The new world: a different kind of response to distress

COMMENT The global coronavirus pandemic has severely impacted the world economy, with many businesses facing significantly reduced revenues, higher levels of indebtedness and a long runway to recovery, while becoming addicted to government financial support measures. As a consequence, business failures are inevitable, particularly in those sectors most affected where recovery may take a long time or, in some cases, their economic environment has materially changed to such an extent that an insolvency event is a real possibility. As with previous economic downturns, real estate is not immune to the crisis. Among the hardest-hit sectors are retail and hospitality, and despite the UK’s vaccine roll-out programme providing cause for optimism at long last, the structural changes in these sectors will undoubtedly result in corporate insolvencies. For lenders, the challenge will be to identify those businesses that have a viable long-term future and prioritise their resources accordingly. Economic crisis Unlike the lead-up to the global financial crisis, banks this time around are significantly better capitalised and therefore better placed to absorb losses. Some UK banks, such as NatWest, have amassed in excess of four times the amount of capital in the lead-up to this crisis in comparison with the GFC (Core Tier 1 ratio was 16.2% in December 2019, compared with 4% in December 2007). Universally, banks have also reduced the size of their balance sheets, by more than 70% in some cases – NatWest actively reduced its risk-weighted assets to £170bn in 2020, from £578bn in 2008 – particularly in areas such as real estate. Whether such prudence has arisen through choice or regulation is irrelevant; the key point is that the systemic risks that plagued the banking sector in 2008/09 are nowhere to be seen in 2020/21. That said, the problems for banks are still significant. For a start, the European Central Bank recently predicted that non-performing exposures could, in a worse-case scenario, peak at €1.4tn (£1.2tn) – a level that would exceed even the height of the GFC. Furthermore, IFRS9 has permanently changed the way in which banks recognise and account for losses. Depending on classification linked to whether the credit risk of a loan has increased since origination, loss allowances are now calculated on either a 12-month or lifetime expected credit loss basis. This is significant because it has the potential to trigger the earlier recognition of losses that could in turn impact the appetite of banks for forbearance or other similar strategies. Forbearance Prior to the global pandemic, the big four UK clearing banks had around £50bn of exposure to commercial real estate. While significantly lower than before the GFC, much of this exposure is in problem sectors such as retail and hospitality where insolvencies, such as that of listed shopping centre owner intu, have already begun. That said, official statistics confirm that there were 13,880 company insolvencies in England and Wales last year, down by nearly 20% on 2019. A reduction in the number of corporate insolvencies during an economic crisis, even one caused by a global pandemic, supports the notion that banks are extending forbearance to their clients. Underpinned by stronger balance sheets and nearly £73bn of government guaranteed loans, it seems that banks are indeed supporting their clients through these unprecedented times. What’s next? In the lead-up to the Covid-19 crisis, significant capital-raising was completed by private equity firms, and collectively they now sit on dry powder estimated to exceed $90.5bn (£65.6bn) across Europe. Approximately £31.2bn of this total is earmarked for the type of opportunistic and distressed opportunities that the crisis is expected to crystallise. With much deeper asset management and servicing capability available in comparison with the GFC, buyers of distressed assets or credit are well placed, so lack of liquidity or market capacity shouldn’t be a constraint on opportunities this time around. Non-performing loan transaction volumes in 2020 of approximately €50bn are expected to increase by 20% in 2021 before nearly doubling in 2022, the latter year likely to witness the start of post-pandemic originated loan defaults and the disposal thereof by lenders. Post-GFC, while it took until 2014 for NPL volumes and ratios to peak, a combination of factors – including relative financial health, the impact of IFRS9 and key stakeholder pressure – are likely to result in banks disposing of their bad loans much more quickly. Ian Guthrie is senior managing director for loan advisory and restructuring services at JLL Photo © JLL