Finance: Research, Policy and Anecdotes

Exit strategies

A few months ago I wrote a first blog entry on how to exit from the support that governments have provided enterprises and households with (and from which banks have also directly and indirectly benefitted). Over the past weeks, I have worked with Brunella Bruno and Elena Carletti on a policy note for the ECON Committee of the European Parliament on Unwinding COVID-support measures for banks. The note is also summarised in this VoxEU piece.

 

What have regulators in the EU done over the past year to support the banking system and complements monetary easing and fiscal support programmes?  Loan loss classifications for loans with interest payment moratoria were relaxed as well as the application of IFRS9 accounting rules, which demands forward looking provisioning; risk weights were adjusted for government loan guarantees; banks were allowed to operate below the level of capital defined by the Pillar 2 Guidance (P2G), the capital conservation buffer (CCB) and hold liquidity below the liquidity coverage ratio (LCR), while at the same time banks were asked to refrain from profit distribution; finally, stress tests were delayed to 2021.

 

How should regulators sequence the exit from these support measures? First, none of the regulatory exit steps can be considered in isolation from non-regulatory exit steps. For example, as governments phase out credit guarantees, a need for wide-spread debt restructuring for overindebted firms might arise, with banks being saddled with non-performing assets and a possible need to address bank fragility.

 

Second, there is a clear advantage in sequencing. One, restoring banks’ balance sheet transparency is a first-order objective to be undertaken early on, after moratoria are phased out (or limited to sectors still affected by lockdown measures).  This is critical to avoid zombie lending, as banks have otherwise incentives to evergreen loans, i.e., rolling over non-performing loans rather than recognising losses   Re-establishing the preconditions for banks’ balance sheet transparency is also importantto enhance banks’ ability to raise private funds when ECB funding and liquidity support will be phased out. Two, as support measures are being phased out and hidden losses on banks’ balance sheets come to light, supervisors and resolution authorities have to stand ready to act accordingly. Authorities have to consider the possibility that the current framework will not be sufficient to address bank fragility, especially if bank failures are geographically concentrated.  Close cooperation in scenario and contingency planning between supervisory and resolution authorities as well as with the European Commission (given possible implications for state aid rules) is therefore called for. Three, capital relief should be phased out last and only in combination (or after) dividend restrictions are lifted to thus ease banks’ access to equity funding.

 

In summary, designing proper exit strategy requires judgment as well as coordination among different, national and international, institutions. Whichever the exit strategy, this needs to be communicated in a clear and timely manner. This would provide banks sufficient time and space of manoeuvre, and enable market participants (investors, market analysts, and rating agencies) to take actions accordingly.