The COVID-19 Pandemic: did companies prepare for this?
As with every individual, companies too are exposed to risks. Therefore, once a year large companies carry out a risk inventory assessment, answering a simple question: What can go wrong? The primary risk of non-financial corporates is business risk, i.e. the risk that they can’t sell as many products/ services as they wanted and/ or not at the planned price. By contrast, the primary risks for financial companies are financial risks like credit and market risk. The business risk of new business is not that important. The COVID-19 pandemic has hit companies hard and suddenly. But, has it hit them entirely unexpectedly? Was there something missing in companies' risk management universe? These are the questions we seek to answer in this article.
A "pandemic scenario" can be expected to play out differently across a number of industries, although the following characteristics can be deemed more or less relevant:
production is stopped or seriously hampered
turnover suddenly drops close to zero
fixed costs remain unchanged
Financial markets collapse because growth and dividend expectations are reversed based on some supervening event or outcome that had not been priced into the market until that point. This is a knee-jerk short term "lockdown shock" to the new information, that is usually followed up by a "standard recession" in which growth stagnates into the negative.
To prepare for disruption to their productions, companies design and implement business and continuity plans. In the current modern economy, supply chains are designed to run as efficiently as a possible, cutting costs at each link in the chain. This is notably present in “just-in-time” productions companies which run without warehousing capabilities, and are as a result far more susceptible to (temporary) defaults of their supply chain. They most likely have contingencies to deal with this and minimise delays when this happens. Whether they have built in contingencies to deal with the closure of borers, land and air space is, however, questionable. But, whether they should have had contingency plans in place to deal with this is also questionable.
This is primarily because there are costs involved in preparing for hypothetical loss/risk scenarios, and no company can protect itself against all potential disruptions. Even with an unlimited risk budget, it will most likely be technically impossible. Moving staff to home office is only possible for certain business models. No business continuity plan can prepare a company for a pandemic if that company’s service or product requires the physical presence of its client (e.g.: cab drivers, restaurants, hairdressers etc.) or its staff (e.g. craftsmen, mechanics, plumber etc.). Thus, these businesses do not have to review their business continuity plans. By contrast, other production models can move to home office (e.g. back offices) and online production (online sales). Some business continuity plans (for example for banks) haven’t been prepared for the sudden need of so many staff members working from home and thus, need to be reviewed.
Companies also prepare themselves against scenarios of financial disruptions, including profit drop and liquidity shortages, by simulating stress with statistical models and scenario analysis. Typical stress scenarios include:
recessions with drops in turnover and lengthening/default of payment cycles
financial market crises (especially for financial companies)
These scenarios imply losses and liquidity shortages against which companies prepare themselves by holding capital and liquidity buffers.
However, it is very likely that "a viral pandemic" wasn't a scenario that companies have tested. If existing/ tested scenarios are as severe and with a similar time-line to those experienced in a pandemic scenario, the tested scenarios would lead to similar liquidity and capital buffer requirements as those needed in response to a pandemic. It follows that, although not having tested exactly the pandemic scenario but a similar one, banks should be prepared for the pandemic scenario, too. Moreover, it is not important to predict the correct scenario, but rather predict the correct consequences. How the scenarios are named and what they represent is of secondary importance.
As an example, Lufthansa applied for government assistance just two days after the travel ban for Europeans to the U.S., the case study provided below shows that for some companies, a "pandemic" is likely to go beyond tested scenarios in terms of severity and time profile, and that they have not been prepared for it.
A case study lesson from Lufthansa:
In 2018, Lufthansa reported 36 bn EUR revenues (3 bn EUR per month) and 2 bn EUR profit. If this year, all of Lufthansa’s planes are grounded for 20 calendar days and all costs (save for fuel and catering) are assumed to be of fixed nature, Lufthansa would report still no loss. Lufthansa has 9.5 bn EUR equity. If all planes would be grounded for 70 days, not only the planned annual profit would be gone, but also 50% of Lufthansa’s capital would be depleted. After 120 calendar days of having its planes parked on tarmac instead of up in the air, Lufthansa would be insolvent. It it very probable that it will take 50 calendar days or more until economic processes return to business as usual. That Lufthansa will be able to recover the lost revenues later is unlikely as lost business trips are unlikely to happen later (business partners might have virtually met in the meantime) and many households might have to revise their holiday budgets due to (temporary) unemployment and income drops. Therefore, it is very likely that Lufthansa’s stress scenarios and -models have not fully anticipated the financial implications of a Pandemic and thus, Lufthansa was not financially prepared for it.
Given that business risk is not as important for financial companies, this may lead one to question whether banks have been financially prepared for a pandemic. Banks are first hit through the short-term lockdown that leads to market turbulences, liquidity withdrawals, higher credit demand, etc.. On a mid-term horizon, banks suffer from increased default rates among those borrowers with production/ income models that are most vulnerable against a pandemic. Thus, the pandemic scenario is composed of sub-scenarios that banks are regularly testing. Banks would have been – even without having explicitly tested a pandemic scenario – prepared for short-term market turbulences; and the mid-term recession in the composite pandemic scenario do not turn out to be much more sever that in the tested stand-alone scenarios.
Banks are prepared for scenarios like the one that EBA (European Banking Authority, the European banking regulator) has tested in 2018. The scenario of 2018 assumed that GDP unexpectedly drops by 4% in 2020, by 4.9% in 2021, and by 0.4% in 2022 from its expected growth path. Stock markets were assumed to drop by 30% in 2020, by 28% in 2021 and by 22% in 2022 (i.e. by 70% compared to its value in February 2020). Furthermore, it assumed that Probabilities of Defaults (PD) triple. Finally, it estimated that credit spreads increase by 0.80% and interest rates by 0.60% every year. For all banks that have been tested, the outcome put their annual profit at risk, but not their existence: the Common Equity Tier 1 ratio (CET1 ratio) dropped on average from 14% to 10%. Translated into our Lufthansa example, the severity of the EBA scenario corresponds to 40 calendar days of parked planes. The drop of 4% from 14% to 10% are European averages and of course there might be individual banks that are poorly prepared for such a scenario. For example, NordLB with its CET1 ratio of 6% (instead of 14% like the European average) and a simulated drop of 6% (instead of the 4% like the European average) might be substantially challenged. Thus, if the pandemic-induced recession does not turn out to be much more severe than the 2018 EBA stress test, banks’ annual profits are at risk, but not their solvency. Also the recently witnessed financial market turmoil (Dax: loss of 12% on 12th March 2020, 30% since February 2020) are within the severity tested by EBA. It is unlikely that we will observe a Pandemic-induced GDP drop of more than 4%. However, the GDP assumptions from above were used for German banks. The scenario for Italian banks only assumed a drop of -2%/ -2.8%/ -1.9%. It might well be the case that COVID-19 sends Italy into a recession that is well above the tested one leaving some Italian banks at the edge to fail.
Naturally, this provides a segue into our next important question: will the pandemic reality be much worse than the 2018 EBA simulated one? The forced and very sudden stop of some industries (transport, restaurants, retail) for 6 weeks has the effect of fast-tracking a recession. This can lead to liquidity shortage, because large corporates, small and medium enterprises (SME), and contractors must withdraw their deposits (their liquidity reserves) to cover fixed cost in times of zero revenues. Banks test for liquidity shortages, but in their models they usually assume 50% withdrawal for large corporates, but only 10% for SMEs and contractors. Pandemic reality might prove this to be much worse – especially for banks with a broad retail and SME franchise. Once, the liquidity reserves are spent, clients switch to credit lines and will extensively draw on them. The 10% drawing that banks are prepared for might prove to be too low. To what extent banks are hit by the PD- and GDP – evolution depends on banks’ willingness to actually respond to the higher credit demand in times where banks’ capital base is tight. Especially in times of large uncertainty, banks might prefer to hoard capital for uncertain bad times instead of spending it on new lending. To ensure sufficient lending, the government could initiate a lending campaign where it lends to banks and they lend it to customers. What would be of high importance is that banks do not carry the default risk, but that this is passed onto the government. Keep in mind that the ultimate lender is the government. Banks merely serve as distribution channel. This brokered lending model would not affect banks’ capital ratios.
To conclude, companies prepare themselves with business continuity plans, capital- and liquidity buffers to withstand potential operational disruptions, losses and liquidity shortages induced by challenging circumstances. Thus, companies should be prepared for recessions and market turmoil. That companies haven’t tested the scenario “pandemic” does not mean that they are not prepared for it. Only in instances where a “Pandemic” is much more severe and exhibits a very different time pattern than the scenarios “recession” and “market turmoil”, would a particular company’s survival be at risk. This could well be the case because the pandemic scenario, with its sudden economic lockdown, affects companies’ financials much quicker than a recession. In a recession, revenues gradually drop over months. By contrast, in a pandemic lockdown, revenues – depending on the type of business – can drop within days and literally remain zero for weeks. This can trigger larger losses and liquidity shortages than in tested recession scenarios where companies have more time to adjust their cost base to decreasing revenues, looking for sales alternatives and thus limit the negative implications. The lockdown acts like a fire accelerant. Pandemic scenarios (short-term: 0 revenues, cost carry on, mid-term: “normal” recession) do not hit all companies the same way: some can move their production or sales model “online”, others can’t. Companies that are fully exposed to the lockdown cannot prepare themselves through testing a recession scenario for it. These companies should extend their scenario testing incorporating a “pandemic scenario” with a pronounced lockdown element. One can expect (and hope) that future pandemic scenarios will be less severe, because politicians and companies have learnt their lessons from the outbreak of COVID-19. However, it is also possible that while testing a pandemic scenario some companies might conclude that the cost of being prepared for a pandemic scenario would be way too high (as is the case for airlines as an example). Those companies would simulate these scenarios but would not try to maintain framework of preparation for it, but would hope for direct or indirect government assistance to alleviate the situation. A company and its shareholders cannot be prepared for all risks. Especially, if revenues drop because of government intervention to protect society, it should also be the government that offers remedies to partially offset the consequences. The beneficiary of the intervention should pay this: society. In any case, every company should at least simulate the pandemic scenario consisting of short-term lockdown and mid-term recession.