S&P Global Ratings' believes domestic credit losses for French banks will more than double in 2020 and remain elevated in 2021, as economic fallout from the COVID-19 pandemic damages asset quality. In particular, unemployment rising to about 10% (despite partial or temporal unemployment schemes) and corporate bankruptcies (despite government guarantees and other measures) will lessen the ability of borrowers to pay back their loans.

COVID-19-related lockdown measures significantly limited economic activity in France for about two months, with activity in some sectors, mainly hospitality and tourism, not yet at normal levels. While the economy appears to be recovering as lockdowns ease, the consequences of the economic shock on businesses and individuals are starting to show. We expect GDP will contract 9.5% in France in 2020 and recession in most European countries, but anticipate a recovery in 2021, although not strong enough to immediately and entirely offset damage to the economy, household wealth, and to companies in a number of sectors. We project GDP will rebound 6.8% for France in 2021 and grow 3.1% in 2022 and 2.4% in 2023 (see chart 1). However, there are downside risks to our forecast, and we believe the economic repercussions of COVID-19 will be felt for years to come.

As already stated in our previous publications on French banks, long-lasting deterioration in asset quality, with both domestic and consolidated credit losses remaining elevated, could weigh on our ratings on French banks (see "Negative Rating Actions Taken On Various French Banks On Deepening COVID-19 Downside Risks," published April 23, 2020, on RatingsDirect).

Chart 1

We note that, while the French banking system had good asset quality metrics and insignificant credit losses prior to the COVID-19 outbreak, they were already facing structural challenges to revenue and profitability. These challenges will remain and may even be exacerbated by the rise in domestic credit losses. They are, by and large, because of pressure from low interest rates and large cost bases. In particular, this stems from fierce competition in the new home loans market, where margins are lower than in other countries, renegotiations by borrowers of lower interest rates on existing residential housing loans, and difficulties in adjusting interest rates paid on deposits due to the existence of regulated savings.

We acknowledge a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Domestic Credit Losses Will Rise Significantly This Year

For full-year 2020, we estimate domestic credit losses will rise to about €13 billion, or 50 bps of domestic lending for major French banks. This is way above the long-term trend of an estimated 35 bps, based on our normalized loss estimates. While that is our current base-case estimate, losses could be even higher, as we note above.

The banks' first-quarter results confirmed a significant increase in reported consolidated cost of risk, ranging from 29-67 bps of customer loans on an annualized basis (see chart 2a; data includes international and domestic lending). We note two important trends (see charts 2a and 2b):

• In the application of International Financial Reporting Standards 9's [IFRS 9's] "forward-looking" rule, banks are now creating provisions in anticipation of future losses, based on their macroeconomic expectations; and
• Aggregated cost of risk between first-quarter 2019 and first-quarter 2020 for the top-four French banks, excluding COVID-19-related provisions, increased 46%.
• The most recent results therefore reflect the end of a very favorable, maybe even abnormal, period of reversal of loan loss provisions, particularly in corporate and investment banking.

Chart 2a

Chart 2b

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 as required for stage 2 or stage 3 loans. This aims to enable borrowers to overcome short-term liquidity constraints arising from the effects of COVID-19, lessening 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.

Domestic credit losses were just 20 bps of domestic lending in 2019, and averaged 18 bps over 2017-2019, meaning we expect domestic credit losses in 2020 will be roughly equivalent to the cumulative amount of those in the past three years. We believe that domestic credit losses in 2021 will be close to or marginally above the 50 bps level estimated for 2020, at about 52 bps. These levels represent 30% of our estimates for net operating revenue before loan loss provision, meaning internal capital generation will be challenging, in our view. In 2019, credit losses represented about 18% of operating revenue for the five-largest French banking groups (BNP Paribas, Credit Agricole Group, Societe General, BPCE, and Credit Mutuel Group). Low loan losses in recent years have been key for French banks, because they partially offset the negative effect of low interest rates on revenue.

We anticipate corporates, small and midsize enterprises (SMEs), and entrepreneurs in the most affected sectors will contribute to most of the increase in domestic credit losses (see table 1). Government policies aimed at supporting businesses, employees, and entrepreneurs, should help the economy and banking sector, but it is still too early to assess the effectiveness and take-up of these measures.

The French government has made a number of unprecedented decisions to support business activities. Among measures relating to short-time work, tax relief, and capital markets, for example, it has introduced a €300 billion state guarantee scheme for new money loans to be granted to French entities by financial institutions. The guarantee covers outstanding principal, interest, and accessories, but only up to 90% for companies with fewer than 5,000 employees and total revenue of less than €1.5 billion in the last fiscal year; 80% for companies with total revenue exceeding €1.5 billion but lower than €5 billion in the last fiscal year; and 70% for other companies. While the state guarantee is a "final loss" guarantee, lenders are entitled, in the event of a payment default by the borrower, to ask for a provisional payment based upon an estimate of the lenders' likely loss. As of June 2020, more than €100 billion of guaranteed loans have been granted.

Table 1

Specifically, for domestic credit losses in 2020, we assume (see chart 3):

A corporate credit loss rate of about 100 bps and a credit loss rate of about 120 bps for SMEs and entrepreneurs, up from 35 bps and 40 bps respectively in 2019. This reflects our view that corporates in some industries have suffered from a temporary weaker economy because of the two-month lockdown, despite government support measures. This is true for the hospitality and tourism sectors, but also automobiles, aviation, and transportation. Banks' credit exposure to more highly affected sectors will largely dictate the pandemic's impact on each bank.

A loss rate of about 7 bps for housing loans, a modest increase compared with 5 bps in 2019. French banks' lending practices are conservative and focus on the borrower's ability to repay the loan rather than on the property valuation, and banks typically follow historically strict limits on affordability to mitigate individual borrowers' solvency risk. Government measures to mitigate the pandemic's impact, such as the partial or temporal unemployment scheme, along with a generally protective social security system, should prevent significant layoffs. Finally, more than half of outstanding loans are covered by loan guarantees. Guarantors are either the subsidiaries of one bank, or in the case of Credit Logement, several banks. However, over the recent years, underwriting criteria has gradually become more lax, with longer loan maturities and deteriorating debt service-to-income ratios.

A consumer credit loss rate of about 100 bps, up from 50 bps in 2019, reflecting that borrowers are more likely to default on unsecured debt such as revolving loans, and that there is no collateral to mitigate losses on defaults. Typically, auto loans and consumer credit, where a specific asset is financed, tend to have lower risk levels.

While we expect domestic credit losses for 2021 will be marginally above 2020 level, at 52 bps, we expect they will gradually decline to 43 bps in 2022, but remain above the estimated long-term trend of 35 bps, based on our normalized loss estimates. We acknowledge government support measures aimed at supporting viable companies, but expect higher insolvencies in sectors heavily hit by the coronavirus outbreak.

Chart 3

Despite Economic Recovery, Total Credit Losses Will Likely Exceed The Long-Term Average Until 2022

According to our economic forecasts, we expect a strong economic rebound in France in 2021 (see table 2).

Table 2

The 25 year long-run data available to us covers the five-largest French banking groups, including their international loan books. We estimate that these banks' long-run average for credit impairment charges is about 53 bps (see chart 4). Because we expect domestic credit losses will only to jump to 50 bps in 2020-2021, total credit losses, including from riskier international exposures and those in CIB, should therefore be higher than the long-term 25-year average. Still, we expect consolidated credit losses in 2020-2021 will be lower than the 110 bps peak reached in 2009.

Like most European banks, French banks have enjoyed years of benign credit losses to persistent low interest rates in the eurozone, modest but stable growth in Europe, and abundant liquidity. Low credit losses on a consolidated basis over recent years also reflect the banks' diversification, typically in low-risk eurozone countries, with the exception of Italy for Credit Agricole and BNP Paribas, and Russia and Romania for Société Générale.

Chart 4

Increased Credit Losses And Structural Issues Will Hinder Profitability

The sharp, but in our view temporary increase in both domestic and international credit losses is not the only factor behind pressure on banks' profitability. Interest rates are low, and will remain so in the eurozone for some time, squeezing interest margins for European banks' retail activities. However, French banks are particularly vulnerable due to some specific features. According to data from the European Central Bank (ECB), gross margins on new home loans in France continued to decline to a very low level of about 1% at end-2019, much lower than in other markets. Of course, we acknowledge that the cost of deposits in France is higher and more rigid than in many other European countries, particularly due to the high share of regulated (tax-exempt) savings for which remuneration is not fully indexed to market rates. However, in our view, the main issue is the fierce competition in retail banking, especially housing loans, to attract or retain customers. A lack of pricing discipline translates into extremely low retail interest margins, which are insufficient to sustain profitability in a low-rate environment and lead banks' profitability to erode. As long as credit losses were low, this was not a major issue. However, with the expected sharp increase, these modest margins for housing loans is a more significant area of concern. Positively, we note French banks have diversified earnings streams and typically depend less on interest margins than peers in Germany or the Benelux (Belgium, the Netherlands, and Luxembourg). French banks tend to disclose the lowest share of interest revenue thanks to their universal business model.

In addition, we note that French banks' still-dense branch network and its significant inefficiencies weigh on profitability. The latest ECB structural report indicates that branches in France were reduced over the last 10 years by a modest 8%, versus 29% in the eurozone. The Netherlands has, for example, more than halved its number of branches and reduced employees by one third. The average unweighted cost-to-income ratio for the top-six largest French banking groups reached 67% in 2019, one of the highest rates in Europe, excluding in Germany. Here again, French banks' still-modest efficiency, despite massive investments in digitalization and leaner structures, leave little room to absorb an expected increase in credit losses.

Chart 5

How We Derive And Use Our Credit Loss Estimates

Given banks' balance sheets usually mirror developments in the real economy, we expect the worsening outlook for the French economy in 2020 will translate into a higher domestic loan cost of risk at roughly the 25-year long-run average. The peak observed during the 2008-2009 financial crisis (111 bps) is a good reminder of how quickly total losses can spike (see chart 3). The 2008-2009 crisis was a financial and liquidity crisis, but this differs from the current situation, which we consider an economic crisis. The speed of the French government's and ECB's response to the pandemic should limit the economic damage this time, in our view. However, a delay in the recovery could lead us to review our forecasts.

In calculating our domestic loan losses, we note:

• Loss estimates are for French domestic lending, not foreign lending. Therefore, these assumptions cover only a portion of the balance sheet of the largest French banking group.
• The assumptions are for the system as a whole, including French-domiciled banks, specialist lenders, and foreign banks. We expect individual banks will likely experience varying levels of loan losses at about our estimated level. The actual aggregate loan losses for rated institutions may differ from these assumptions, depending on how much better or worse than average unrated or nonbank lenders fare.

To inform our ratings opinion, we use the credit loss estimates set out in this article in two ways:

• First, the estimates represent our base case for the loan impairment charge line within our earnings forecast until 2023. We tailor individual bank forecasts to reflect the profile and our expectations for that institution based on its risk management and clientele, among other factors. 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. Our earnings forecast is a key consideration for our projected risk-adjusted capital (RAC) ratio 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 French banking industry, one of the elements of our Banking Industry Country Risk Assessment (BICRA) for France. 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 low risk, respectively. This contributes to an economic risk assessment of '3' (with '1' being the lowest risk, and '10' being the highest). The trend for BICRA economic risk is negative. This is a an assessment that is broadly in line with France's main peers--the Netherlands and the U.S. (with economic risk assessments of '3', with negative economic risk trends), the U.K. and Spain ('4', with negative economic risk trends), Germany ('1', with a negative economic risk trend), Belgium ('2', with a negative economic risk trend), and Denmark and the Czech Republic (respectively '2' and '3', with stable economic risk trends).

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 French credit loss estimates are slightly better that the peer average, in our view, despite the usual hurdles with data comparability.

Chart 6

Domestic Credit Losses Will Increase Above Our Normalized Loss Rate

We have compared actual credit losses with normalized credit losses generated using our RAC framework. Normalized credit losses are a calculation of long-term average annualized credit-related losses for France. 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 will occur for a given asset class. We derive the estimates using a 12-year cycle, including three years of recession.

For France, over the last eight years to end-2019:

• Credit losses on corporate lending have been about 36 bps, compared with our normalized loss rate of 36 bps for corporate loans and 107 bps for construction and real estate development loans (see chart 7).
• Credit losses on mortgages have averaged at about 6 bps compared with to our normalized loss rate of 20 bps (see chart 8).
• Credit losses on consumer credit have been about 59 bps compared with our normalized loss rate of 350 bps for revolving credits, 107 bps for other retail lending, and 50 bps for auto loans (see chart 9).

In aggregate, actual loss rates over recent years have been below our normalized loss rates, indicating very benign economic conditions. However, as our forecasts show, we expect the impact from the coronavirus outbreak will increase significantly the credit loss rates to a level that is, on average, higher than our normalized loss rate.

Chart 7

Chart 8

Chart 9

Related Criteria

• Criteria - Financial Institutions - General: Risk-Adjusted Capital Framework Methodology, July 20, 2017

Related Research

• COVID-19 Impact: Key Takeaways From Our Articles, July 9, 2020
• Credit Conditions Europe: Curve Flattens, Recovery Unlocks, June 30, 2020
• Eurozone Economy: The Balancing Act To Recovery, June 25, 2020
• EMEA Financial Institutions Monitor 2Q2020: Resilient But Not Immune To COVID-19, May 14, 2020
• How COVID-19 Risks Prompted European Bank Rating Actions, April 29, 2020
• The Lowdown On Lockdowns, April 27, 2020
• Negative Rating Actions Taken On Various French 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