S&P Global Ratings' credit loss estimates for U.K. banks reflect the radically more negative environment as a result of the COVID-19 pandemic. Measures to limit the spread of the virus have resulted in large parts of economic activity grinding to a halt, and returning to a more normal environment will take time. That is why we expect a sharp economic contraction in 2020, with a 6.5% forecasted GDP decline in the U.K. The consequences--including higher unemployment and corporate failures--will feed through into bank asset quality and higher credit losses. We project a rebound in 2021, with GDP growth of 6.0%, but risks remain skewed to the downside, and the effects of COVID-19 will be evident for long after the crisis subsides. A deterioration in asset quality could pressure bank ratings if the temporary slowdown turns into a protracted recession (see “Outlooks Revised On Six U.K. Banks On Deepening COVID-19 Downside Risks,” published April 23, 2020).

We acknowledge 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.

Credit Losses Will Rise Very Sharply This Year

Recent first-quarter results from the major U.K. banks confirmed a sharp uptick in reported credit losses, ranging between 93 bps and 233 bps of customer loans on an annualized basis (see chart 1, this data includes international as well as domestic lending). As chart 1 also shows, much weaker macroeconomic outlook forecasts applied by bank management in estimating expected credit losses largely drove the rise in losses.

Chart 1

For the full-year 2020, we estimate that domestic credit losses will rise to around £18.5 billion, or 100 bps of domestic lending. While that is our current base-case estimate, we believe that losses may be higher still. We note that loans subject to COVID-19-related forbearance activity (such as payment holidays) generally remain classified as IFRS 9 "stage 1" (performing) loans and are thus subject to a 12-month expected credit loss (ECL) allowance, rather than a lifetime ECL required for stage 2 or stage 3 loans.

This forbearance aims to enable borrowers to overcome short-term liquidity constraints arising from the effects of dealing with COVID-19, and thus mitigate the risk of repayment defaults. As such, it is not necessarily an automatic indication of a decline in asset quality. Still, some borrowers that are subject to forbearance may never recover.

By way of comparison with our 100 bps credit losses estimate for 2020, this metric was just 24bps in 2019 and averaged 18bps in the five years from 2015-2019. In other words, we estimate that credit losses in 2020 will be higher than total credit losses over the past five years.

These levels are over 20% of our estimates for operating revenues, which in our view makes them a challenging level for internal capital generation. In 2019, impairment losses were around 6% of operating revenues for the six largest U.K. banking groups. Low loan losses in recent years have been a silver lining for U.K. banks, as they partially offset the negative effect on revenues from low interest rates.

We anticipate that consumer credit will contribute to most of the increase in credit losses, followed by corporate loans in the most affected sectors (see table 1). Government policies, aimed at supporting businesses, employees, and the self-employed (see appendix), should cushion the economy and banking sector, but it is too early to assess the effectiveness and take-up of these measures.

Table 1

Specifically, for credit losses in 2020, we assume:

• A mortgage loss rate of around 20 bps, taking into account banks' exposure to buy-to-let. Relatively conservative loan-to-value profiles, and government measures to support households, will help to mitigate mortgage losses.
• A consumer credit loss rate of around 620 bps, considering that borrowers are more likely to default on unsecured debt and there is no collateral to mitigate losses on default. We also note that impairment rates have historically been correlated with unemployment levels. In the 2019 Bank of England stress test, consumer credit represented 41% of losses on banks' U.K. lending, despite being only 7% of exposures. We acknowledge the likelihood of a sharply higher household savings rate as a result of dramatically lower spending during the lockdown period. Still, the U.K. household sector remains highly leveraged compared to some peer countries, which makes it more vulnerable to an economic downturn. We expect that U.K. financial institutions' lower risk appetite in the past three years, and government measures to support income, will offset the impact on credit losses to some extent.
• A corporate credit loss rate of around 160 bps, reflecting our view that corporates in some industries have likely not undergone a temporary weakening. The impact of the pandemic on individual banks will largely be determined by the bank's credit exposure to more highly affected sectors.

For 2021 and 2022, we expect loss rates on mortgages and unsecured consumer credit to improve substantially, but less so for corporates (see chart 2). While we acknowledge the government support measures aimed at supporting viable companies, we expect higher insolvencies in sectors heavily hit by the coronavirus outbreak.

Chart 2

We project a marginal increase in the total loan book in 2020, before rising by 2% in 2021 as the economy recovers. In our projections, we expect muted growth for mortgages and consumer credit for 2020, but expect the corporate loan book to rise by approximately 3% as corporates draw down on their revolving credit facilities, and benefit from government-backed support. Indeed that support may result in higher corporate loan growth than we currently estimate.

Tough Domestic Conditions In 2020 With Recovery Into 2021

Our economic forecasts indicate that the COVID-19 outbreak will affect U.K. domestic economic conditions in 2020 and rebound in 2021 (see table 2).

Table 2

Even before factoring in the impact of the pandemic, we anticipated muted growth over our forecast horizon. An unwieldly U.K. exit from the post-Brexit transition period at the end of this year would further hurt the U.K. economy. The U.K. government has so far not committed to seeking an extension beyond 2020.

Domestic conditions have been supportive in recent years

2019 was another benign year for U.K. domestic loan losses. Actual domestic loan losses amounted to 24 bps of domestic loans, comprised of:

• A mortgage loss rate -0.01 bps, compared with our forecast of 0.01 bps;
• A consumer credit loss rate of 232 bps, compared with our forecast of 220 bps; and
• A corporate loss rate of 27 bps, compared with our previous forecast of 34 bps.

The specific drivers of these low credit losses in 2019 reflect a different, pre COVID-19 world. Indeed the drivers remained largely unchanged over recent years and included very low interest rates and the consequent beneficial impact on borrowers' debt-servicing costs. Low rates have also meant a relatively muted level of corporate insolvencies, which, in turn, also contributed to multi-decade lows for unemployment rates.

In mortgage lending in particular, much-improved underwriting standards have been an additional factor for effectively zero mortgage loan losses over the last four years. In consumer credit, the pace of credit growth has slowed markedly in 2019, partly reflecting greater prudence by lenders.

The long-run data available to us covers the six largest U.K. banking groups and their predecessors, including their international lending--we don't have access to industrywide long-run data covering just U.K. domestic loan losses. We estimate that their long-run average for credit impairment charges is about 65 bps (see chart 3). Recent loss rates have been among the lowest on record--for example, chart 3 shows that loss rates in each of the six years from 2014 to 2019 were the lowest in the 30-year period since 1990. We estimate that the long-run average for all domestic lending is about 60 bps, as U.K. banks' international lending has tended to perform worse.

Chart 3

On a systemwide basis, the actual outturns compare favorably with our previous published forecasts of industrywide domestic losses (see chart 4). The differences reflect a degree of caution inherent in credit analysis. We recognize that our figures may appear conservative, but our estimates attempt to capture our long-term experience that past accelerations in credit growth and the search for yield can lead to credit problems down the road. A shift in U.K. economic policy or external shocks can also exacerbate this.

Chart 4

How We Derive And Use Our Credit Loss Estimates

Derivation

Banks' balance sheets usually mirror the developments in the real economy. We therefore expect the worsening outlook for the U.K. economy in 2020 to translate into higher domestic loan impairment charges, above their long-run average. In fact, the peaks shown in long-run U.K. data are a salutary reminder of how quickly losses can spike (see chart 3).

In calculating our loan losses, we note in particular the following:

• Loss estimates are for U.K. domestic lending, not foreign lending. Therefore, these assumptions cover only a portion of the balance sheet of the major U.K. banks.
• The assumptions are for the system as a whole, including U.K.-domiciled banks and building societies, specialist lenders, and foreign banks. We expect individual banks are likely to experience varying levels of loan losses around this level. The actual aggregate loan losses for rated institutions may differ from these assumptions, depending in particular on how much better or worse than average unrated or nonbank lenders fare. For example, we note that recent growth rates in consumer credit have been relatively higher at smaller banks (see chart 5).
• Our calculation is based on 17 financial institutions, representing the majority of domestic lending assets.
• We divide the U.K. domestic loan book into three broad asset classes, based on Bank of England data for lending to U.K. nonfinancial residents by the banking sector.

Chart 5

Use

We use the credit loss estimates set out in this article in two main ways to inform our ratings opinion.

• First, the estimates represent our base case for the loan impairment charge line within our earnings forecast over the period to 2022. For individual bank forecasts, we tailor these estimates higher or lower than the base case to reflect the profile and our expectations for that institution. However, it would typically be rare to have a material deviation from our base case, and we would always take a more conservative view than bank management projects to us. In turn, our earnings forecast is a key input into our projected risk-adjusted capital (RAC) ratio range for the next 18-24 months, which is the primary determinant of our capital and earnings assessment for a bank.
• Second, the estimates are part of our assessment of economic risk for the U.K. banking industry, one of the elements of our Banking Industry Country Risk Assessment (BICRA) for the U.K. Specifically, the credit loss estimates help inform our view of economic imbalances and credit risk in the economy. We currently view these factors as presenting intermediate and high risk, respectively. This contributes to an economic risk assessment of '4' (with '1' being the lowest risk, and '10' being the highest). The trend for BICRA economic risk (ER) is negative. This is a weaker assessment than for the U.K.'s main peers--Canada (with an economic risk assessment of '3' and stable ER trend, France ('3' with a negative ER trend), Germany ('1' with a negative ER trend), Japan ('2' with a stable ER trend) and the U.S. ('3' with a stable ER trend).

The BICRA is the starting point for our assessment of a bank's stand-alone credit profile. The BICRA economic risk assessment score is also a key determinant of risk weightings applied to the RAC ratio.

Chart 6 highlights that our U.K. credit loss estimates compare quite well with key peers, although we acknowledge that data comparability is an imperfect science.

Chart 6

Comparisons With Our Capital Framework

We have compared actual credit losses with the normalized credit losses generated from our RAC framework. Normalized credit losses are a calculation of long-term average annualized credit-related losses for the U.K. We use an estimate of normalized loss rates for each asset class by country using an approach based on the average "through the cycle" annual loss rate we expect to occur for a given asset class. We derive the estimates using a 12-year cycle, including three years of recession. For the U.K., over the last four years to end-2019:

• Actual mortgage loss rates have been at or below zero, which compares to our normalized loss rate of 25 bps (see chart 7).
• Actual consumer credit losses have averaged around 195 bps, which compares to our normalized loss rate of 393 bps for credit cards, 115 bps for other retail lending, and 58 bps for auto loans (see chart 8). We estimate that the stock of U.K. consumer credit, which excludes student loans, is split broadly evenly between credit cards, unsecured personal loans, and auto loans.
• Losses on corporate lending have been around 19 bps, which compares to our normalized loss rate of 54 bps for corporate loans, 115 bps for SME loans, and 163 bps for commercial real estate (CRE) lending (see chart 9).

In aggregate, actual loss rates are below our normalized loss rates, indicating the very benign economic conditions that the U.K. has experienced in recent years. However, as our forecasts show, the impact from the coronavirus outbreak has changed this trend.

Chart 7

Chart 8

Chart 9

Appendix – U.K. Measures In Relation To COVID-19

Fiscal

• Coronavirus Job Retention Scheme: Employers can claim 80% of furloughed employees' wages up to £2,500 for at least three months.
• VAT deferrals for three months.
• Self-employed Income Support Scheme: 80% of the trading profits for three months up to a maximum of £2,500.
• Statutory sick pay relief package for SMEs.
• 12-month business rate holiday for all retail, hospitality, leisure and nursery business in England.
• SME grant funding of £10,000 for all business in receipt of small business rate relief or rural rate relief.
• Grant funding of £25,000 for retail, hospitality, and leisure businesses with property with a rateable value between £15,000 and £51,000.
• Coronavirus Business Interruption Loan scheme makes £330 billion of loans and guarantees available, of up to £5 million for SMEs through the British Business Bank.
• Coronavirus Large Business Interruption Loan scheme enables banks to offer loans with an 80% government guarantee to firms with an annual turnover of greater than £45 million and £500 million.
• Small Business Bounce Back Loans scheme allows small companies to rapidly borrow up to £50,000, with a 100% guarantee for the lender and government financing of fees and interest in the first year.
• Help for Start-Ups scheme includes a £500 million loan scheme for high-growth firms and £750 million of targeted support for SMEs focused on research and development.

Monetary--Bank Of England

• Cut base rate by 65bps to 10bps.
• Cut countercyclical buffer to 0% from 1%.
• Re-opened Term Funding Scheme, focusing on SMEs.
• Commercial paper scheme for corporates.
• Final 2019 dividend cancelled and interim dividends for 2020 suspended.

Other

• Mortgage payment holiday for an initial period of three months, including buy-to-let mortgages.
• Ban on evictions for rented accommodation.
• Temporary payment freeze on loans (including car finance arrangements) and credit cards for affected individuals for up to three months.
• For those with existing overdraft facilities on personal current accounts, up to £500 at 0% interest for up to three months.
• 2020 stress test cancelled.

Related Research

• Outlooks Revised On Six U.K. Banks On Deepening COVID-19 Downside Risks, April 23, 2020
• Europe Braces For A Deeper Recession In 2020, April 20, 2020
• European Banks’ First-Quarter Results: Many COVID-19 Questions, Few Conclusive Answers, April 1, 2020
• Coronavirus Impact: Key Takeaways From Our Articles, April 30, 2020