Finance: Research, Policy and Anecdotes

Finance in times of COVID-19

In the evening of Thursday, 27 February, I received an email from VoxEU editor-in-chief Richard Baldwin whether I could write a short piece on the possible effects of COVID-19 on the financial sector; deadline: the following Monday. This morning, the eBook was released – a collection of 14 chapters by economists around the globe, with chapter on macroeconomics, trade, policy cooperation and finance.  My chapter (Finance in times of COVID-19) is not trying to predict the impact of the virus on the financial sector, but rather offer some ideas on how to interpret what might happen during the next months. Obviously, the effect of the virus on the financial system will depend on (1) how much further the virus will spread across the globe and its effect on economic activity, (2) fiscal and monetary policy reactions to the shock, and (3) regulatory reactions to possible bank fragility. Current economic scenarios range from a small growth dip over a recession in several affected countries to a global recession as in 2008/9. While there is less monetary policy space today than during the Great Recession, bank regulatory and resolution frameworks certainly offer more policy options than 12 years ago, though the question is whether they are really fit to deal with a systemic crisis. I am writing all this, recognising that there are much more urgent and immediate public policy questions related to containing the spread of the virus and the associated socioeconomic damage.


One big factor will be whether virus-related disruptions will be temporary or persistent. As important as this is for the economic damage done by the virus shock (a V-shaped dip and recovery or a deeper U-shaped recession), this will have repercussions for the financial system. In the case of a temporary disruption to supply chains or a mild demand-side shock resulting in a delay in consumption, banks can serve as support for struggling firms, especially in the case of many European banking systems with close and long-running relationships between firms and banks. Recent research (including my own work with Hans, Ralph and Neeltje) has shown that relationship lenders can help firms during times of recession and economic crisis, and based on their extensive knowledge of firms and long-run relationships. A longer slowdown or even a recession, on the other hand, will put pressure on banks’ loan portfolios and solvency positions. Rather than the recent correction of stock markets across the globe, it will be non-performing loans (as well as a freezing of funding markets) that could be a direct source of bank fragility. Non-performing loans, however, will not show up immediately, but rather (in a negative to adverse scenario) in the second half of 2020.


One starting point to assess the impact of such a negative or adverse scenario are stress tests undertaken by regulators across the globe, including by the Single Supervisory Mechanism (SSM) and European Banking Authority (EBA) for the largest banks in the euro area and EU. The 2018 stress test modelled a cumulative fall of 8.3% over three years relative to the baseline projection in its adverse scenario and concluded that even after such a shock, the average CET1 ratio would still be 10.1%, though with a large variation across banks. Obviously, there might be quite some variation in such an adverse scenario across countries and banks, and there certainly could be bank failures, especially among banks whose loan portfolios are concentrated in the areas most affected.


Regulatory forbearance with respect to loan classification and thus loan loss provisions would be the wrong response. Letting markets guess what the true financial situation of banks is rather than providing such information can make things only worse. While there is an ongoing academic debate on whether more transparency is always better, experience from the early EBA stress tests in the EU – which turned out to be too lenient, with banks that passed the test failing shortly afterwards – suggests that pretending that things are just fine is not conducive to creating confidence. Rather than allowing forbearance on loan classification and thus loan provisions, regulators should instead allow banks to eat into their capital conservation and counter-cyclical buffers. Such loan losses would not show up that quickly anyway and consequent losses would not be expected before late 2020. At the same time, bank resolution frameworks might be put to the test, as will the political willingness to let supervisors and resolution authorities do their job.


Loan losses are only one source of fragility, though. Last October, the Hong Kong Monetary Authority ran a crisis simulation exercise with its major banks, which included the breakout of a disease like the Coronavirus, with the resulting operational challenges. Operational risks can loom large in scenarios with widespread socioeconomic disruption, and the better prepared central banks, regulators and financial market participants are, the more limited the damage to the financial system and the real economy will be.


A third challenge (though related to the previous two) would be the loss of confidence in banks, be it by depositors (resulting in bank runs) or by markets. Loss of access to funding markets can easily turn into systemic distress, and much earlier than non-performing assets will show up on banks’ balance sheets. Swift intervention by central banks as lenders and market-makers of last resort will be critical in such circumstances.


What will be the policy reaction of monetary and fiscal policy authorities? In the euro area, the ECB has all but run out of munition, unlike the Federal Reserve and the Bank of England – with the former having already taken action this week. While there might be still be options to influence the yield curve, large aggregate demand effects cannot be expected from such actions. Lowering already negative interest rates further might trade off aggregate demand effects with putting further pressure on banks’ balance sheets.


Fiscal policy, on the other hand, has quite some space, especially in some of the ‘frugal countries’ such as Germany. Italy has just announced temporary tax cuts and higher health spending, with an obvious negative effect on its fiscal position. This seems the most reasonable approach right now, though it certainly might lead to problems further down the road in terms of Italian debt sustainability. The Italian government has requested that the European Commission relax the fiscal policy targets for Italy in light of both expected growth and a higher deficit resulting from COVID-19.  However, it seems to matter little if the Commission loosens fiscal criteria for the Italian government, as it will ultimately be the market that will take a view on whether or not Italian sovereign debt is sustainable. In a perfect storm, an increase in Italian government bond yields together with rising loan losses could put Italian banks under pressure. While this might seem like a tail risk at this stage, it certainly should not be excluded. Policy responses to such an event would certainly fall outside regular frameworks. They might require a new ‘whatever it takes’, a restart of the Outright Monetary Transactions (OMT) programme (announced by Draghi in summer 2011, but never used) and a coordinated effort at the euro area level.


Which brings me to a final point. COVID-19 is a typical example of a shock that is hard for each country to handle separately. It is a challenge for which ‘Europe’ seems an appropriate level to coordinate action (notwithstanding urgently needed global coordination). Beyond handling the challenges for the health system, economic and financial policy coordination is critical for the EU and the euro area in the case of an adverse scenario. It might very well turn into another historic test for the EU and the euro area, in terms of economic policy response but also in terms of political significance and sending a signal of relevance and strength to its citizens.


In summary, in the most adverse scenario, COVID-19 could have quite important repercussions for the financial system. Immediate attention should obviously be focused on the public health aspects of the virus and on avoiding a global pandemic, if still possible. Adverse solvency effects in the financial system will most likely not be immediate, so appropriate responses can be prepared. Panic and spillover effects in markets, on the other hand, might come much more rapidly, so complacency over short-term effects might be mistaken as well.  The experiences and regulatory upgrades of the past decade will come in useful for regulatory and monetary policy authorities; however, there seems to have been as little preparation as before for a tail-risk event. If I had to make one humble recommendation to regulatory authorities, it would be to (1) focus on possible operational disruptions in the financial system, (2) strengthen confidence in financial markets by clearly signalling that they stand ready to intervene, and (3) prepare for possible interventions in and resolution of failing banks, without ignoring tail-risk events.