The pandemic has rapidly developed into the biggest economic crisis in living memory, causing the equity market to crash, business closures, job losses, a lock down of society, and for many, significant decline in earnings and an erosion of their savings. It is already clear that the economic impact will be felt long after the virus has been contained.
The financial services industry in Australia has responded responsibly. Its adoption of a 'community first' mindset, helping customers and others deal with the economic fallout through a variety of measures, is not only admirable but has provided the industry with an opportunity to significantly repair its reputation. And it's an opportunity that appears to have been grasped, at least initially, with both hands. It will be important for the industry to sustain its community minded efforts and at the same time manage the expectations of its shareholders.
That the industry, and the banks in particular, has been able to play the role of 'crisis shock absorbers' and 'crisis backstop' is due in no small part to having built up 'unquestionably strong' capital buffers and healthy liquidity positions mandated by APRA following the prescient recommendations of the Murray Financial System Inquiry of 2014.
Once the 'here and now' existential threats have been dealt with it will be important for organisations to continue to ensure that the risk management, compliance and operational controls frameworks continue not just to operate robustly but potentially anticipate changing threats. While working from home may make the task challenging, financial institutions are demonstrating agility and adapting to the current challenging environment.
It is also encouraging to observe that the industry is not just dealing with the issues of today but is already turning its mind to bending the downward curve back to a narrow U, and the significant opportunities that the recovery will provide. It is already clear that when we emerge, there will be a new normal. Australia has a well-deserved reputation for rising to a challenge and there is every reason to be optimistic that when the crisis is behind us, the industry will pivot successfully to the new world.
To assist you to understand how COVID-19 continues to impact, this summary – from a macroeconomic, Government, regulatory and financial services industry participants viewpoint - suggests what the new normal may look like. This snapshot is not designed to be comprehensive, and as the landscape evolves, MinterEllison will provide further commentary.
There is significant uncertainty, however, it is clear that we are in a recession globally and in Australia, and with the global lockdown, economic activity has slowed dramatically and GDP will take a large hit for at least the next 2 quarters.
Best case scenarios suggest GDP will rebound in the second half of this calendar year, whilst worst case is the expectation of a rebound in early 2021. Much will depend on how quickly the pandemic can be contained, and the effectiveness of the policy stimulus. It is impossible to be definitive.
The RBA has cut interest rates to a historic low of 0.25%. It has been buying Government bonds to provide liquidity to the market and it appears likely that we will remain in a low interest environment for the foreseeable future.
Unemployment in Australia is likely to reach double digits with casual workers, and those in the travel & airlines, hospitality, entertainment and retail industries the hardest hit. However, the Government has responded strongly and introduced wide scale fiscal stimulus (outlined in the government section of this article).
There are strong indicators of corporate stress and an increasing number of listed companies are withdrawing earnings guidance. With this comes the strong expectation of receiverships and insolvencies on scale not seen in recent years
The share market has been volatile and mostly in freefall with some limited rallying with volumes down significantly and is expected to remain volatile in the near term. At the time of writing the S&P/ASX200 is at just over 5000.
Expectations are that house prices will decline before picking up potentially in 2021, with inflation expected to remain materially unchanged.
Capital and liquidity/solvency are critical areas of focus for many companies and market experts believe that the A$ will remain, for the moment, in the low 60s, with the potential for it to drop further before rallying.
The Government has announced a $320 billion consolidated package of policy, fiscal and balance sheet support to assist businesses and individuals. The details of this are set out in Latest COVID 19 Government stimulus package: support for business. The measures include:
- Relief for directors of companies from any personal liability for trading while insolvent
- The Government will provide a guarantee of 50% to SME lenders (with turnover up to $50 million) for new unsecured loans to be used for working capital purposes. Maximum total size of loan is $250,000 per borrower
- Exemption for six months from Responsible Lending obligations for lenders providing credit to small business customers
- The RBA has made available to the banking system a new $90 billion(included in the $320 billion referred to above) funding facility for business lending purposes
- To assist small and non ADIs, the Government will provide the Australian Office of Financial Management with $15 billion (included in the $320 billion referred to above) to invest in structured finance markets used by these smaller lenders (ie direct investment in primary market securitisations and warehousing facilities)
The Government has also announced a $130 billion wage subsidy to keep an estimated six million workers in jobs and retain the nation's productive capacity.
Specific Pandemic Planning
In May 2013 APRA released CPG 233 Prudential Practice Guide on Pandemic Planning. The CPG provides useful guidance or reminders in relation to:
- Pandemic planning governance, structure and timing
- The need to review or modify traditional BCP models to incorporate staffing impacts, identifying critical business functions and prioritising resources
- Stand-alone pandemic plans
- On-going communication with other financial institutions, regulators, Government
- Reliance on third party suppliers
- Significantly increased usage of electronic transactional and communication channels
- Modelling the financial impact on assets, liabilities, capital and liquidity and keeping APRA informed of pressure points
The regulators have rallied strongly and are taking a constructive approach by providing relief or waivers from certain regulatory requirements. On March 16, the Council of Financial Regulators (APRA, ASIC, RBA and Treasury) issued a statement stating that they would examine how the timing of regulatory initiatives might be adjusted to allow financial institutions to concentrate on their businesses and assist customers.
Subsequently, APRA has announced that the implementation date of APS 110,112,113, 115,116,117 and 330 will be delayed by 12 months and APRA has temporarily reduced its capital ratio requirements to ensure banks are well positioned to continue to provide credit.
APRA has also expressed its expectations that banks and insurance companies will limit their discretionary capital distributions (including dividends). Clearly this will have a major impact ,particularly on retail investors and retirees who rely on franked dividends for their income.
ASIC has announced that it will take no action against public companies with 31 December 2019 balance dates that are unable to hold their AGMs by 31 May 2020, as long as the AGMs are held by 31 July 2020. Subject to the requirements of their own constitutions, companies can hold their AGMs virtually or take a hybrid approach.
ASIC has stated that until at least 30 September 2020 it will:
- Prioritise serious breaches of the law, significant consumer harm, risk to market integrity and time sensitive matters. It will maintain its enforcement activities
- Suspend non time critical matters (such as the Close and Continuous Monitoring Program and Internal Dispute Resolution)
- Provide waivers from certain regulatory requirements where warranted (eg the AGM requirements described above)
- Work alongside financial institutions to speed up the payment of outstanding remediation to customers
There are a number of issues that are common to all sectors in the financial services industry. These include:
- Managing the physical & mental health and welfare of staff
- Key person risk
- Reduction in reliability of supply chains, especially cross border
- Changed dynamics of working at home
- Significant pressure on infrastructure, telecommunications and electronic transactional channels
- Increased pressure on cyber security and risk of online fraud
- Increased pressure on other operational risks
- Declining financial performance caused by several factors
- Very low return on free funds and continued margin squeeze
- Managing liquidity in priority to managing margin
- Declining access to global capital markets
- Fall in equity markets leading to a decline in funds under management and lower fees
- Pressure on credit ratings
- Limited deal flows
- Although some Royal Commission recommendations might be put on the back burner it is important for institutions to stay the course and ensure that good work to date is not undone.
Specific impact on each of the sectors is set out below.
The banking industry has responded responsibly and is taking a lead role in helping its customers and the community cope with financial pressures and provides the industry with a major opportunity to accelerate the rehabilitation of its reputation in the community.
The industry, and the majors in particular, are well capitalised and have strong liquidity buffers with these immediate impacts on results:
- Reduction in interest income from continued margin pressure
- Reduction in fees and charges
- Mortgage arrear rates could exceed the 5.4% arrear rate that occurred during the GFC
- Increased loan loss provisions triggered by rise in unemployment, business failures and fall in property prices
- Pressure on capital and liquidity except for institutions that are financially robust
- Increase in cash deposits and fixed income investments as investors flee to safety
- Pressure on ratings
- Widening of spreads in the debt markets
The banks are already undertaking a range of mitigating measures to protect their financials. These include:
- Deferring non-essential projects, and re-prioritising essential projects
- Promoting the taking of annual leave, long service leave and unpaid leave by their staff
- Considering alternative employment models, e.g. part time, haircuts on remuneration, redeployment of parts of the workforce
- Cutting costs / eliminating discretionary spend where possible without compromising operational resilience
Following the example of British banks, NZ banks have agreed not to pay any dividends or to redeem any tier-one capital instruments. The measures appear to be designed to ensure banks retain profits they make in NZ to support lending to New Zealanders during the crisis.
On 7 April, APRA issued guidance to ADIs and insurers on capital management. APRA's expectations are that discretionary capital distributions will be limited to maintain capacity to lend and underwrite insurance. This includes 'prudent reductions in dividends'.
Wealth management and superannuation entities
The economic crisis is putting particular pressure on wealth management and superannuation entities, some examples are listed below.
- Significant losses in member portfolios
- Fear based selling / switching to cash
- Increasing proportion of illiquid or unlisted assets created by withdrawals
- Potential adverse impact on remaining super fund members caused by declining value of infrequently revalued illiquid assets but artificially high unit prices
- Important to comply with requirements of SPG 530 Investment Governance and SPG 531 Valuation
- Large volume of member enquiries to the superfund or their financial advisers
- Easing of Government restrictions on (limited to $10,000 in each of 2019/2020 and 2020/2021) hardship related withdrawals to meet income needs (hardship defined as: made redundant, working hours reduced by 20% or more, or for sole traders and businesses in situations where the business has been suspended or where turnover has declined by 20% or more)
- Major impact on pension benefits of retirees, potentially exacerbated if redemptions are suspended
There are also strong arguments put forward for and against the provision by the RBA for liquidity to support pandemic-related withdrawals.
Life and general insurance companies
The particular ways in which the crisis is impacting insurance companies includes:
- Decline in revenue from reduced business activity
- Reduced profitability caused by downward pressure in equity markets, interest rates, and management fees
- Re-assessment of IBNR related claims reserves caused by crisis related delays in claims reporting and general uncertainty
- Pressure on life product profitability
- Increase in health, travel and business interruption claims
- The obligations under, the effectiveness of, and the impact of 'force majeure' clauses
- Increase in credit related claims
- Loss recognition testing might require review and be performed more frequently
- Drop off in the use of face-to-face channels
- Pressure on solvency tests
- Fast tracking claims processes
- Adoption of a supporting-the-community mind set
- Reduction in dividends (refer above under 'Banks')
MinterEllison will provide periodic updates on developments in the industry together with insights on what they mean for entities, their directors and management.
If you have any questions or require advice, please contact us.