In response to the COVID-19 pandemic, Congress has passed a $2 trillion fiscal stimulus package--the largest in U.S. history--and the Federal Reserve and other U.S. regulators are taking extraordinary measures. These will help alleviate some liquidity, funding, earnings, and asset quality risks for U.S. financial institutions. We believe the regulatory initiatives and the stimulus should also reduce the likelihood, frequency, and magnitude of financial institution downgrades resulting from the impact of the coronavirus pandemic than may have otherwise been the case.

However, we believe the ultimate effectiveness of these efforts hinges on a number of variables, including:

• How efficiently and extensively individuals and businesses take advantage of them,
• How the Fed structures likely additional lending programs,
• The duration of the pandemic, and
• The strength of the ultimate economic rebound.

Even in an optimistic scenario, asset quality will worsen from the highly benign levels prevailing before the crisis, banks' and nonbank financial institutions' (NBFI) liquidity could be tested in some instances, and earnings will fall materially.

We already have lowered 14 ratings on NBFIs and changed the outlooks on 17 others, many of which have speculative-grade ratings ('BB+' and lower) and focus on riskier asset classes or have far weaker liquidity or funding than banks typically have. We have revised our rating outlooks on 14 banks--either to negative from stable because of energy exposures, or to stable from positive because our expectations for improvements relating to acquisitions or other factors declined (see Related Research). More negative actions could follow on NBFIs and banks. The number and severity will likely rise if the economy performs worse than our economists expect in their baseline forecast.

In that forecast, they project a sharp downturn in U.S. real GDP in the first half of the year, a rebound in the second, and a contraction of 1.3% for the full year. But this forecast is subject to a high degree of uncertainty. In a downside scenario, and one more likely to trigger downgrades of financial institutions, they see a much sharper contraction in GDP for the year and a very steep rise in unemployment.

Reviewing Regulatory Actions And The CARES Act

Here we review aspects of both the extraordinary actions the Federal Reserve and other regulators have taken and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) that are, in our view, most important for U.S. financial institutions. We have broken them into three categories to assess their impact on banks and NBFIs:

• Actions to support market and bank liquidity;
• Actions to support households and businesses through monetary support, lending programs, or loan modifications; and
• Actions to provide regulatory or accounting relief to financial institutions to encourage them to continue providing credit to households and businesses.

We believe the programs to support market liquidity, coming from the Fed, are substantially aiding bank liquidity and alleviating some of the pressure from corporate borrowers increasingly drawing on revolving credit facilities (see "Most U.S. Banks, Helped By Fed Actions, Are Well Positioned To Meet Corporate Borrowers' Demand For Cash," March 24, 2020). The Fed programs have supported largely investment-grade borrowers with little assistance to speculative-grade companies, including NBFIs, beyond an asset-backed security (ABS) program. The CARES Act's authorization of the Federal Deposit Insurance Corp. (FDIC) to guarantee non-interest-bearing transaction accounts and new bank debt issues, if and when it is utilized, would also support bank liquidity.

However, notwithstanding the benefits to market liquidity and asset quality, the move to ultra-low interest rates will substantially pressure the net interest income of banks and some NBFIs and securities firms, all else equal (see "The Fed's Crisis Actions Will Further Bolster Liquidity For U.S. Banks, But Earnings And Asset Quality Are Set To Worsen Substantially," March 18, 2020).

We expect the fiscal actions to support households and businesses, mostly stemming from the CARES Act, will reduce the likelihood of many borrowers defaulting on their borrowings at least in the next few months, as well as give financial institutions the opportunity to originate more loans and perhaps earn more revenue. Still, even with the CARES Act, we continue to expect borrowers to seek significant amounts of forbearance and modifications on loans. We also think nonperforming loans and net charge-offs will rise as cash flows and incomes dry up in response to the sharp slowdown in economic activity.

Financial institutions that focus on the areas that have come under the most stress will probably be hardest hit. Furthermore, while the CARES Act explicitly provides support to individuals, small businesses, and a few larger industries, the legislation essentially leaves it up to the Fed to design lending programs to support other types of businesses. It is unclear how the Fed will do so and whether those programs could provide assistance to NBFIs, some of which have been seeking help. Our base-case expectation is that help from the Fed will be limited for NBFI sectors.

By providing regulatory and accounting relief in response to the pandemic, legislators and regulators have reduced the amount of provisions for loan losses financial institutions otherwise would have likely taken. In effect, this could stem the decline in earnings that's almost certain to occur this year.

Still, these are mostly temporary measures, and their effectiveness later into 2020 and 2021 will hinge on whether the CARES Act and other measures taken help the economy rebound in line with our current base economic forecast. It's also possible that other fiscal measures could be forthcoming, if the duration of the lockdown is longer than expected or the return to business as usual is slower than expected.

Actions to support market and bank liquidity

In response to market dislocations, the Fed took a flurry of actions, including introducing facilities to help unlock certain asset markets and to try to keep others operating smoothly. We believe these programs have not only helped provide some stability to funding markets, but have also added significant liquidity to the banking system.

For instance, we believe the Fed's plan to purchase at least $700 billion of securities is likely contributing to a significant rise in deposits in the banking system and helping banks to meet draws on their revolving credit facilities. (In fact, the Fed's holdings of securities have already risen by more than the $700 billion--they climbed by more than $900 billion between March 2 and April 1). When the Fed buys securities, it is, in effect, printing money that ends up as deposits and cash on bank balance sheets. Banks can use this extra liquidity to meet liquidity needs, including draws on their revolvers.

Banks' ability to meet the demand for draws on revolving credit facilities from large corporates received an important boost from two key Fed facilities:

• The Primary Market Corporate Credit Facility (PMCCF), which helps investment-grade corporations tap into the capital markets; and
• The Commercial Paper Funding Facility (CPFF), which helps investment-grade corporations access short-term borrowing for working capital purposes.

While these two facilities should help reduce the need for borrowers to draw on bank facilities, they are not a cure-all. Companies still are tapping bank revolvers at a rapid rate, faster than what was observed during the 2008-2009 financial crisis. Since the beginning of March, borrowers have drawn more than $200 billion (defensive or otherwise), equating to at least 8% of the undrawn commitments banks reported on facilities extended to commercial and industrial and financial institution borrowers at the end of 2019.

JPMorgan Chase, the country's largest bank, recently said that borrowers had drawn more than $50 billion on facilities it has extended, which "dramatically exceeds what happened in the global financial crisis," and that it had made $25 billion of new credit extensions in response to borrower requests. Its undrawn revolving commitments in its wholesale business were about $295 billion as March 31, 2020.

In addition, speculative-grade companies, including many NBFIs, some of which are under stress, are not eligible to use the PMCCF or CPFF.

Banks also have some other options to accommodate the demand for draws from a liquidity perspective. For instance:

• Extension of the duration of a bank's ability to borrow from the discount window to 90 days (from overnight previously); and
• The Primary Dealer Credit Facility (PDCF), which offers overnight and term funding to primary broker-dealers that, in turn, can increase inventory and improve market liquidity.

Also, importantly, the CARES Act authorizes the FDIC to fully guarantee non-interest-bearing transaction accounts (rather than just the portion up to $250,000) and new issues of bank debt until the end of the year. If the FDIC chooses to use that authority, as it did during the 2008-2009 financial crisis, it could lower banks' liquidity risk substantially. In our view, such deposits make up a material portion of the liquidity risk that banks face. The FDIC guaranteeing those deposits could cause dramatic rises in the liquidity coverage ratios of banks under enhanced supervision--at least until the end of the year.

For NBFIs, the Fed programs probably are not as directly beneficial as they are for banks. Positively, the Fed programs help stabilize markets in general, and the Term Asset-Backed Securities Loan Facility supports the ABS market that many NBFIs rely on. Still, most of the Fed programs to date are targeted toward investment-grade borrowers. Whether programs the Fed designs in response to the CARES Act provide more direct funding support to NBFIs remains unclear.

Table 1

Actions to support households and businesses

By providing relief to households and businesses, the CARES Act should bolster FI borrowers, and therefore mitigate credit distress that balance sheets otherwise likely would experience. The support the government provides, for example via cash, lending, or loan modification programs, could enhance borrowers' ability to continue to pay their debt. Also, financial institutions may earn more revenue related to the lending programs stemming from the CARES Act, offsetting some portion of the earnings decline they are likely to see this year.

Under the CARES Act, the government will make payments to individuals and households with income up to certain limits. It will also add $600 per person to the unemployment insurance amounts paid by states, expand unemployment eligibility, and extend the period by 13 weeks. Given that most states pay less than $600 in weekly unemployment insurance, this addition should be material.

Some lower-wage workers may receive more than they did when they were employed. Benefits will also be available to those who may have been ineligible in the past, such as the self-employed, independent contractors, and those with limited work histories.

The CARES Act also allocates up to $46 billion for passenger and cargo air carriers and businesses important to national security, as well as $454 billion for other loans, loan guarantees, or investments in Fed lending programs (likely to be targeted at midsize commercial borrowers, states, and municipalities) and $349 billion for small business loans. If small businesses retain employees, a significant portion of those loans is forgivable. That should support industries and municipalities in need of help, including those most clearly affected by the pandemic (such as airlines and hotels), as well as those more indirectly affected.

But the CARES Act cannot compensate for all lost incomes, and it cannot dictate the duration of the economic slowdown or the pace of the recovery. The amount of the stimulus is unlikely to fully offset the damage that the economic lockdown inflicts on the U.S. economy. Lenders that have focused on higher-risk asset classes, which would include many NBFIs, could be particularly hard hit.

Also, while the CARES Act allocates funds that the Treasury may invest in Fed lending programs (which the Fed presumably will leverage, as it has done with some of its already announced programs), it remains to be seen how exactly those programs will work and who will be eligible for them. To date, existing Fed programs have mostly supported households or investment-grade businesses. While Fed programs must be broad-based, whether usage will extend to leveraged borrowers or those in industries deemed riskier is unclear.

Table 2

Mortgage servicers are one type of company likely hoping for funding assistance. While the CARES Act allows for forbearance on federally guaranteed mortgages, servicers will have to continue advancing payments to the trusts of mortgage-backed securities (which they will recoup later). Requests for forbearance on federally backed mortgages, which can last for up to 360 days, reportedly are surging. Servicers could offset that funding pressure if there was a lending program available to them, which remains unclear.

While Ginnie Mae has said that it plans to offer funding assistance to servicers, Federal Housing Finance Agency Director Mark Calabria said that he does not plan to authorize Fannie Mae or Freddie Mac to provide any liquidity support. We expect nonbank servicers to seek funding through secured bank lines and/or the servicer advance securitization market.

Finally, while the bill offers a bulwark against the economic challenges in the weeks and months ahead, it also raises some operational hurdles, including how quickly and effectively loans can be disbursed. FDIC data indicates that banks had less than $650 billion of small business commercial and industrial and commercial real estate loans in 2019. The Small Business Administration also reported unpaid principal balances of $95 billion on 7(a) loans, the type that is expanded in the CARES Act.

Those statistics imply that adding $349 billion could be a tall operational order. (In addition, it appears the Trump Administration is seeking to add $250 billion more in funds to this program). There have been early reports that some small business owners, particularly those that do not have affiliations with major banks, have had some struggles submitting applications and receiving funds. Banks may prioritize existing customers, partially because extending them credit will help those businesses to continue paying their bank loans.

While we expect demand for small businesses loans to accelerate meaningfully, banks will have their work cut out for them to quickly respond. Small business loans make up a minor proportion of the loan portfolio of the largest banks, meaning they would have to devote many more resources to significantly ramp up in this area. Community banks, which tend to have more small business loans proportionally, may also need to devote more resources to this effort. A reduction in one of their required capital ratios (see the regulatory relief section) and CECL relief may allow community banks to take more of these loans on their balance sheets.

Although these loans carry a 0% risk weight, they probably will not generate a material amount of revenues or returns for banks. The loans will have an interest rate of just 1%, are deferrable for six months, and can be partially or fully forgivable (including accrued interest), making them almost like grants. After considering funding costs, banks probably will generate little net interest income on these loans.

Banks will earn processing fees for originating them, which presumably will at least cover the expense associated with devoting more resources to this effort. Assuming an average processing fee of 3% (they range from 1% to 5%), banks would earn about $10 billion in these processing fees before expenses. That compares to the $290 billion in pretax income FDIC-insured banks reported in 2019.

Table 3

Actions to provide regulatory or accounting relief

The CARES Act combined with statements from regulators should mitigate the impact of the coronavirus pandemic on provisioning for loan losses and earnings, at least temporarily, and offer banks some leeway on meeting regulatory requirements. These actions are aimed at encouraging financial institutions to continue providing credit to households and businesses.

In particular, they allow banks to delay the new accounting standard for setting loan losses reserves--Current Expected Credit Losses (CECL)--after it went into effect on Jan. 1 for all except private banks and certain small banks. The CARES Act allows banks subject to CECL as of Jan. 1 to delay it until either the end of the year or when the national emergency declared by the president terminates, whichever is earlier.

Regulators are allowing banks to delay for two years an estimate of CECL's effect on regulatory capital, relative to the prior accounting standard for setting loan loss reserves, and then to phase in CECL's impact on capital for three years after that. In other words, even if banks do not use the option in the CARES Act to delay CECL, they could still exercise an option whereby CECL would not affect regulatory capital at all for two years and then on a gradual basis for the following three years.

Similarly, regulators have indicated they will give banks more leeway on their classification of loans as troubled debt restructurings (TDRs) and have encouraged them to work with borrowers on modifications when needed. Specifically, banks can suspend normal accounting rules pertaining to TDRs, giving them room to modify loans that were directly affected by the public health emergency without categorizing them as such.

We believe the result will be fewer impaired loans and lower provisions and higher earnings than would be the case without these changes. For instance, we recently estimated that an adverse stress scenario, including net charge-offs (NCOs) to average loans of 1.25%, would cause the return on equity for banks we rate--which was about 11% in 2019--to fall by greater than 600 basis points (bps) at the median. (See "Stress Scenarios Show How U.S. Bank Ratings Could Change Amid Pandemic-Induced Financial Uncertainty," March 24, 2020.)

NCOs were an important driver of that decline since we assumed banks would increase provisions by roughly an equivalent amount to NCOs. If the leeway offered by the CARES Act for CECL and TDRs resulted in net charge-offs rising only to 0.75%, rather than 1.25% (and versus the median 0.3% for our rated universe in 2019), the drop in returns on equity would be around 400 bps, rather than 600 bps, at the median.

Despite these accounting changes, our analysis will focus on whether companies are prudently adding to loan loss reserves, given the risks in their loan portfolios, and the companies' expectations about problem loans. We will also seek to analyze the extent to which companies have made loan modifications, such as payment deferrals. Similar to our analysis of delinquencies and TDRs, we will assess the characteristics and duration of the modifications as possible signals about future loan losses.

Finally, bank regulators recently adjusted the calculation of the supplementary leverage ratio (SLR) capital requirement, removing Treasuries and deposits at the central banks from the calculation. We believe this should cause SLRs to rise materially, effectively freeing up around $60 billion for additional balance sheet expansion. However, given the size of deposit inflows, balance sheet growth could cause the Tier 1 leverage ratios (the calculation of which has not been altered) of some of the subsidiaries of large banks to fall closer to the 5% that they must maintain for well-capitalized status.

Table 4

Many Variables Will Determine Financial Institutions' Performance In The Coming Months

For U.S. financial institutions, the CARES Act and regulatory actions should help shield the sector from some of the fallout of the COVID-19 pandemic. Nevertheless, we expect financial institutions will experience an increase in nonperforming assets, net charge-offs, and corporate draws on bank revolving credit facilities this year, as well as other challenges. How long the pandemic lasts, how hard it hits the economy, and how efficiently and effectively the various measures of the CARES Act and the Fed programs are implemented will greatly influence the extent of downgrades.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

• Rate Cuts And Stock Market Decline Related To COVID-19 Led To Rating Actions On Certain U.S. Securities Firms, March 30, 2020
• Six U.S. Regional Banks Outlooks Revised To Negative On Higher Risks To Energy Industry, March 27, 2020
• Rating Actions On Commercial Real Estate Finance Companies Reflect Funding And Liquidity Risks Because Of COVID-19, March 26, 2020
• IBERIABANK Outlook Revised To Negative, First Horizon National Corp. Ratings Removed From CreditWatch Positive, March 24, 2020
• Outlooks On Six Banks Revised To Stable From Positive On Emerging Economic Downturn; Ratings Affirmed, March 23, 2020