We've taken a close look at banks' energy exposures and potential losses, and see both good news and bad news for investors. First, the good news; for most banks, we think the losses will be manageable. And now the bad news; nearly all banks are under-reserved and several could be facing capital shortfalls in a worst-case scenario.
Will energy losses be merely painful, or pose a serious risk to capital?
We use the bond markets to proxy what total losses could be. The S&P 500 Energy Corporate Bond Index is down about 15% peak to trough, and the Bloomberg USD High Yield Corporate Bond Energy Index is down about 30%.
We use these to model mark-to-market – the S&P index – and stress case losses – 30%. We then compare these to the reserves banks already have in place, and to the banks' common equity. This helps us to gauge whether energy losses are likely to be merely painful, or whether they could pose a serious risk to capital.
As a rule of thumb, we think that anything under 10% of common equity, remembering that losses are likely to roll in over two to three years, is likely absorbable by a well-capitalised bank. After that, we think the risk becomes more serious, depending on the bank's existing capital and the quality of its book. On average, we think cumulative losses will be approximately 2.7% of common equity for the banks we cover, and could average 4.6% of common equity in a worst-case scenario. We think Commerzbank and Standard Chartered (STAN) are most at risk.
Most U.S. banks have reported their 2015 results, and the banks with material energy exposures have reserves averaging 2.8% of energy loans, far below the 15% cumulative losses the markets are forecasting. This means that additional losses are likely, in our opinion. Of the U.S. big four, we think Citigroup and Bank of America are the most exposed. Given their current reserves of about 3.8% and 2.4% of energy loans, respectively, we think they could face additional impairments worth about 1.1% of the common equity. We think this would dent earnings, but would not pose a threat to their financial health.
The Canadian banks have also reported and provide an interesting contrast. Canadian firms use IFRS accounting standards, while U.S. firms use GAAP. US GAAP allows banks to reserve for losses earlier, so the Canadian reserves are notably lower than those of U.S. banks. Canadian banks have reserved an average of 0.4% of energy loans, compared with 2.8% in the U.S., which means they have further to go to absorb likely cumulative losses. We think the pain will be the greatest at Bank of Nova Scotia, where losses could consume 3.4% of common equity, and the least painful at TD Bank, where losses could be just 0.6% of common equity.
What About European Banks?
European banks are just beginning to report, and given that they use IFRS, we think Canadian bank provisioning is a better proxy for what we'll see in 2015 results, therefore, we expect losses to be low and manageable in the short term. In the longer term, we think cumulative losses could be a bigger issue. We think energy losses could consume 10.1% of common equity at Commerzbank, and 7.8% at Standard Chartered.
The rest of the European banks we see as less exposed. We anticipate cumulative losses of 3.1% of common equity at Barclays (BARC), and about 2.0% at Lloyds (LLOY), UBS and Nordea, and less than 1% at Danske. We'll keep a close eye on this issue, as reporting on energy exposure has been thin among European banks, but we expect greater disclosure as results roll in over the next several weeks.
