In March this year, we marked the anniversary of COVID-19 pandemic that broke out across the globe affecting the lives and businesses of our clients, employees, neighbors, and friends. Alarming news on the pandemic were building up eventually pushing financial markets into turmoil during the late February – early April 2020 period. Stock markets lost 1/3 of their value during that period before slowly recovering and rising again to new highs. Signs of restricted credit appeared as well during that period, with bond markets going “bearish”, strict lockdown measures being imposed, and businesses in vulnerable sectors shutting down. Nevertheless, markets and sentiment recovered by mid/late Q2 with governments of the major global economies announcing extended support packages to their economies; and the IMF, in concert with development banks, announcing support to emerging economies.

During periods of market crisis overreaction, from depositors, lenders, and other creditors, can push a financial institution into liquidity crisis even if its capital adequacy, portfolio quality and other key metrics are exceptionally strong. Shareholders and management of financial institutions (FIs) face a challenge on how to respond to the crisis events breaking out. There is a choice of alternative routes to take, which will be discussed in this article. We are continuing our series of articles on impact to the finance sector in emerging economies with lessons learned from the COVID-19 crisis.

Restricting lending is a difficult decision to make

How would you explain to a repeat borrower, when s/he turns up for a new loan, that your FI is currently not issuing loans? Usually, Management and Board of the FI would come up with a decision to stop or restrict lending to manage the credit and liquidity risk. With a pandemic breaking out and lockdown measures being implemented, uncertainty about client loan repayments and availability of funding from deposits and institutional debt goes high. The most prudent approach, given this uncertainty, seems to be to stop or restrict lending to observe how the situation will unfold. But the biggest strategic concern for management remains – how will clients interpret this? Will they just suppress their funding need or go to a competitor? Will they think the FI is having financial difficulties since it has stopped lending? Spreading this information further might affect overall sentiment of the FI’s clients to service their loans.  If the FI has a deposit license and notable retail deposit portfolio, pressure towards the institutions’ liquidity position might escalate further. Thus, it is critical for the FI to control its message when a decision is made to limit or stop lending.

Another negative impact from stoppage of lending comes from pressure on net margins due to a decrease in interest and fee revenue from the loan portfolio. If the FI stops lending for 2 months (17% of the financial year), the loan portfolio will decrease at that rate, while resumption in lending might take extra effort and cost affecting profitability of the institution.

As stated earlier - these are never easy decisions to make.  The COVID-19 crisis so far has shown that FIs in emerging markets who have implemented less restrictive lending (e.g., to high-risk sectors only) came out in better shape than institutions that restricted lending on a broader scale. Moreover, support liquidity packages to the economies, along with strong liquidity through debt markets (post March – April market turmoil), helped keep the funding flow uninterrupted this time to avoid a credit crunch impact on FIs funding base.

Keeping engaged with institutional lenders and debt holders

The COVID-19 crisis has brought high levels of uncertainty and ambiguity to all stakeholders of FIs. Imagine stepping into the shoes of an international lender or bondholder who is located thousands of kilometers and many time zone hours away from the FIs place of business. When the crisis broke out and negative news streamed in from the market, debt holders wanted to receive real-time and trustful information from the institution itself on its ability to continue business, the effects on its loan and deposit portfolios, and other key financial metrics. Therefore, timely and proactive communication from the FI to its debt holders is a critical component for maintaining productive relations during the adverse economic environment. If the FI has several lending partners, who all are keen to get updates quickly and at the same time, the best strategy might be to organize regular memo write ups to share via email, followed with bilateral or group calls. Upfront proactiveness by the FI gives an opportunity to control the message it wants to give on the events unfolding within its business, and to smooth the communication process for difficult conversations.

International lenders were proactive as well, when the COVID-19 crisis started, by coming together and aligning on template approaches to support FIs based on their need and situation. Given the magnitude of the pandemic and its impact on the clients’ ability to make loan repayments according to the original payment schedule, flexible approaches to rollover, reschedule, or restructure the institutions debt was needed from the lenders. This allowed for FIs to stabilize liquidity positions and avoid adverse selection problems with the lenders, who were looking at each other’s actions on loan agreement breaches and providing new funding.

Moreover, attracting deposits allow FIs to diversify their funding sources, liability tenor structure, currency mix and funding costs. In crisis periods, deposit stickiness is the biggest concern to manage, as systemic or institution focused deposit runs can put abnormal pressure on an institution’s liquidity. During this COVID-19 crisis, overall deposits remained stable and even increased in many countries affected by extensive support and intervention packages provided by the governments. Deposits play an important role to attract funding on the local market from different groups of investors, which diversifies the need to source funds through institutional investors who provide senior loans. It also allows tapping into the local currency funding base with more stable pricing, rather than institutional funding through external markets. Keeping liquidity at an optimal level during the crisis requires a combination of these various funding sources. The more diversified the better.

Managing open currency exposure

Daily, and even more so during the crisis, FIs maintain and target a balanced open currency position to avoid getting exposed to currency fluctuations that can significantly affect the capital adequacy position of the institution.

Ideally, FIs search and attract funding in the same currency as they disburse loans to clients. However, in reality, FIs are faced with challenges to match the asset side with an exact composition of currencies that exist on the liability side. Two main reasons for this are pricing (or net interest margin) considerations and availability of a particular currency. This gets magnified during crisis situations. Retail depositors fearing devaluation risks tend to convert their local currency (LCY) into hard currency deposits, which in turn puts pressure on increasing LCY deposit rates while reducing the open currency position. Corporate client deposits, in those instances, are a more reliable source as balances on current accounts are usually local currency based for daily transaction purposes. Additional pressure on currency position can come from external borrowings in local currency, where the lender rates depend on international hedge partners. Rates on local currency hedge can be volatile, and increase during crisis situations, which further erode net margins on the local currency. In extreme cases, local currency hedges might even become unavailable for a period of time.

Below are a few strategies and tips when faced with eroding currency exposure on the balance sheet:

1. Diversify the LCY deposit portfolio with current accounts from both retail and corporate customers. Those tend to be more stable.
2. If the capital market situation allows, consider issuing LCY bonds (ideally to a diversified investor base), which will provide a more stable LCY funding base during crisis conversion pressures.
3. Diversify LCY borrowing options from both local and external lenders. Even if LCY pricing is elevated, having a LCY funding option available, going into crisis turbulence, should help maintain a stable currency position (and better manage the periods of local currency devaluation).
4. Maintain a flexible structure on the asset side with client loan portfolio (in terms of managing tenor and re-pricing possibilities). This is especially important for larger loans and longer tenor loans (e.g., mortgages). FI’s survival might depend on its ability to adequately reprice the asset side in LCY to maintain a sustainable net margin.

Keeping optimal liquidity and managing net margin

Managing net margin is one of the key strategic actions for any FI. Keeping the funding cost as low as possible and netting it against gross interest rate received from the loan portfolio allows FIs to remain competitive and sustainable. Net margin is affected by the following drivers from the asset side (e.g., loan product pricing, tenor, regulatory restrictions, liquid cash reserves), and the liabilities side (e.g., deposit rates, bond rates, and institutional loan rates with respective tenors for repricing risk purposes).

During the pandemic, almost all the above-mentioned factors were negatively affected, putting significant pressure on net margin. Fortunately, several of those effects were short lived and had quick recovery within a 3-month period. Let us explore some of those factors in more detail:

• Keeping minimum cash position. When a crisis begins, prudent FIs will build up extra liquidity in case funding becomes restricted and collections from the loan portfolio deteriorate. During COVID-19 we observed pressure on cash liquidity for one quarter, on average. With deposits being stable and institutional lenders resuming lending after the initial shock, a majority of FIs managed to build up strong and even excessive liquidity positions. Client demand for new loans was low, while elevated moratorium restructurings on client loans allowed liquidity to remain strong and excessive until the end of 2020.
• Regulatory caps on loan rates. Some countries experienced soft interest rate caps on client loans, which were imposed by the Regulator during the pandemic period. These measures created pressure on net margin in local currency, especially for micro and small loan segments. With anti-inflationary agendas being announced by many governments, further intervention of rate caps on loans can be expected.
• Deposit rates.  Majority of emerging countries experienced pressure on its exchange rate with subsequent depreciation. Despite overall deposit portfolios growing, local currency rates soared, putting pressure on LCY deposit availability and cost.
• Institutional loan rates and availability. With concerns over crisis impact on FI performance, international institutional lenders tightened loan availability for one quarter. The elevated risk environment also put pressure on loan rates, especially in LCY. Hedge market LCY rates were increased by 100-200 basis points for at least 2 quarters. Decrease in LCY rates was observed during Q4 2020 as crisis risk concerns diminished and strong liquidly on the markets persisted.

Overall, the COVID-19 crisis so far has shown almost non-existent credit crunch symptoms as in the previous financial crisis 10 years ago. Support from governments and international lenders facilitated strong liquidity for FIs. However, with global inflationary pressures building up, managing net margins will remain a challenge for the coming 12-18 months.

Our next article in the Covid-19 series

For the next topic in our conversation, please continue to follow this page - where another issue will be further explored and discussed.