers and companies that rely on face-to-face human interaction may experience significant disruption to revenue. Community bank credit portfolios have substantial exposure to some of these industries. Other industries will do well, such as online media, online retail, vaccine developers, and certain healthcare systems.
- Credit Risk vs. Liquidity Risk – While the global spread of the virus results in continued supply and demand shocks, it is the length of business activity disruption that will gravely affect community banks. The longer the outbreak affects economic activity, the more likely the chance of a recession. In the short-term, access to liquidity will have a more significant impact on community bank borrowers than credit risk. In a rapidly contracting business environment, the ability to pay suppliers, employees, and rent is of primary importance. While monetary and fiscal policies may limit damage to the economy in the long-term, in the short-term, businesses will need to survive based on their ability to access cash. Community banks will do well to monitor their borrower’s cash and working capital positions, and their borrower’s access to standby credit facilities.
- Credit Spreads – With higher risk and volatility, we have already seen credit spreads widen for larger borrowers. In the community bank credit market, we are seeing lenders become more opportunistic in widening spreads for specific borrowers. We have seen some community banks reprice individual commercial loans with 25 to 100 bps wider spreads. This strategy is especially profitable if lenders can obtain some prepayment provisions to protect the earning asset from refinancing at a future date when markets rebound.
- Lower for Longer – The shock to demand and supply has translated to a financial shock. The yield curve is flat and very low. Community banks must adjust to this reality for the near term future. Borrowers will demand longer-term fixed-rate financing, and community banks’ NIM will be pressured at least for the next year. Banks that cannot offer competitive and profitable products in a low and flat yield curve will be at a disadvantage. The value of DDA will be lower, deposit repricing will become more inelastic, and loan duration will extend.
- Profitability Is Challenged – To remain profitable, community banks must develop lines of business outside of credit products, and they must be able to generate fee revenue within their credit lines of business. Many community banks have incorporated hedging programs to drive fee business within their commercial loan portfolios. Other community banks are developing ancillary lines of business to cross-market to their existing customer base (such as wealth management, non-traditional lending, insurance, and advisory work). Community banks must become more efficient in offering their products and services, and bankers must quantify which customers and products are profitable, and shed unprofitable businesses.
This virus contagion will eventually wane, and demand will recover. The amount of time it takes to arrest the spread of the virus is crucial in limiting the impact of the economic slowdown on the banking industry. We assume that warmer weather in the spring and summer will bring a pick in economic activity in the second half of the year. Community banks will feel the economic fallout of the coronavirus, but the majority of the banking industry will be resilient to this adverse shock.
Submitted by Chris Nichols on March 09, 2020