North American financial institutions are facing their greatest challenge since the 2008-2009 crisis. The COVID-19 pandemic and sudden recession has reversed what had been a few years of good fortune for these firms.

Business activity has plummeted because of social distancing measures, millions have lost their jobs, and financial institutions are feeling the strain. Consumers are less creditworthy and less confident. They're spending less and putting off payments more, and bank earnings and revenue streams have dropped. In response to all of this, banks have sharply increased their allowances for loan losses.

And nonbank financial institutions (NBFIs) are faring much the same--S&P Global Ratings expects profitability to fall for NBFIs, particularly revenue from asset-based fees, net interest income, and investment banking activity.

Positively, unlike in the last crisis, North American banks are entering this period from a position of strength, with capital, liquidity, and profitability near the highest levels they have been in decades.

In addition, the governments and central banks in the U.S. and Canada have passed stimulus measures and changed monetary policy, steadying capital markets and offsetting at least a portion of the pain many financial institutions' customers are feeling.

Ultimately, credit and bottom-line losses, as well as many of our ratings on financial institutions, will depend on the length and severity of the downturn--and how effective government programs are at stemming it.

A Change In The U.S. BICRA

Despite government support measures to contain the coronavirus pandemic's impact on the U.S. economy, we expect pressure on banks' asset quality, net interest margins, and earnings that could lead to substantial credit losses and declines in capital, especially if the downturn is longer lasting or the rebound is more tepid than we expect.

S&P Global's economists are predicting that the damage to the U.S. economy will be three times greater than the Great Recession, in one-third the time. They expect economic activity to shrink by 11.8% ($566 billion) in real terms, peak to trough, and well over 30 million people to lose their jobs. And our economists don't expect the recovery to be quick--they're anticipating more of a prolonged "U"-shaped curve than the swift "V"-shaped rebound markets initially expected.

When assigning financial institution ratings, we take into account economic trends of the home country. As a result of these new conditions in the U.S., we revised our expectation for the economic risk trend in the country to negative. The economic risk score is one of two factors that determines our Banking Industry Country Risk Assessment (BICRA), which helps us determine our anchor, or starting point, for our ratings on financial institutions.

Since the start of the pandemic, we have revised the outlooks on the ratings of 30 U.S. banks, either to negative from stable or to stable from positive. Many of those banks have had significant exposures to areas facing elevated pandemic-related stress, such as commercial (including energy), commercial real estate (including multifamily), and consumer lending.

The economic risk score of the U.S. BICRA is currently '3'. A negative trend indicates a one-third chance that we could revise it to '4' if the economy's rebound is weaker than we currently expect, causing a surge in loan losses for banks. A change to '4' would not lead us to change the current 'bbb+' anchor. Still, if we lowered the economic risk score to '4', this would probably mean banks are struggling more than we currently expect, which would likely come with downgrades.

NBFIs Are Facing A Variety Of Pressures On Earnings, Asset Quality, And Funding

Since the beginning of March, we have taken about 65 negative rating actions on business development companies, commercial real estate finance, securities firms, residential mortgage services, auto finance companies, asset managers, and other types of NBFIs.

NBFIs with high exposure to energy, hospitality, residential mortgages, and commercial real estate, as well as retail securities firms and asset managers with substantial amount of asset-based fees, are some of the companies most at risk to the COVID-related downturn. Exchanges and technology-driven trading firms could be more insulated due to surging trading volumes.

At business development companies, we expect the economic impact of the pandemic to result in increased credit losses, increased calls on liquidity to fund underlying commitments to portfolio companies, and adverse financing conditions.

Commercial real estate finance companies will suffer from tougher funding conditions, as well as weaker asset quality and liquidity. Many of those companies that we rate rely heavily on repurchase facilities for funding--in some cases for more than half of their borrowings. The risk of margin calls related to repurchase facilities is elevated, in our view. However, terms and conditions vary across facilities, and some firms are at greater risk than others.

Unemployment is likely to reach 19%, and people are falling behind or pausing payments on residential mortgages in the U.S., weakening mortgage servicers' funding and liquidity. Servicers will still be required to advance principal and interest payments to residential mortgage-backed security trusts, even when mortgageholders stop making payments to them. The higher cost of servicing such mortgages, coupled with lower interest rates, could lead to losses on mortgage-servicing-right portfolios and hurt debt-to-tangible equity metrics.

Securities firms with high levels of liquidity and capital--as measured by our risk-adjusted capital (RAC) ratios--should be better positioned. The increased potential for credit and market losses could erode the RAC ratios of these firms with large trading inventories or loan books, however, and we expect these firms will see lower rates earned on clients' uninvested cash balances as a result of the near-zero interest rates. The decline in stock prices since December could reduce earnings from asset-based fees. Investment banking should also slow substantially.

We had a negative outlook on the traditional asset management sector and stable outlook on the alternative asset management sector before the COVID-19 pandemic. The negative outlook on traditional asset managers was largely because of the switch from active to passive investing. Traditional managers are particularly exposed to fluctuations in financial markets and redemption risk, because assets under management (AUM) is not locked in. Alternative managers are less exposed to many of the challenges facing traditional managers since their AUM is largely locked up and their strategies are harder to index, though they, too, aren't invulnerable to worsening conditions.

We expect the technology-driven trading firms and exchanges we rate to benefit from market volatility and surging trading volumes, offsetting any potential declines in nontrading revenues (such as from reduced listings for the exchanges).

Regarding funding, we expect debt issuance activity and financing costs for the largely speculative-grade NBFIs we rate to be choppy and opportunistic. Issuances we have seen since mid-March have largely been to build liquidity as a defensive measure. There is $43.8 billion of debt maturing over the next five years across 53 NBFIs that we publicly rate. Of these companies, we assign 40% an issuer credit rating that is lower than what it was a year ago at this time, or we have revised the outlook to negative. Positively, only a small portion of this debt comes due this year.

Bank Earnings Fall, Allowances Spike

In the first quarter, earnings for banks we rate fell almost 70% in aggregate, largely because of weakening confidence in the economy and the implementation of the Current Expected Credit Loss (CECL) accounting standard. At the same time, provisions for loan losses more than tripled.

Banks have been offering loan modifications and deferrals to their borrowers, which we expect to continue. We will monitor how many of these could turn into nonperforming assets or net charge-offs.

Most banks remained profitable even with these big jumps in provisions, often producing low- to mid-single digit return on equity, and the big increases in allowances should position U.S. banks to absorb a meaningful amount of losses that may be coming.

That said, we still expect further increases in allowances, and these will vary by bank. A more adverse scenario could mean a lot more provisions. Not every bank is equally positioned, though, with some appearing to hold higher allowances than others with similar loan portfolio compositions.

Revenues from sales and trading and debt underwriting were a couple bright spots in first-quarter earnings. The global systemically important banks (GSIBs) benefited from a surge of issuance of investment-grade debt, as well as of high volumes and volatility in trading. Mortgage refinancing volumes were also high.

But those sources of strength may not be there in the coming quarters to offset weakness elsewhere. Near-zero interest rates should lead to a drop in bank net interest margins and net interest income, and fee income is likely to decline, too.

On the balance sheet, many banks reported very robust growth in loans (especially in the commercial and industrial sector). Much of the spike in loan growth was the result of commercial borrowers drawing heavily on their bank revolvers. We believe this has slowed greatly, but we are uncertain to what extent borrowers will use the liquidity they have drawn and when they ultimately may pay it down.

Deposit growth was another bright spot. Deposits--which have risen about $1.5 trillion since the start of the pandemic, according to data from the Fed--have risen at the roughly double the pace of loan growth. In the last two months, deposits were up about 12%. This is partially because of the growth in loans. New loans create deposits, and, as borrowers drew on revolvers, new deposits were created. Also, the Fed's actions, most notably its purchases of securities, have also created substantial amounts of deposits. Its holding of securities, now about $5.8 trillion, is up almost $2 trillion.

The outsize deposit growth has supported bank liquidity. Cash on bank balance sheets is up about $1.5 trillion, generally allowing banks to meet revolver draws without trouble--especially as those draws at least in part have been re-deposited at the banks they have been drawn from.

The increase in loans, however, has led to a reduction in bank capital ratios, which fell by 50 basis points (bps) or more. This was owing to growing balance sheets as well as the decline in earnings and share repurchases in January and February.

Ratios may fall further, depending in large part on how much banks ultimately need to build their allowances for credit losses and what that means for earnings. Regulators have given banks a little bit of break, however, by allowing a phase-in of the impact of CECL as it pertains to their capital ratios. Capital ratios in the quarter would have been down further without that.

Assessing Banks' Ability To Cope With Loan Losses

Not all banks have been building their allowances for loan losses to the same degree. As part of our ratings analysis, we have been comparing the allowances with banks' Dodd-Frank Act Stress Test (DFAST) stress loan losses. For the banks that don't participate in DFAST, we have used our own estimate of stress losses.

We look at capital levels, too, combined with the allowances, to determine how fortified each bank is to handle losses.

We also look at the composition of a bank's loan book. Management teams have been deciding how much to build allowances based on the types of loans they hold. Banks with a higher portfolio of credit card or student lending, for example, have generally been building higher allowances than peer institutions, and we expect this to continue.

In March, we conducted two stress tests of banks: an adverse and a severely adverse scenario. The results showed only a modest decline in common equity Tier 1 ratios in our adverse scenario because we expect banks would be able to preserve capital and deliver decent preprovision earnings even under stress. However, the capital declines were more sizeable under the severely adverse scenario with a median drop of 100 bps. If that scenario were to materialize, it would likely result in a significant number of negative rating actions, perhaps including on the largest banks.

U.S. Government Support: An Alleviator, Not A Fix

The combination of the trillions of dollars of lending programs the Federal Reserve has announced and the stimulus from the federal government should help U.S. financial institutions' asset quality.

But these measures won't solve all problems. Unemployment is higher than it was during the 2008-2009 financial crisis. Government assistance doesn't apply to all individuals and businesses, and is often limited when it does apply. The Fed's lending programs for business may leave many, particularly medium and large businesses, with more leverage and doesn't make up for lost revenue.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act included the Paycheck Protection Program (PPP) to aid small businesses with loans that are largely forgivable if the business retains employees. However, while this program provides a life line to businesses up to a certain size, it does not replace lost revenue or guarantee these businesses will stay alive and meet all of their existing obligations for an extended period.

But, without those programs and others steps the Fed has taken to support financial stability, the challenges banks and NBFIs are now facing because of the coronavirus pandemic would likely be far greater.

Canadian Banks: Prepared For Home Price, Commercial, And Other Risks

In 2020, Canadian domestic systemically important banks (DSIBs) will suffer a sharp increase in COVID-19 induced losses, particularly in the commercial and unsecured loan segments, and weaker earnings from lower interest and fee income.

Like in the U.S., the Canadian government has taken fiscal stimulus and monetary policy actions to steady capital markets and boost funding and liquidity for banks. The government has announced multiple programs to provide financial support to qualifying workers and small businesses. Direct government stimulus to households and firms represents nearly 9% of GDP. This includes $500 per week for up to 16 weeks directly to individuals who have lost their jobs or income due to COVID-19 and a 75% subsidy for employee wages and salaries to firms experiencing a sharp drop in revenues. We believe these measures should mitigate the immediate liquidity needs of households and businesses, but they will likely not stimulate new demand.

Our stress tests suggests all DSIBs have sufficient capital and liquid assets to handle higher credit losses and increased draws on corporate credit lines, but a more severe or prolonged downturn could result in downgrades.

Oil and gas exposures at banks are likely the most immediately vulnerable from a credit standpoint. Even though these loans make up a small portion of bank portfolios, they are often to speculative-grade borrowers. Credit card loans are another risk, because, during times of stress, consumers tend to wait to pay off their credit card bills. While several commercial real estate property types like (retail, hospitality, and office space) will continue to remain at high risk from social distancing, the overall exposure of Canadian banks to commercial real estate is low at 9% of total loans on average, and their commercial and corporate exposures are well diversified by industry, with manageable exposure to highly leveraged companies.

The biggest wildcard in determining the severity of future losses is home prices. Social distancing measures have disrupted housing markets in the near term. As of end of April, Canadian banks had deferred about 15% of their total number of mortgages loans. These borrowers could be vulnerable if unemployment levels remain elevated beyond the six-month payment deferral period. However, we believe Canadian residential mortgage exposures are structurally sound, because about 36% of these are backed by mortgage insurance, and the average loan-to-value ratio on the uninsured mortgage portfolio is quite low at about 55%, which offers a lot of buffer.

In our severely adverse capital stress scenario, all Canadian DSIBs remained above the minimum regulatory capital requirement of 9%, suggesting they are well positioned for the ensuing downturn. And we don't expect a severely adverse scenario.

Starting From A Place Of Strength

The COVID-19 pandemic has completely changed the global economy, leading us to take more than 1,500 negative rating actions worldwide, mostly on nonfinancial corporate companies. Of those actions on banks, the vast majority have been changes to the outlook. The U.S. and Canada, however, have accounted for a relatively small 17% of total bank actions so far.

That's because, when the pandemic began, these institutions were largely in a position of strength. They had excellent profitability, stronger balance sheets, higher levels of capital, and better liquidity than they had in years.

This durability is not limitless, of course, and will depend on the depth and duration of the downturn, government efforts to mitigate it, and the strength of the rebound.

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