Finance: Research, Policy and Anecdotes

Finance in times of COVID-19 - what's next?

As the COVID-19 pandemic continues its march across the globe, with the epicentre having moved from Asia to Europe (with another move towards the Americas possible in a few weeks), the socio-economic disruptions have increased the likelihood of a global recession and with that of problems in the financial system.  What can policymakers do now and what should they be prepared to do when the damage will become clearer when the virus has receded?   While there is a high degree of uncertainty and limited information, lessons from previous crises can come in useful to define possible policy actions and gauge policy actions that have been taken.  The following discussions will focus on three main policy steps:


(i)             Governments have to stand ready as the ultimate loss absorber, in the first instance for the real economy, but also for the banking system

(ii)           This has to happen on the EU or eurozone level, given limited fiscal space for some countries

(iii)         This has to be announced clearly and early on to create confidence


Proactive measures needed


COVID-19 and the disruption it has caused and continues to cause constitute an enormous shock to both real economies and financial sectors, reflected in financial market distortions, mis-aligned prices (which arbitrage should make unsustainable in normal times) and funding concerns for many market participants, including banks. The problems originate in the economic disruption: not earning money, households might not be able to repay mortgages and consumer credits; not having clients or not being able to produce goods/services results in lost revenues for firms, undermining their ability to repay loans. But it is more: where they have them available, firms are drawing down credit lines to have a sufficient cash buffer during times of economic disruption. This trend is exacerbated as access to market finance is drying for most firms that used to have access to it.  While banks can help overcome their clients’ liquidity constraints, they have a limited ability to do so.  Initiatives such as by the UK government and Bank of England as well as of the German and French governments to offer funding liquidity for banks and credit guarantees can be helpful in this context. Fiscal support measures can also help mitigate the negative effect of the crisis on banks’ asset quality by ultimately targeting the source of the losses.


One of the defining characteristics of bank lending over the business cycle is its procyclicality: in a recession banks reduce lending rapidly, especially to smaller enterprises and riskier borrowers. While some of this lending retrenchment is demand-driven, agency conflicts at the core of banking point to substantial supply-effects. Regulation can further exacerbate this procyclicality, requiring forward-looking loan classification (as under IFRS 9) and provisioning, as well as forcing an increase in risk weights and thus capital.   Anticipating negative effects from the disruption for real economy and financial sector and mitigating these negative effects is therefore critical and urgent. Steps taken by supervisors across Europe to (i) lower countercyclical buffers where currently above zero, (ii) reduce capital requirements, allowing banks  to operate temporarily below the level of capital defined by the Pillar 2 Guidance and the capital conservation buffer (CCB), and (iii) allowing banks to operate below 100% of the liquidity coverage ratio (LCR) are adequate and can help reduce risks of lending retrenchment. Capital forbearance seems the correct way to go; hiding losses less so.


In addition, it seems advisable to stop the clock on the timeline for implementing further capital increases under Basel III reforms as well as delay the EBA 2020 stress tests (as it has already decided to do). Building capital buffers is important, but timing is critical.


While all these measures can help mitigate credit retrenchment and thus avoid a deeper recession, losses for banks and reduced equity buffers will still be a concern for markets. While these losses might not show until later this year, financial markets will price them in as soon as more information become available, which will require further forward-looking actions, discussed below.



Instilling confidence


Government is the ultimate backstop for absorbing losses in crisis situations like this one. One of the critical tasks for policymakers is to provide a maximum degree of certainty and instil confidence. As much as this applies to the public policy response to the health crisis caused by the virus, it also applies to the financial sector.  Communication is critical in these circumstances. We saw both good and bad examples last week, with Christine Lagarde’s remarks during her 12 March press conference that the ECB was not in the business of reducing spreads causing immediate negative financial market reactions as well as positive reaction to the correction of these remarks by her subsequent interview and the blog by ECB’s chief economist Philipp Lane the following day.  Standing ready as lender and market-maker of last resort and providing clear signals that central banks will stand ready to avoid any price overshooting and market freezes is critical in such situations.


Planning ahead


Assuming projections on how the virus will play out turn out to be accurate, the attention will turn to economic recovery later this spring and early summer. This will also be the moment, when there will be a clearer picture of the losses in the financial system and policy actions will be needed. The regulatory reforms of the past ten years, including bank resolution frameworks, will then be put to their first massive test.  


As many economists, I have pointed to missing elements in the banking union: a common deposit insurance scheme and a limited funding backstop for the SRF. While the former has still not been addressed, there is progress on the latter, but probably not in time for the current crisis.  Another misstep in my opinion was that a new regulatory framework was being implemented without the legacy of the crisis being addressed first. The Italian approach to bank failures in recent years can be easily explained with this legacy: bailinable debt that was politically not bailinable and legacy assets that had not been resolved yet resulting in taxpayer support where such support was – at least in principle – not to happen under the BRRD. A final item on the unfinished agenda has been to cut the link between banks and governments in the eurozone, which would require concentration limits for sovereign bonds and the creation of the safe assets. Obviously, these are not reforms that can be introduced in time for a possible crisis later this year, but one can hope that a crisis might be the trigger for finally completing the banking union.  


It is widely accepted that the bank resolution regimes established under the BRRD across the EU and on the euro-area level are not adequate for a systemic banking crisis.  If we see widespread bank undercapitalisation if not failures, a flexible and systematic approach is needed, and on the Eurozone rather than national level.  


We might easily come into such a situation later this year when authorities in the eurozone are faced with several mid-sized if not large banks showing significant undercapitalisation. At a time when the real economy will try to get back on its feet and will have to rely on bank lending for this, widespread recapitalisation efforts with taxpayer support might be the only option.  Applying an approach built for idiosyncratic bank failures – including bail-ins and liquidation -, on the other hand, might deepen the crisis further.


Some countries, most prominently Italy, might not have the fiscal policy space for such a recapitalisation of banks and might also face limits in direct support for the real sector. This is where a eurozone response is required. While the ESM has the option (so far not used) to directly recapitalise banks, the total amount is limited to 60 billion euros. An alternative option, more adequate for a systemic crisis situation and suggested by several economists, is to establish a eurozone-wide bank restructuring agency (e.g., Beck and Trebesch, 2013).  Such a temporary agency could be in charge of restructuring viable and non-viable banks throughout the eurozone, funded by the ESM and possibly leveraged with private sector funding. Such an ad-hoc approach would also signal that these are special circumstances and that the eurozone is not falling back into the bailout mode.



The moment for European solidarity


There has been less coordination across EU countries in public health responses than optimal.  Many countries have also taken decisive actions to address the economic disruptions caused by the virus-induced social shutdown, while there are tentative efforts at the EU level to follow suit. However, the fiscal firepower of such efforts on the EU level is simply not enough. A longer recession and increased fiscal policy demands might turn some member countries’ fiscal position unsustainable, further undermining their banking sector, and deepening the crisis further.


For the eurozone to survive such risks, a eurozone- or EU-level approach is needed. This is the moment of European solidarity, required on the highest political level, i.e., the European Council (EU heads of governments). As wrong as president Lagarde’s remarks were during her 12 March conference (“we are not in the business of reducing spreads”), as clear is it that it is fiscal policy that has to finally come to the table.  Monetary policy has carried for too long the burden. Yes, the ECB will again step forward when needed, but it is clear that this is politically not a long-term crisis resolution strategy.


It is time for a fiscal policy “whatever it takes” moment in the euro area. During the eurozone crisis, there was often talk of moral hazard risks coming with “bail-outs” of peripheral countries of the euro area. As wrong as these criticisms were then, there is no basis whatsoever for such concerns now, as this is an exogenous shock.  It is important to stress that it is not enough for the European Commission to loosen budget guidelines for national governments, as financial markets will still price in countries’ debt sustainability. Now is the time to put the money where the words are – a post-pandemic eurozone budget where fiscally stronger countries help fiscally weaker and more affected countries. Addressing a possible systemic banking crisis jointly can be part of such an effort.


And even though events are still unfolding, and the final tab has not been passed on, stating upfront and clearly that eurozone governments stand together and will fiscally do whatever it takes, can be incredibly useful!