Zawya - COVID 19 pandemic - impact on financial industry

“The cure is worse than the disease”. Perhaps no other phrase best describes the ill effects of COVID 19 pandemic on our day to day lives than this one. Over the course of last 6 months, countries all over world have faced increased hardship in containing & preventing the spread of the virus. From partial lockdown to complete lockdown and even enhanced social distancing measures, the manner in which businesses world over are conducted is about to change drastically. This will not only result in overall change to the basic business model but also impact the cost of doing business. Considering the most adverse scenario, the entire supply side of the market is going to be hugely impacted as capacity restrictions come into play. This has already caused huge job losses in major sectors of the global economy like retail, travel & tourism, leisure & hospitality.

One of the worst affected sectors happens to be the financial industry. Within the financial industry, various other sectors like banking & insurance are likely to take a worst hit. COVID – 19 pandemic has taken the world economy into a state of emergency. Countless entrepreneurs and big legacy corporate names have declared bankruptcy. Case in point – Hertz, JC Penny & other well-established names. The financial sector is currently facing challenges on multiple fronts. With overall demand for new products becoming less and requirements for stringent social distancing requirements, fewer customers will be served in a physical branch. This will likely put additional strain on other communication mediums like online support & social media.

The MSCI world Banks index, which tracks mid to large scale banks across 23 developed markets, is currently trading near its decade low levels of 60. Banks all over the world from US to Russia are currently experiencing immense pressure from COVID 19 pandemic ill effects.

For the insurance industry too, things do not look good. Overall reputation of insurers is taking a huge hit as consumers and businesses come to terms with the fact that most insurers do not cover the COVID - 19 pandemic. Insurance industry is further likely to face immense pressure from increased number of insolvencies & bankruptcies. Falling equity markets as well as interest rates could further put additional pressure on the fiscal health of insurers.

NIRP – The New Norm in Post COVID 19 World

Ever since the pandemic has started hitting the global and financial markets, central banks world over led by US FED & ECB have added record amounts of liquidity into the system. Recent market estimates put the combined world central banks’ balance sheet in excess of $ 20 trillion, a record in itself. In US, the FED has virtually started to backstop each and every type of financial asset. From consumer loans to investment & junk bonds, the overall stimulus measures have surpassed any other seen in past history. Countries with deep negative interest rates like Switzerland, Denmark, and Japan are likely to have more members added to their club. USA is currently the leading contender even as the FED reiterates its message of no NIRP (Negative Interest Rate Policy) for now.

The case for negative interest rates has only grown louder day by day. Recent evidence has suggested of the consumer tendency to spend more and thereby increase aggregate demand. This is primarily based on the fact that with interest rates at record lows & even in negative territory, the individual is better off not saving the surplus cash and instead deploying it for other spending purposes as well as invest in other high return products. A policy of deeply negative rates in the advanced economies would also benefit emerging & developing market economies like India & Pakistan which are already suffering from early stages of COVID 19 cycle, rising USD debt, capital outflows & falling commodity prices.

According to US 30 Day Fed Futures Rate, markets are expecting US interest rates to enter into negative territory from early next year and stay there till mid of 2022.

Negative Interest Rates – Impact on banking sector

Banks profitability from its core operations is primarily function of their local currency yield curve. As the yield curve steepens Net Interest Margin or the NII grows, improving banks profitability. Inversely, when policy rates turn negative, banks will have to pay interest on the excess reserves stored with their central bank. US banks alone are likely to lose billions and billions of dollars’ worth of revenues once the US FED implements NIRP. Competition between the banks and the option for clients to hold liquidity in cash do not allow for the negative interest rates to be passed on to individual clients very easily. This was the case with major European banks who took huge hit on their balance sheet year after year ever since ECB reduced the interest rates to record low.

Way Ahead

Going forward, financial sector led by banks & insurance is likely to stay under immense stress. With majority of market analysts now expecting either a “W” Shaped and some even expecting worst “L” Shaped depression based recovery, things are only likely to get bad for the sector before the recovery happens. Owing to its very nature of business, firms in this sector will be at the mercy of demand recovery in other core sectors.