Finance: Research, Policy and Anecdotes

FInance in the Time of COVID-19 - a year on!

Today  a year ago I published my first blog entry on Finance in the Time of COVID-19, chapter of a VoxEU eBook. Time to look back and to look forward. A year ago, not much attention was paid to the impact of COVID-19 on the financial sector and rightly so – the immediate focus was on public health. Next came the fiscal policy reaction, supporting households and enterprises during the Great Lockdown(s).  However, here the banking system already took an important role as transmission channel for fiscal support measures (loan moratoria and guarantees but also direct support payments). At the same time, there was the justified fear that ‘banks and financial markets might be catching COVID’, resulting in a swift monetary and regulatory policy reaction.  It was clear already last year that any fragility in the form of non-performing loans would not show up immediately on banks’ balance sheets, but with a delay – though my original estimate of this possibly happening in the second half of 2020 was clearly – in hindsight – naïve (then again, I was also counting to being back on the road by late May)!  Where I was clearly wrong was to call for continued standard loan classification and provisioning standards to be applied – given the high degree of uncertainty, the only wise response was to ease these requirements until more clarity emerged on viability of borrowers. A second source of fragility has not emerged so far: the shift to working from home has worked well for banks and the disruption in public life has not resulted in operational problems for banks. In the long-term, however, the shift to further digitalisation will result in new risks. A third source of risks I pointed to were market disruptions – they happened indeed, with investors chasing liquidity and safety. The central banks as market makers of last resort played a critical role in calming the markets. Regulatory authorities also acted quickly, with capital relief but also imposing profit distribution restrictions, delaying stress tests and an overall accommodative approach.

 

A journalist recently asked me: “Are banks really suffering – or are they actually doing ok or maybe even making profits?” The answer to this is ambiguous. Banks have been affected by loan moratoria and an increase in general (rather than specific) provisions. Loan losses have been limited (because of the easing of classification standards discussed above) and investment banks have been able to profit from a higher volume of market transactions (including larger firms raising funding on public capital markets).  However, it is also clear that the pain is still to come; there is hidden fragility, to surface after the end of support programmes.

 

One additional source of risk that was on many people’s mind a year ago was the re-emergence of sovereign fragility, as countries with limited fiscal space saw a drop in tax revenues and increase in expenditures due to COVID support measures. Early on, many European economists called for a EU-level fiscal response, e.g., in the form of Coronabonds – well, these might be gone, but we got the European Recovery Fund, and thus an entry into common fiscal policy.

 

Where do we go from here? Attention has shifted from support measures for households and enterprises (and thus indirectly for banks) to exit strategies.  As vaccines hold the promise of a return to some kind of new normal, the attention will shift from helping households and enterprises to survive through the pandemic to helping them to adjust to the new reality. There is clearly a need for reallocation at I outlined earlier.  I will come back to this in a later blog entry. It is also clear, however, that while this moment of normalisation might not be here yet, it is important to prepare for it – for widespread overindebtedness in the corporate sector as for banking sector fragility. It is also clear that this does not only require careful coordination and cooperation between governments, central banks and bank regulators, but that many of these steps and possible interventions have to be coordinated if not undertaken on the European level (or at a minimum at the euro area level).

 

Never let a crisis go to waste. There is a lot of talk that the economic recovery should be a green one. There are also opportunities from crisis and recovery in the banking sector. One, the crisis has been a test of the post-GFC regulatory framework and will certainly lead to a debate on lessons learned and possible future reforms. Two, even more after than before the pandemic, the European banking system needs restructuring and consolidation; the crisis can give an impetus for that. Three, the banking union needs completion, this crisis can provide the necessary impetus.

 

Today, my worst-case scenario for the next five years is still the Great Lockdown recession being followed by a financial (and possibly sovereign debt) crisis if the economic exit from the pandemic is mis-handled. But there are lots of positive scenarios – yes, there will be losses, there will be a need for restructuring, but ultimately, the European banking sector (and broader financial system) might emerge stronger. May the experience of the last decade allow policymakers to make the right choices!