On June 26, the Federal Reserve Bank of Boston (“FRBB”) released new guidance on compensation restrictions for Main Street Lending Program (“MSLP”) borrowers. This new guidance defines for borrowers “total compensation” pursuant to restrictions on all programs established through Title IV of the CARES Act (§ 4004), including the MSLP. Additionally, the FRBB updated the financial information a borrower must submit to the lender during the underwriting period of a MSLP loan.
Executive Compensation Restrictions
During the term of the MSLP loan and for one year after (“restricted period”), employees or officers who earned more than $425,000 in total compensation in 2019 are subject to the following compensation restrictions:
Annual compensation cannot exceed their 2019 compensation
Severance pay cannot exceed two times their 2019 compensation
Maximum total annual compensation of $3 million, plus 50% of the excess over $3 million of their total 2019 compensation
Excludes those with collective bargaining agreements dated before March 1, 2020.
According to the FRBB’s new guidance (see FAQs H-12, H-13 and H-14), total compensation includes salary, bonuses, awards of stock, and other financial benefits provided by the borrower and its affiliates to an officer or employee of the borrower but does not include the value of severance pay or other benefits paid in connection with a termination of employment. The specific standards for calculating total compensation vary by business as follows:
Public company borrowers
Must calculate according to the methodology set forth in Item 402(c) of Regulation S-K (17 CFR 229.402(c)(2)).
Nonpublic company borrowers with 2019 revenues less than $10 million
May choose between calculating total compensation according to federal tax rules or the methodology in 402(c).
Nonpublic company borrowers, 2019 revenues greater than $10 million
May choose between calculating total compensation according to federal tax rules or the methodology in Item 402(c).
EXCEPTION – Total compensation for Significant Deferred Compensation Recipients must be calculated according to Item 402(c).
Significant Deferred Compensation Recipients are those whose total compensation that exceeds $425,000, where more than 30% of such compensation consists of “deferred compensation.
Borrower Financial Data
The FRBB also included updated guidance on what financial data the borrower must provide to a lender at the time of MSLP application (in addition to any further data required by the lender). These include:
Financial Information
2019 Results – including the borrower’s 2019 revenues, adjusted EBITDA, and 2019 assets and liabilities, as well as any other data the lender required from the borrower to comply with the lender’s underwriting practices
Most Recent Quarter Results
When the lender submits the loan for sale to the Federal Main Street Special Purpose Vehicle, they must include the following details:
Borrower Identification
Borrower Characteristics
Loan Characteristics
Legal Agreements and Certifications
Lender document upload requirements
See the FRBB’s MSLP landing page for the full set of Frequently Asked Questions, including a redlined version that highlights these recent changes.
How to Apply for a Main Street Loan
An MSLP loan application may be submitted to a federally insured lending institution, which will apply its own underwriting criteria. In addition, the Federal Reserve also released application forms and agreements that must be completed in conjunction with the primary loan application. The documents include borrower certifications and covenants.
The Federal Reserve cautions that “eligible borrowers should contact an eligible lender for more information on whether the eligible lender plans to participate in the program and to request more information on the application process.”
Please refer to the Federal Reserve’s Main Street website for the latest program information.
Countries across the globe instituted lockdown measures to reduce the spread of COVID-19, the novel coronavirus. From the economic perspective, these measures have had a disruptive impact on all organizations, including banks and insurers. While authorities have taken steps to mitigate the worst effects of the pandemic, the risks persist.
In terms of an outlook, much depends on (a) how long the period of COVID-19 disruption lasts, and (b) the degree of further government response. The first point is unknown at this stage. However, we have seen myriad government responses announced or implemented to mitigate the effects of the crisis, including tax payment deferrals, debt moratoria and credit guarantees. In addition, central banks have cut interest rates—for example the Fed’s emergency rate cuts in March 2020—thereby reducing the cost of short-term borrowing.
Not all financial institutions will experience the COVID-19 impact in the same way. Some are better positioned than others. A few banking segments even benefited from COVID-19. For example, debt and equity underwriting performed well and trading income was strong during the market turmoil in March 2020. On the other hand HSBC, to name just one example, reported financial results for Q1 2020 with profits almost halved on increased loan loss provisions due to COVID-19.
We think this is not about ‘weathering the crisis’. Quite to the opposite, banks and insurers have to find strategic answers to a once-in-a-generation structural change. To assess the initial impact (as at the end of April 2020), we have designed a study that explores how COVID-19 has affected market valuations. Our computation is based on a group of international banks and insurers domiciled in the U.S. and in Europe. We start by defining milestones on which we measure the market valuation.
How Were Valuation Measures Impacted During the Crisis?
Source: S&P Capital IQ, DB Research, BDO analysis
As at the date of the five milestones introduced on the previous slide, we calculate the 2021 price-earnings (P/E) forward multiples. While the price (P) is based on the market capitalization at the respective date, the FY 2021 forward earnings (E) are based on analysts’ consensus view.
To provide for a more comprehensive picture, we include the MSCI World Index as well as the Baltic Dry Index, the economic indicator issued daily by the London-based Baltic Exchange that provides an assessment of the price of moving the major raw materials by sea globally. For the purpose of illustration, both indices (as well as other stock market indices presented in this paper) are indexed to December 31, 2019 = 100.
The graph demonstrates that the Baltic Dry Index served as a strong early indicator before the WHO declared that the world should prepare for a pandemic on February 25, 2020 and prior to market values of banks and insurers being adversely affected by the crisis. It is also shown that, at the end of April, this indicator had only partially recovered.
The MSCI World decreased substantially between February 21 and March 11, when the WHO declared COVID-19 a pandemic. Actually, some critics argue that the public health emergency declaration and the pandemic classification by the WHO came too late (and that the pandemic was handled inadequately). In an unprecedented time of stock market turbulence, the MSCI World further declined between March 11 and 31.
The graph illustrates the stark decline of the Forward P/E ratios of both the bank and insurer groups between February 21 and March 11. Note that this decrease was prior to the WHO declaring COVID-19 a pandemic.
Until the end of April, the FY 2021 P/E ratio of the banking group revived to 95% of the December 31, 2019 level (8.5x versus 9.0x), stronger than the MSCI World (87%).
In contrast, the market values of the insurers group measured by P/E ratios recovered to only 78% of the December 2019 level (7.2x versus 9.1x). Is the value of insurers hit more substantially by COVID-19? We will elaborate on this question in more detail on the next slide.
Our Peer Group
Our peer group consists of 20 international banks and insurers domiciled in Europe and in the U.S. and assembled into four groups by means of calculating the median of FY 2021 forward P/E ratios:
Banks
Insurers
Europe
Barclays BNP Paribas Credit Suisse Deutsche Bank HSBC UBS
U.S. banks’ results for Q1 2020 provided a first glimpse of the heavy impact of the COVID-19-induced recession on the banking sector.
According to DB Research, the seven largest U.S. institutions reported a drop in net income of 58% year-over-year. Whereas all banks remained profitable, credit loss provisions rose to $26 billion, 4½ times the level at the end of Q1 2019.
In many segments, business deteriorated, including lower M&A advisory and asset management fees as well as pressure on net interest income. The latter had already been visible for some time since the Fed started cutting rates in summer 2019. In addition, some banks took write-downs on securities and short-term bridge loans.
However, debt and equity underwriting performed well and trading income during the market turmoil in March 2020 was strong.
Initial Value Impact In The U.S. And In Europe Compared
Source: S&P Capital IQ, EIOPA, BDO analysis
As at February 21, 2020, the P/E ratios of U.S. banks and insurers had slightly decreased to 9.5x and 8.7x, which was 93% and 99% of their December 31, 2019 level. In contrast, the S&P 500 increased to 103% of its year-end 2019 level.
The valuation of U.S. banks and insurers experienced a strong decrease between February 21, and March 11. Consequently, during the month of April, U.S. banks recovered substantially, back to 8.7x or 91% of their year-end 2019 value.
Different from banks, the P/E ratio of U.S. insurers only increased to 5.9x during the month of April (67% of the December 31, 2019 level).
Outlook for U.S. Banks
In the coming months, the negative effects of a recession are expected to materialize in the real economy, while mitigating factors, including debt moratoria and credit guarantees, might partly disappear. Volatility and trading volumes will most likely return to a normal level and investment banking business will lack the trading profit that helped the large U.S. banks in March. The Fed’s March emergency rate cuts will most likely affect the banks’ interest margins. Even more important, U.S. banks will need to watch rating migration and the impact credit losses will have on their RWA and capital ratios. Overall, our analysis shows some pronounced differences between the U.S. and Europe regarding the COVID-19 valuation impact, especially a stronger and faster recovery of U.S. banks.
Outlook for U.S. Insurers
U.S. insurers will need to closely monitor solvency ratios in order to meet economic, regulatory and rating agency capital requirements. The volatility and falling interest rates within the financial markets will likely impact life insurance the most, while many insurers have introduced exclusion clauses for epidemics/pandemics into their non-life policies. The latter may apply to business interruption. Lines of business potentially affected include trade credit and workers’ comp. Also, event cancellations may cause greater losses to insurers as a few large events have policies that may cover them even for pandemics. Finally, health insurance will be affected by COVID-19, as healthcare is privately provided in the U.S. (except for Medicare for the elderly and for people with disability status). After COVID-19, many carriers are expected to increase rates and deductibles while limiting coverage.
Source: S&P Capital IQ, EIOPA, BDO analysis
At the end of April 2020, European banks and insurers were back to 84% and 82% of their respective year-end 2019 P/E market valuation, at 6.8x and 8.0x. In comparison, the Eurostoxx 50 was at 78% of its December 31, 2019 level.
European banks continued to be traded at lower P/E multiples compared to their U.S. peers, consistent with the market valuation in previous years. Also, the opposite continued to apply with regard to the valuation of insurers, with European P/E ratios being higher than in the U.S.
In contrast to U.S. insurers, the P/E ratio of European insurers partly recovered until the end of April.
Outlook for European Banks
Unlike their U.S. peers, the large European banks are not focused on investment banking/trading income. They are more active in traditional commercial banking which is intensely exposed to COVID-19 with its focus on the real economy. The lending business of European banks typically has a lower risk intensity than U.S. banks, due to a business model with low-risk mortgages, resulting in lower RWA relative to total assets. An increase in risk during a recession might therefore lead to a higher vulnerability of European banks compared to U.S. banks. Furthermore, major European banks use internal risk models and calculate capital ratios under the Basel III advanced approach, also typically leading to lower RWA. As a consequence for major European banks, a larger CET1 reduction has to be expected in times of a crisis of the real economy.
Outlook for European Insurers
For European non-life and life insurance, we refer to the outlook for U.S. insurers. Furthermore, in contrast to the U.S., healthcare insurance will most likely not be much affected due to public provision in most European countries.
EIOPA, the European Insurance and Occupational Pensions Authority, strongly encourages insurers to consider practical implications of COVID-19 for the day-to-day activities of consumers, in particular with regard to the social distancing and self-isolation. Specifically, EIOPA asked European insurers on April 1, 2020 to consider the interests of consumers and exercise flexibility in how they are treated, where reasonable and practicable.
Digital Transformation in the Pandemic and Post-Pandemic Era
If there were any lingering doubts about the necessity of digital transformation to business longevity, the coronavirus has silenced them. In a contactless world, the vast majority of interactions with customers and employees must take place virtually. With rare exception, operating digitally is the only way to stay in business through mandated shutdowns and restricted activity. It’s go digital, or go dark.
This digital mandate isn’t new; it’s simply been brought into sharp focus. Prior to the pandemic, a paradigm shift towards digitization and servitization of the economy was already underway. Current events have accelerated the paradigm, as evidenced by the marked shift in spending towards digital businesses.
And this is just the beginning.
The pandemic is a reality check for businesses that have been reluctant to embrace digital transformation and now find themselves woefully unprepared. On top of the stress of potentially health-compromised employees, a sudden and dramatic drop-off in demand and total economic uncertainty, these digital laggards are now scrambling to migrate their operations and workforce to a virtual environment. While fast and furious is the name of the game when it comes to digital innovation, fast and frantic can lead to mistakes.
On the other hand, businesses that had not only developed digital strategies but executed on them prior to the pandemic are now in a position to leapfrog their less nimble competitors. That isn’t to understate the COVID-19-related challenges they now face, irrespective of their current level of digital maturity. Going digital in and of itself isn’t a panacea to all that ails businesses in the current economic environment. They do, however, have significantly more tools at their disposal to not only weather the storm, but to come out the other side stronger for it.
Don’t write off the digital laggards just yet, however. Crisis breeds ingenuity, and good ideas put into practice can propel any business to breakout performance. Organizations that rest on their existing digital laurels can be surpassed by those that invest in adapting their digital capabilities for the post-coronavirus future—a future that looks very different from the world pre-pandemic.
Spotlight: The Digital Advantage
Organizations that embrace digital solutions have greater resiliency in the face of adversity—and a leg up on the competition that will enable them to recover faster and pivot from playing defense to chasing growth.
Efficiency advantage:They harness digital technologies to streamline operations and automate manual processes—resulting in greater speed, less waste and more focus on revenue-generating activities.
Productivity advantage:Their employees were already set up to work remotely, so their focus is on leveraging collaboration technology and tools to maximize workforce productivity and sustain company culture.
Security advantage: They are better prepared for and more resilient to the proliferation of cyber threats in the current environment.
Customer advantage:They mine customer data to monitor for shifts in demand and uncover emerging customer needs.
Agility advantage: They leverage data-driven insight to make decisions faster and act on them faster. They have built-in cultural flexibility to adapt or change course at any point.
New Reliance on Digital Solutions During COVID-19
Under COVID-19, the world has, by necessity, gone into isolation. Social distancing is currently the most effective way to slow the spread of the virus until a vaccine can be found to protect the population. As a result, anything that relies on human-to-human contact–which is to say, most aspects of our lives–must be amended to account for the dangers of the virus.
Digitization has stepped in to bridge the gaps left by mandated shutdowns and social distancing measures. Without digital tools and technologies, we would have no way to work, shop, go to school, and more.
Let’s take a closer look at how digitization is keeping society–and businesses–afloat during the pandemic:
Remote Work: Before the pandemic, only 30% of U.S. employees worked remotely 100% of the time, according to Owl Labs. For the other 70%–including the 38% of the total U.S. workforce that only worked on-site—the transition to working remote full-time has been a shock to the system—figuratively, and in some cases, quite literally, when user demand has exceeded system bandwidth. But the silver lining is that with such a high percentage of the working population now remote, digital collaboration is improving in leaps and bounds, both in terms of the sophistication of the tools to facilitate it and workers’ level of comfort with it.
Omnichannel Commerce: As many physical business locations are shut down, consumers are turning to online shopping to meet their needs, even those who had historically been reluctant to do so. In particular, grocery delivery services, such as Instacart, have been in high demand. Consumers can choose their groceries, pay online, and leave feedback all on one convenient app. Businesses are blending the physical and the digital to provide for their customers through delivery methods such as curbside pickup and contactless delivery. Physical-digital integration is more important now than ever before.
Digital Content Consumption: Homebound consumers are turning to digital content providers to meet their entertainment needs. 51% of internet users worldwide are watching more shows on streaming services due to the coronavirus, according to data from Statista. Netflix alone saw 16 million new signups for its service in the first three months of 2020. Meanwhile, many film studios have been pushing new releases to streaming services early to captive audiences.
Platformification: Institutions and organizations of all types are trying out digital platforms to stay above water during the pandemic. The fitness industry has shifted to holding virtual classes on streaming services, both live and pre-recorded. Almost every school, from elementary schools through graduate programs, have shifted to online courses. Large-scale conferences and events are being held virtually. The NYSE has moved entirely to online trading. While some businesses will revert to their traditional models when the crisis abates, others may opt for a hybrid approach as they recognize the benefits of recurring revenues.
Digital Health Solutions: Much of America’s healthcare system has gone digital to alleviate some of the strain imposed by the coronavirus. Telemedicine and remote diagnostics are helping patients get medical advice and diagnoses at home so they don’t need to come in to the doctor’s office or hospital, and 3D printing is being used to expedite the production of critical medical supplies, such as PPE. In the absence of a vaccine or proven treatment, the best preventative medicine is information-sharing. Digital contact tracing has already been used to effectively slow the spread of COVID-19 in East Asia. The technology itself is at least a decade old but has struggled to gain traction in the Western world where views on privacy have been prohibitive. Whether American citizens (and those that govern them) will be willing to trade individual privacy rights for the greater public good remains to be seen, but there may be more leniency around data collection going forward.
The pandemic serves as a widespread test case for the effectiveness of these digital solutions, many of which will be permanent fixtures and lead to long-term changes for many businesses.
The Case for Digital Transformation in Crisis
The economy is now mired in a downturn, which may outlast the current (and hopefully sole) wave of the pandemic. Some organizations may be inclined to retrench on their digital transformation plans, as part of a broader belt-tightening agenda. A good cost reduction program focuses on trimming the fat without cutting away the essential parts of the business that are necessary to sustaining current levels of business performance. If we view an organization as a living organism, digital transformation powers the backbone, muscle, brain and heart of the organization. Halting digital innovation efforts in crisis will significantly compromise overall business health.
Though it may seem counterintuitive, crisis is the ideal time to double down on digital transformation. Rather than putting digital transformation plans on hold, organizations need to go all in.
It shouldn’t be prohibitively expensive. Many businesses are understandably reluctant to loosen the purse strings in the current environment of uncertainty. While digital transformation is often viewed as a massive upfront investment in long-term results, it doesn’t need to be. Some of the most successful transformation projects start with low-cost pilots and limited resources that are scaled up once the kinks are worked out and the results are proven. Done in the right way, digital transformation can be self-sustaining, with each incremental improvement paying for the next leg of the journey.
You can actually save money. Past recessions show that controlling costs by improving operational efficiency—a task for which digital solutions are perfectly suited—is more effective in sustaining businesses through financial turbulence than traditional cost-cutting measures alone. For example, companies that rely primarily on workforce cuts to manage costs only have an 11% chance of “breakaway performance” coming out of a downturn, whereas companies that focus on operational efficiencies over layoffs are more likely to experience breakaway performance, according to research from Harvard Business Review.
The biggest efficiency play is automation. With automation projects, ROI is realized near-instantaneously, offsetting the upfront investment. Robotic process automation allows organizations to automate certain types of work processes to reduce the time spent on costly manual tasks and reallocate resources elsewhere. The economics of automation are simple: the same work is performed faster and with fewer mistakes, while human capital resources can be redeployed to higher-value tasks or to fill critical gaps. More sophisticated machine learning tools can be used to identify and address unforeseen areas of waste.
Business reinvention isn’t always a choice. Many businesses are experiencing devastating financial consequences from the pandemic, whether because of supply chain impacts, forced shutdowns, a significant pullback in consumer spending, or all of the above. Consumer discretionary manufacturers and retailers, oil and gas companies, and the service industry are among the sectors that have been struck the most grievous blows. To avoid catastrophic revenue losses, these companies have no choice but to shift focus to their business’s existing digital channels or make a bigger pivot to a digital business model. But again, there is a silver lining: The innovations that are made out of necessity could become lasting pillars of the business that help it to thrive well beyond the pandemic.
There will be no “return to normal”. The coronavirus is permanently reshaping the way we live and work. Some of the behaviors developed in crisis—including wide-scale digital adoption—will outlast the pandemic, well after restrictions on activity are lifted. To stay competitive, organizations must respond to these behavioral changes and meet emerging customer demands. Savvy organizations will focus now on leveraging advanced analytics to extract insights from their customer data and continue internal and external data integration efforts to develop a more holistic view. Detecting those signals of change early will be crucial to optimizing the customer experience and redefining customer value propositions in line with evolving preferences and needs.
COVID-19 Trends Here to Stay
Remote Work Arrangements
Digitization of Customer Service
Shift to e-Commerce
Greater Use of Self-Service
Contactless Delivery Options
Outsourced IT
Customers Focusing on Spending Less and Saving More
Increased Focus on Safety, Cleanliness and Health
Bulk-Buying and Stockpiling
Use of Online and On-Demand Platforms
Summary Digital transformation is more necessary during this crisis, not less. But that doesn’t mean it will look the same as it did before the pandemic. Resources—both in terms of talent and money—will likely be constrained. Digital initiatives may need to be reprioritized based on relevance in the current environment. New problems and opportunities may come to light with greater urgency. For some businesses, the forces of disruption may be so great that the long-term strategic vision will need to be overhauled. And any digital transformation roadmap that does not deliver value at every increment will need to be reimagined. The key is continuing to experiment and innovate with digital solutions front and center. With the right approach, businesses can come out of the fray stronger, more agile, and more customer-centric than before.
