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Numbers

May 12, 2021 by José Manuel Mansilla-Fernández

Authors

José Manuel Mansilla-Fernández[1]Public University of Navarre and Institute for Advanced Research in Business and Economics (INARBE).

 

Incidence of the Covid-19 in Europe

Figure 1: The Covid-19 pandemic exploded in Europe in March 2020; a second wave started in Fall, with more heterogeneous effects across countries. Lockdowns and social distancing measures had a strong negative impact on the economy.

Source: Own elaboration based on data from Refinitiv Eikon. Data are presented as a 5-day moving average to smooth variations in recording daily deaths.  

 

Figure 2: The Great lockdown in Europe (2020Q1 and 2002Q2) diminished production substantially, although economic recovery began in the second half of the year (2020Q3 and 2020Q4).  

Figure 2: The Great lockdown in Europe (2020Q1 and 2002Q2) diminished production substantially, although economic recovery began in the second half of the year (2020Q3 and 2020Q4).  

 

The impact of the Covid-19 crisis on the banking sector

Figure 3: Investors perceived banks as comparatively safer institutions during the Covid-19 crisis than during the sovereign debt crisis. The European Central Bank’s pandemic programmes supported more favourable financing conditions. 

Source: Own elaboration based on data from Refinitiv Eikon. The lines represent the daily difference between 5-year Banks’ CDS and 10-year Sovereign Bonds CDS.  

 

Figure 4. European banks slightly improved their capitalization during the Covid-19 crisis.  

Source: Own elaboration based on ECB data. The Tier 1 capital ratio is defined as the proportion of tier 1 capital – equity capital and disclosed reserves – to total risk-weighted assets.Interruzione pagina 

 

Figure 5. The dispersion of Tier 1 capital across banks increased during the Covid-19 crisis, and more in some countries than in others. 

Source: Own elaboration based on the EBA database. The Tier 1 capital ratio is defined as the proportion of tier 1 capital – equity capital and disclosed reserves – to total risk-weighted assets. The whiskers represent the maximum and the minimum of the distribution. The box is divided into two parts by the median. The upper (lower) box represents the 25 percent of the sample greater (lower) than the median up to the third quartile and down to the first quartile). The mean of the distribution is represented by ×. 

 

Figure 6. Banks slightly increased the share of domestic sovereign bonds held in their balance sheets, the more so in periphery countries.

Source: ECB. Ratio of the holdings of domestic sovereign debt and total assets by MFIs in each country. Core countries are Austria, Belgium, Finland, France, Germany, and the Netherlands; periphery countries are Greece, Ireland, Italy, Portugal, and Spain (see the Numbers note in the European Economy 2016.1 issue). 

 

Figure 7: Bank lending increased on average in the Euro zone, but at different rates across countries. 

Source: Own elaboration based on ECB data. Figures are year-on-year percentage changes of the stock of banks loans.  

 

Figure 8. The ratio of non-performing loans (NPLs) to total loans reduced slightly during the pandemic. 

Source: Own elaboration based on ECB data. This ratio is calculated as the volume of impaired loans to total loans by country.

 

Figure 9. The share of loans under forbearance, and its evolution during the pandemic, are heterogeneous across European countries.  

Source: EBA Risk Dashboard. The forbearance ratio is calculated as exposures with forbearance measures to total gross loans and advances. Forbearance denotes a situation where a lending contract or other bilateral credit relationship has become problematic (in the sense of unexpectedly deviating from contractual cash flows due to the actions of one counterparty) leading to lender granting concessions or modifications that it would otherwise not consider.

 

Moratoria and Public Credit Guarantee Schemes (PGS)

Figure 10. In some European countries, contingent liabilities related to the government guarantees offered on bank loans are a relevant share of new loans. 

Source: EBA supervisory reporting.  

 

Figure 11. Loans under moratoria is comparatively higher in the so-called periphery countries than in core countries.  

Source: EBA supervisory reporting.  

 

Figure 12. The share of loans under moratoria which are classified as Stage 2 is heterogeneous across European countries, and it is higher than the average share of loans classified as Stage 2 in the country.  

Source: EBA supervisory reporting; data refer to 2020Q2. According to the International Financial Reporting Standard (IFRS) 9, a loan should be classified as stage 2 when its credit risk has increase significantly, and the payment past due by 30 days (underperforming). Countries included in the sample are: Austria (AT), Belgium (BG), Bulgaria (BG), Cyprus (CY), Denmark (DK), Estonia (EE), Spain (ES), Finland (FI), France (FR), Greece (GR), Croatia (HR), Hungary (HU), Ireland (IE), Iceland (IS), Italy (IT), Lithuania (LT), Luxembourg (LU), Latvia (LV), Malta (MT), The Netherlands (NL), Poland (PL), Portugal (PT), Romania (RO), Sweden (SE), Slovenia (SI), and Slovakia (SK). 

 

Figure 13. European banks increased their holdings of cash and central bank reserves, partly as a result of central bank funding. 

Source: EBA supervisory reporting.

 

Figure 14: Bank deposits increased in all European countries.  

Source: Own elaboration based on ECB data.  

 

Figure 15. Bank profitability generally decreased in all major European countries during the Covid-19 pandemic crisis.

Source: Own elaboration based on ECB data. The return on equity ratio is calculates as the annualized operating profits before taxes over total equity and represents banks’ profitability. Data are adjusted for seasonality.   

 

Stylised facts on moratoria and public guarantee schemes (PGS)

Figure 16. NPL ratios are larger for countries with higher level of loans subject to moratoria.  

Source: Own elaboration based on the EBA database; data refer to 2020Q4. NPL ratio is calculated as the value of amount of non-performing loans to that of total loans. Countries included in the sample are: Austria (AT), Belgium (BG), Bulgaria (BG), Denmark (DK), Estonia (EE), Spain (ES), Finland (FI), France (FR), Croatia (HR), Ireland (IE), Iceland (IS), Italy (IT), Lithuania (LT), Luxembourg (LU), Latvia (LV), Malta (MT), The Netherlands (NL), Poland (PL), Romania (RO), Sweden (SE), Slovenia (SI), and Slovakia (SK). 

 

Figure 17. Debt-to-GDP ratios are higher in countries with a larger share of loans subject to moratoria.  

Source: Own elaboration based on the EBA database; data refer to 2020Q4. Countries included in the sample are: Austria (AT), Belgium (BG), Bulgaria (BG), Cyprus (CY), Denmark (DK), Estonia (EE), Spain (ES), Finland (FI), France (FR), Greece (GR), Croatia (HR), Hungary (HU), Ireland (IE), Iceland (IS), Italy (IT), Lithuania (LT), Luxembourg (LU), Latvia (LV), Malta (MT), The Netherlands (NL), Poland (PL), Portugal (PT), Romania (RO), Sweden (SE), Slovenia (SI), and Slovakia (SK).  

 

Figure 18. The Tier 1 capital ratio is found to be lower in countries with higher level of loans subject to moratoria.  

Source: Own elaboration based on the EBA database; data refer to 2020Q4. Countries included in the sample are: Austria (AT), Belgium (BG), Bulgaria (BG), Cyprus (CY), Denmark (DK), Estonia (EE), Spain (ES), Finland (FI), France (FR), Greece (GR), Croatia (HR), Hungary (HU), Ireland (IE), Iceland (IS), Italy (IT), Lithuania (LT), Luxembourg (LU), Latvia (LV), Malta (MT), The Netherlands (NL), Poland (PL), Portugal (PT), Romania (RO), Sweden (SE), Slovenia (SI), and Slovakia (SK).  

 

Figure 19. Higher loans with moratoria ratios are associated with lower returns on equity (ROE).  

Source: Own elaboration based on the EBA database; data refer to 2020Q4. ROE is the return on equity ratio, which is calculated as operating profits over equity. Countries included in the sample are: Austria (AT), Belgium (BG), Bulgaria (BG), Cyprus (CY), Denmark (DK), Estonia (EE), Spain (ES), Finland (FI), France (FR), Greece (GR), Croatia (HR), Hungary (HU), Ireland (IE), Iceland (IS), Italy (IT), Lithuania (LT), Luxembourg (LU), Latvia (LV), Malta (MT), The Netherlands (NL), Poland (PL), Portugal (PT), Romania (RO), Sweden (SE), Slovenia (SI), and Slovakia (SK).  

 

Figure 20. The higher the Tier 1 ratio, the lower new loans under public guarantee schemes (PGS).  

Source: Own elaboration based on the EBA database; data refer to 2020Q2. The vertical axis represents newly originated loans under PGS.  The Tier 1 capital ratio is defined as the proportion of tier 1 capital -equity capital and disclosed reserves- to total risk-weighted assets. Countries included in the whole sample are: Austria (AT), Belgium (BG), Bulgaria (BG), Cyprus (CY), Denmark (DK), Estonia (EE), Spain (ES), Finland (FI), France (FR), Greece (GR), Croatia (HR), Hungary (HU), Ireland (IE), Iceland (IS), Italy (IT), Lithuania (LT), Luxembourg (LU), Latvia (LV), Malta (MT), The Netherlands (NL), Poland (PL), Portugal (PT), Romania (RO), Sweden (SE), Slovenia (SI), and Slovakia (SK).  

 

Figure 21. The higher the Tier 1 ratio, the lower the non-performing loans (NPLs) ratio.   

Source: Own elaboration based on the EBA 2020 EU-wide transparency exercise data, which refer to 2020Q2. The horizontal axis represents the Tier 1 capital ratio, which is defined as the proportion of tier 1 capital -equity capital and disclosed reserves- to total risk-weighted assets. The vertical axis shows the non-performing loans (NPLs) ratio, which is calculated as impaired loans over total loans. The slope of the regression is statistically significant (p-value < 0.011). The sample includes individual observations of banks from Austria, Belgium, Denmark, Estonia, Finland, France, Germany, Hungary, Iceland, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Norway, Poland, Portugal, Romania, Slovenia, Spain, Sweden, and the United Kingdom.  

Footnotes[+]

Footnotes
↑1 Public University of Navarre and Institute for Advanced Research in Business and Economics (INARBE).

Filed Under: 2021.1, From the Editorial Desk

Banking and COVID-19 – Through the Crisis and Beyond

May 12, 2021 by Thorsten Beck

Authors

Thorsten Beck[1]Professor of Banking and Finance, The Business School (formerly Cass), City, University of London, Director, Florence School of Banking and Finance, European University Institute, and Research … Continue reading

 

Unlike during the Global Financial Crisis and Great Recession, the financial sector has not been at the core of the current crisis. Rather, the financial sector has been affected as much as other sectors by the public health crisis and the lockdown measures imposed by governments. Borrowers affected by the pandemic are less likely to repay loans and the lowering of interest rates across the globe has put pressure on banks’ interest margins.

At the same time, however, the financial sector has served a critical function in the transmission of multiple support measures of governments and central banks to limit and mitigate the economic fall-out from the pandemic. Specifically, monetary authorities have not only reduced interest rates (where they were not already in negative territory as in the euro area), but also expanded asset purchase programmes and stepped in as market maker of last resort where financial markets showed clear disruptions. These aggressive monetary policy actions have had the objective to maintain liquidity and credit to the real economy.

There has also been a wide range of government support programmes, including (i) compensating firms for the containment measures enforced to close businesses or reduce economic activity such as government-sponsored job retention programmes paying firms for specific fixed costs such as rents or interest on loans, (ii) tax cuts or holidays, and (iii) public guarantee schemes and moratoria on loan repayments. Payments of support programmes are transacted through the banking systems and guaranteed loans often granted by banks.[2]See ESRB (2021) for more detail on support measures in the EU.

Finally, there has been a variety of supervisory measures, including (i) capital relief (i.e., allowing banks to operate below regulatory minimum thresholds), (ii) relaxation of loan classification and provisioning rules and, (iii) (in the euro area) delay of stress tests and the supervisory review and evaluation process (SREP) to 2021. These actions aimed at easing operational pressure on banks and providing incentives to maintain if not extend lending during the crisis. In return, banks were requested to constrain profit distribution to thus maintain the necessary liquidity and buffers both for lending and for loss absorption.

These different support measures can also – at least partly- explain why banks have not suffered as one might have expected given the economic downturn. On the one hand, banks have benefitted from higher fee-based revenue from activities in financial markets.  On the other hand, loan loss recognition has been delayed, an effect that seems stronger than the effect of loan moratoria. And while lending might not have increased by as much as simple multiplier models of the capital relief suggested, buffers have been maintained if not built up and resilience strengthened, even if at the costs of lower returns for shareholders (Hardy, 2021).  This also implies, however, that the pain might still be ahead.

 

The real economy after the pandemic

As much as governments have provided emergency support for real economies across the globe and thus taken on economic losses stemming from the pandemic, there is likely to be a fallout.  Specifically, while government support has achieved to ‘freeze the economy’ and avoid unnecessary frictions of illiquidity and insolvency in the real economy, this has also put on hold the market-based process of resource allocation. And as a lot of support has come in the form of debt rather than grants, many firms might exit the crisis with a debt overhang.

A first important step will be the exit strategy from support for the real economy, both in timing and in speed.[3]For a more extensive discussion on exit strategies, see Beck, Bruno and Carletti (2021) At the core lies the tension between “Keynes” and “Schumpeter”. On the one hand, continuous support even beyond the opening-up phase can be justified with the attempt to avoid hysteresis, i.e., the risk that the current severe economic downturn and consequent high unemployment (in absence of support measures) cause unemployed individuals to lose their job skills or become demotivated, turning into high rates of long-term or structural unemployment. Such scaring effects would hamper not only economic recovery but also permanently reduce potential output and ultimately result in lower long-term growth rates.   Similar arguments can be developed for other economic input factors, such as commercial real estate and manufacturing capital. This is not only challenging from macroeconomic perspective, but also from social and political viewpoints. Supporting firms and people is thus the first priority – and through such support, pressure is also being relieved on banks.

On the other hand, the pandemic will have (possibly permanently) changed the returns on activity in different sectors and industries. There is thus a need for reallocation of resources within the economy post-pandemic.  This requires a process of Schumpeterian “creative destruction”, where some firms, even if viable before the outbreak of the pandemic, may have to undertake a profound transformation towards new products, services and/or markets, and new firms are created in sectors and industries with growth opportunities. Such a process would be impossible, if support measures keep all firms in their current structure alive, independent of whether they are viable in their current structure in the long-run or not. Capital and labour would be tied in such firms, reallocation thus impossible and growth depressed.

At the core of this tension is uncertainty.  While Europe has been emerging from the third wave, it is not clear whether this will be final one. While the introduction of different vaccines has provided hope, their effectiveness against further mutations is unclear as is the point when COVID-19 is no longer to be regarded as pandemic but limited to local and possibly much less fatal outbreaks. Given the uncertain trajectory of the (exit from the) public health crisis, there is similar uncertainty about the necessary constraints on socio-economic life, which will impact the economic recovery. On the one hand, this speaks for maintaining the support for longer until the recovery process has clearly taken off, thus also avoiding cliff effects that can result in wide-spread insolvency and unemployment; on the other hand, this calls for a more differentiated approach in support going forward, focusing on sectors that are most affected by continuing constraints on economic activity and where persistence effects in consumption will imply a slower recovery process. Most importantly, however, this calls for erring on the side of maintaining support for too long rather than terminating too early.

On a more macroeconomic level, these considerations also strongly speak against repeating the mistake from the early 2010s when an expansionary fiscal policy to (successfully) mitigate the extent of the Great Recession (or rather: prevent a second Great Depression) was quickly replaced by an austerity stance on both sides of the Atlantic – in the US due to political conflict between president and Congress and in Europe to comply with arbitrary fiscal policy constraints and the political desire of several euro area core countries to lead periphery countries with ‘good example’ on how to implement austerity. On the euro area level, this ultimately resulted in a deflationary fiscal policy stance, deepening the economic recession and putting too much burden on monetary policy. While one might argue about the appropriate size of fiscal policy stimulus (a discussion primarily on-going in the US), it would be economically illiterate and damaging to use the inadequate appeal to ‘household finances’ to ‘recover’ government expenditures incurred during the crisis and aggressively reduce government deficits and debt levels. As the example of austerity in the UK in the first half of the 2010s has shown, this can throttle a speedy recovery, augment deficits and debt levels further, and have severe socio-political repercussions.

It is clear, however, that as we proceed towards an exit from the public health crisis and thus, towards broader-based economic recovery, the weights on the reallocation process in the real economy become stronger compared to the weights on the survival/hysteresis arguments. Some sectors that rely a lot on personal interaction or physical presence will have to shrink, while others that rely on remote interaction will have growth potential. There might also be a geographic reallocation of growth potential, possibly away from larger cities. On the micro-level this implies that some firms are no longer viable while there is the potential for new enterprises entering growth sectors.

This reallocation process will not necessarily be without frictions. Important will be the distinction between (i) unviable firms and (ii) viable but overindebted firms, where among the latter some might already have entered the pandemic with overleveraged balance sheets, while others have seen an unsustainable increase in debt during the pandemic. The regular insolvency framework might not be appropriate for widespread corporate fragility nor might be its heavy focus on liquidation rather than debt restructuring.

There are different ways to address widespread corporate fragility (Sandbu, 2020): one would be to convert emergency loans – either direct ones or bank loans guaranteed by the government – into grants; however, this would be costly and would probably be mis-targeted, as it would benefit firms that might not rely on such support while keeping alive unviable firms. A more targeted measure would be government equity support for viable but overindebted firms; however, this will be difficult to manage given the large number of firms and the limited if not negative track record of governments to pick winners. A third option would be a bank-based restructuring process, as especially for smaller firms in Europe the largest part of their debt will be bank loans, so that banks have the right information and capacity to restructure debt. The main problem is whether banks have the right incentives to undertake this role in the societally most efficient way; if they provide too much debt relief to benefit from future relationships with their clients, borrowers might jump ship to other banks afterwards; if they provide too little, the economy might end up with walking zombies, even though these clients are tied to the bank, deteriorating banks’ asset quality. Regulatory rules (as well as taxation) might influence banks’ actions. Having a central role for banks in this process, however, might also divert their resources from the necessary funding of new companies and thus the economic recovery process.

In previous crises, this challenge has been addressed with asset management companies (AMC), which can help reduce non-performing assets on banks’ balance sheets by transferring them to special purpose vehicles. Among the benefits of AMCs are economies of scale in the workout of non-performing assets and helping to close the gap in pricing, when asset prices are temporarily depressed. AMCs might also be in a better position to restructure the debt of borrower with multiple bank relationships and – by taking on a coordination role – avoid fire sales that result in a further depression of asset prices. At the same time, being able to off-load non-performing assets allows banks to focus on lending to performing and new borrowers.  While in theory, similar effects can be achieved through market-based securitisation schemes, asymmetric information between banks and investors (resulting in a lemons problem) and the more urgent need for banks to offload assets than for investors to buy might result in market failures, in addition to absorption limits of private markets. Public-private partnerships, where publicly-supported AMCs are partly funded by private investors, seem a more promising route.   The more successful AMCs, including after the Global Financial Crisis in Ireland and Spain, however, have dealt with real estate rather than with SME loans, which are more heterogeneous, complex and costly to work-out.

There are constraints, however, on the use of publicly-supported AMCs, as they are subject to state aid conditions and have to be compatible with BRRD and can thus only be established for solvent banks with viable business models. Further, the effectiveness of AMCs might be hindered by slow and ineffective corporate insolvency frameworks, a problem that is stronger in some EU member states than in others.

A critical issue are the prices at which AMCs take on non-performing assets from banks. If purchased at book prices, this involves a transfer of losses from banks to the AMC and ultimately government, in conflict with state aid rules. A transfer at market prices, on the other hand, can result in large losses for banks and thus the need for recapitalisation or resolution. A transfer at the economic value (most likely in between market and book values) might reduce bank losses, but at the same time result in the need for government resources to be tied up in the AMC.

 

Banks’ asset quality after the pandemic

Debt restructuring of some firms and liquidation of others will have obvious repercussions for the quality of banks’ asset portfolios. There is certainly variation across banks and countries in this negative impact. It is important, however, that these losses be recognised; any delay can result in zombie lending and further accumulation of losses as the case of Japan in the 1990s has shown. At the same time, leaving the process completely to banks creates the risk of overwhelming them and thus hindering the reallocation and recovery process. AMCs as discussed in the previous section, might come in useful here.

In spring 2020, loan loss classification standards were relaxed in Europe, with supervisors advising banks “to make use of the flexibility provided by standards and take a long-term view in assessing which creditors are in a good position to recover from the crisis.” (ESRB, 2021), while at the same time forcing banks to start accumulating general provisions in response to the deterioration of the macroeconomic scenario. Such flexibility, however, can result in opaqueness of banks’ balance sheets and provide perverse incentives for banks to roll-over loans to non-performing borrowers and thus zombie lending.  Evergreening and zombie lending has negative repercussions not only for average firm growth but also negative growth implications for non-zombie firms who might be undercut in pricing by zombie firms and who cannot expand at the expense of zombie firms. It also prevents the entry of new innovative firms that might contribute to overall (productivity) growth in an industry or sector (Adalet McGowan et al., 2018). It is thus clear that a return to forward-looking loan loss provisions is an important part of the exit strategy for regulators.

As banks have to provision for prospective loan losses, incur such loan losses, or have to adjust book value in the context of transfers to AMCs, the question on how to deal with the consequent bank fragility arises. Stress tests under way in Europe will give a clearer picture of banks’ prospective post-pandemic asset quality; the continuous uncertainty on the course of pandemic and economic recovery, however, makes clear prediction on future asset quality and the likelihood of different scenarios more difficult. Importantly, authorities have to be prepared for possible bank failures, a topic I will turn to next.

 

Bank resolution in Europe – ready for the first big test?

The absence of effective bank resolution frameworks forced European authorities in 2008 into one of two ‘corner solutions’: send failing banks into corporate liquidation processes or bail them out. The former ignores the interconnected character of banking and the negative externalities that the failure of banks cause for borrowers, depositors and the broader economy; the global shock of the Lehman Brothers’ failure illustrated these effects and can explain why European authorities went mostly for the bail-out option, at least in the case of larger banks. However, the bail-out implied not only losses for taxpayers and consequent cuts in other government budget lines (one of causes for the subsequent rise of populist parties), but also raises moral hazard concerns.

The introduction or reforms of bank resolution regimes across Europe aimed at ending such bail-outs, while at the same time allowing for efficient resolution or liquidation of failing banks and minimising negative externalities and spill-over effects on other banks and the real economy. The Bank Recovery and Resolution Directive (BRRD), translated into national legislation, created common standards, including restrictions on the use of taxpayer resources.

Even in the years leading up to the adoption of the BRRD across the EU, there was already a shift from bail-outs to bail-ins (World Bank, 2016). Most prominently, the failure of Banco Espirito Santo (BES) in Portugal was addressed by a mix of bail-in of junior debtholders, a good-bank bad-bank split and a bridge bank structure. Specifically, the resolution involved the immediate creation of a bridge bank named Novo Banco that received sound assets and liabilities such as cash, retail deposits, performing loans, and central bank funding. In contrast, shareholders and junior bondholders were bailed in and thus left with the toxic assets that led to the mounting losses, which remained in a “bad bank” that was subsequently liquidated. Importantly, the newly created bank became fully owned by the Portuguese Resolution Fund, which provided the entirety of the Euros 4.9 billion of capital. The financial resources of the Fund did not include public money, as it was financed by the initial and periodic contributions of all of the country’s lenders as well as the proceeds from a levy on the banking sector. Beck, Da-Rocha-Lopes and Silva (2021) show that firms linked to BES suffered a significant contraction of credit at the intensive margin, but were on average able to compensate for the supply-driven shock. However, affected SMEs experienced a binding reduction of funds available through credit lines, and those with lower internal liquidity increased precautionary cash holdings and reduced investment and employment. This suggests that bank resolution without bail-outs and taxpayer support can limit though not eliminate real sector costs from bank failures. It is important to stress, however, that the failure of BES was an idiosyncratic case, not related to deeper imbalances or fragilities in the Portuguese banking system. The swift intervention thus limited any contagion effects, though the idiosyncratic nature of the BES failure might have limited them anyway. One cannot conclude from these findings for this specific case, that the fallout of bail-ins would be similar in a systemic crisis situation.

Since the adoption of the BRRD, gaps in the new resolution frameworks have become clear. These gaps include a focus on liquidation for banks, for which there is no positive public interest assessment for resolution (assessment that normal insolvency proceedings would “give rise to significant adverse effects on the financial system and severely impede the functioning of the real economy in one or several Member States”, SRB, 2019). While there might be indeed no such narrowly defined public interest in the case of many smaller banks, widespread insolvency and liquidation of several smaller banks, especially if geographically concentrated can have severe negative economic repercussions (e.g., Ashcraft, 2005). Further, “significant differences in national legal regimes for the liquidation of banks imply divergences from the European supervisory framework; they generate level playing field concerns that might impair banking market integration and they may stand in the way of a smooth exit from the market for the weakest players” (Enria, 2020). Discussions on possible reforms are currently under way, but any such reforms will be too late to address possible bank fragility post-COVID-19.

Can the current bank resolution framework be used in a systemic banking crisis?  Theory is ambiguous on the effect of a more comprehensive bank resolution framework on stability during instances of systemic distress. On the one hand, reducing the likelihood of bailouts and thus taxpayer support, allowing early intervention, and providing ample tools for resolution of failing banks reduces moral hazard risk (Repullo, 2005; Farhi and Tirole, 2012). Specifically, bail-in and clarity on how losses will be distributed in case of bank failure can increase market discipline by equity and debtholders of banks. They can also reduce incentives for too high leverage on banks’ balance sheets (Adrian and Shin, 2014). On the other hand, a rule-based system that ties regulators’ hands can result in bank runs and contagion if regulators have private information about bank performance (Walther and White, 2020). Rule-based bail-ins might make banks more vulnerable to adverse events and thus destabilize the financial system in the middle of a crisis, through direct interlinkages of banks holding each other’s’ claims, as well as information effects and a sudden reassessment of bank risk (Acharya and Yorulmazer, 2008; Eisert and Eufinger, 2018). According to this view, bailouts of failing banks (which were supposed to end with the post-2008 reforms) can protect other banks from contagion and thus provide incentives to reduce risk-taking (Cordella and Yeyati, 2003; Dell’Ariccia and Ratnovski, 2019). There might also be economic costs of too rigid an application of rules, resulting in underinvestment (Keister, 2015; Leonello, 2018).

Beck, Radev and Schnabel (2020)’s empirical assessment of the relationship between bank resolution frameworks and systemic risk sheds doubt on the usefulness of bank resolution frameworks during systemic banking crises. Specifically, they show that banks in countries with more comprehensive bank resolution frameworks experience a higher increase in systemic risk contributions after system-wide shocks, such as the Lehman Brothers’ failure or the Greek debt crisis; further, these amplification effects are mainly driven by the overall bail-in framework and the tools and powers the resolution authority has at its disposal, while the existence of a designated resolution authority is related to system-wide shocks and banks’ systemic in a dampening way. Interestingly, the authors do not find such amplifying effects during idiosyncratic shocks (such as, for example, the failure of Banco Espirito Santo, discussed above).  These results suggest that more comprehensive bank resolution may exacerbate the effects of system-wide shocks and should not be solely relied on in cases of systemic distress.

The theoretical and empirical evidence matches experience from previous crises across the globe, where often blanket guarantees, system-wide recapitalisation efforts and – as discussed above – asset management companies are being used (Laven and Valencia, 2018). Bank resolution frameworks are designed for idiosyncratic failures and both the toolbox of resolution techniques and political appetite for bail-ins shrink in the face of systemic fragility, something also referred to as scale diseconomies of resolution (De Young et al, 2013, Beck, 2011). Specifically, the simultaneous failure of several institutions not only exacerbates the stress experienced by directly or indirectly affected institutions, but also limits the effectiveness of resolution techniques, such as purchase and assumption of failing banks by healthy ones, as potential acquirers might either be affected themselves or be reluctant to acquire in times of high uncertainty.

In the context of multiple and geographically concentrated bank fragility in Europe, a strict adherence to the current framework, designed for idiosyncratic bank failures (just to stress this again), might exacerbate fragility, as discussed above. A flexible approach to the use of the different tools discussed above including where a positive public interest assessment might not be met in normal times, with waivers of state aid rules where necessary and – most importantly – pan-European solutions, is critical. As a focus on purely national fiscal policy stances is no longer an option within the euro area, forcing resolution, restructuring and recapitalisation decisions onto the national level can restart the vicious cycle of bank and sovereign fragility we saw in the early 2010s. While a completion of the banking union and a reform of the BRRD is not feasible to address bank fragility in the short-run, the spirit of a complete banking union should be applied. This also implies early coordination between regulators, resolution authorities and governments on the national and European level.

 

The crisis as opportunity

While the immediate objective of the banking union was to cut the vicious cycle between bank and sovereign fragility, the medium- to long-term objective has been to create a Single Market in Banking, moving away from national towards an integrated banking system.  Neither of these two objectives has been fully accomplished.  The banking union is not complete and the early stages of the COVID-19 crisis increased fear of a renewed bank-sovereign fragility cycle, ultimately countered with the aggressive actions by the ECB and the strong signal sent by the European Recovery Fund (Next Generation EU).  One example for negative repercussions of an incomplete banking (and fiscal) union emerged in spring 2020: while the ECB asked for restrictions on profit distribution on the group-level within the EU, several national supervisors also restricted within-group profit distribution, effectively undermining the Single Market of free capital movement but with the valid argument that local subsidiaries benefit from national fiscal support packages.  And while banks in Central, Eastern and South Eastern Europe are much less dependent on parent bank funding that a decade ago, memories of lending retrenchment in the wake of the Global Financial Crisis are still fresh, while an incomplete banking union leaves national authorities in these countries in a relative weak position vis-à-vis home country authorities (Ahmad et al. 2019).

However, even a completion of the banking union is only a necessary but not sufficient step towards a Single Market in Banking. Cross-border mergers can help delink banks from countries and thus governments; but it is the same governments that often stand in the way, as the recent example of Germany has shown where the government actively tried to facilitate a merger of the two largest private banks.

Beyond creating a truly Single Market in banking, where larger banks are European rather than national, one can consider a second longer-term objective: reducing the bank-bias in the European financial system (Langfield and Pagano, 2016). Strengthening public capital markets is only one aspect, strengthening private capital markets, including equity funds, angel financing and venture capitalists are other important aspects. Balancing the financial system is critical in the context of the increasing importance of intangible relative to tangible capital (Haskel and Westlake, 2017). Recent research has shown the limitations that banking faces when enhancing growth of industries and economies increasingly relying on intangible assets that are harder to be used as collateral that can be recovered and resold and with more uncertain investment projects (Beck et al., 2020).  This is consistent with increasing evidence that such industries are more likely to be financed by non-bank financial institutions, including venture capitalists, equity funds but also through public capital markets (Dell’Ariccia et al., 2021).

Another medium- to long-term challenge for the European banking system is the rise of fintech and bigtech companies, which have the potential to disrupt banking markets. Fintech companies have undermined banks’ franchise in specific services, most prominently payment services, and are thus threatening economies of scope and scale banks have been enjoying by offering bundles of services.  Bigtech companies have a critical advantage vis-à-vis banks through their access to big data and large networks, which they can use for an envelopment strategy in new markets, including financial services. Ultimately, the competitive threat to banks from bigtechs and banks’ reactions will be critically determined by the regulatory response.

 

Conclusions

The crisis has not started in the banking system, but banks have been a critical transmission tool for the management of the economic crisis. It is clear, however, that unless the phasing out of support programmes is undertaken carefully and in a coordinated way, there is the risk that corporate distress will result in banking distress, in the form of a vicious cycle that might even bring sovereign fragility back into the picture. And while the bank resolution tools at the disposition of authorities are vastly superior to the ones available in 2008/9, it is doubtful that they are sufficient to resolve multiple bank failures, especially if geographically concentrated.

Careful coordination between different national authorities (bank supervisors, resolution authorities, and governments) and between European and national authorities is needed to not only design coordinated exit plans but also put in place the necessary plans for severe fragility in an adverse scenario; plans that build on existing frameworks, but with the necessary flexibility to address systemic banking distress.

On the upside, if properly handled, any bank fragility resulting from the pandemic and the economic fallout can be used to kickstart a deeper restructuring of Europe’s banking systems, completing the banking union and building a truly Single Market in banking in Europe. The time to prepare is now.

 

References

Acharya, V., and Yorulmazer, T. (2008). Cash-in-the-Market pricing and optimal resolution of bank failure. Review of Financial Studies, 21, 2705-2742.

Adelet McGowan, M., Andrews, D., and Millot, V. (2018). The walking dead? Zombie firms and productivity performance in OECD countries. Economic Policy, 33, 685-736.

Adrian, T., and Shin, H.S. (2014). Procyclical Leverage and Value-at-Risk. Review of Financial Studies, 27, 373-403.

Ahmad, I., Beck, T., d’Hulster, K., Lintner, P., and Unsal, F. (2019). Banking Supervision and Resolution in the EU. Effects on Small Host Countries in Central, Eastern, South Eastern Europe. World Bank Group.

Ashcraft, A. B. (2005). Are banks really special? New evidence from the FDIC-induced failure of healthy banks. American Economic Review, 95,1712–1730.

Beck, T. (2011). Bank Failure Resolution: A Conceptual Framework, in: Panagiotis Delimatsis and Nils Herger (Eds.): Financial Regulation at the Crossroads: Implications for Supervision, Institutional Design and Trade.

Beck, T., Bruno, B. and Carletti, E. (2021). When and how to unwind COVID-support measures to the banking system? prepared for the European Parliament’s Committee on Economic and Monetary Affairs (ECON).

Beck, T., Da-Rocha-Lopes, S., and Silva, A.F. (2021). Sharing the Pain? Credit Supply and Real Effects of Bank Bail-ins. Review of Financial Studies, 34, 1747-1788.

Beck, T., Radev, D., and Schnabel, I. (2020). Bank Resolution Regimes and Systemic Risk, CEPR Discussion Paper 14724

Beck, T., Doettling, R., Lambert, T., and van Dijk, M. (2020). Liqudity Creation, Investment and Growth, CEPR Discussion Paper 14956

Cordella, T., and Yeyati, E.L. (2003). Bank Bailouts: Moral Hazard vs. Value Effect. Journal of Financial Intermediation, 12, 300-330.

DeYoung, R., Kowalik, M., and Reidhill, J. (2013). A theory of failed bank resolution: technological change and political economics. Journal of Financial Stability, 9, 612-627.

Dell’Ariccia, G., and Ratnovski, L. (2019). Bailouts and systemic insurance. Journal of Banking and Finance, 105, 166-177.

Dell’Ariccia, G., Kadyrzhanova, D., Ratnovski, L., and Minoiu, C. (2021). Bank lending in the knowledge economy. Review of Financial Studies, forthcoming.

Eisert, T., and Eufinger, C. (2018). Interbank Networks and Backdoor Bailouts: Benefiting from Other Banks’ Government Guarantees. Management Science, 65, 3673-3693.

Enria, A. (2020). Crisis management for medium-sized banks: the case for a European approach. Keynote speech at the Banca d’Italia workshop on the crisis management framework for banks in the EU.

ESRB (2021). Financial stability implications of support measures to protect the real economy from the COVID-19 pandemic. Frankfurt a.M., Germany
Farhi, E., and Tirole, J. (2012). Collective moral hazard, maturity mismatch, and systemic bailouts. American Economic Review 102, 60-93.

Hardy, B. (2021). Covid-19 bank dividend payout restrictions: effects and trade-offs. BIS Bulletin 38.

Haskel, J., and Westlake, S. (2017). The rise of the intangible economy: Capitalism without capital. Princeton University Press, Princeton.

Keister, T. (2015). Bailouts and financial fragility. The Review of Economic Studies, 83, 704-736.

Laeven, L., and Valencia, F. (2018). Systemic banking crises revisited. IMF Working Paper 18.206.

Langfield, S., and Pagano, M. (2016). Bank bias in Europe: Effects on systemic risk and growth. Economic Policy, 31, 51-106.

Leonello, A. (2018). Government guarantees and the two-way feedback between banking and sovereign debt crises. Journal of Financial Economics, 130, 592-619.

Repullo, R. (2005). Liquidity, Risk Taking, and the Lender of Last Resort. International Journal of Central Banking, 1, 47-80.

Sandbu, M. (2020). The corporate zombies stalking Europe, Financial Times, 8 September.

Single Resolution Board (2019). Public Interest Assessment: SRB Approach, Brussels, Belgium.

Walther, A., and White, L. (2020). Rules versus discretion in bank resolution. Review of Financial Studies, 33, 5594-5629.

World Bank (2016). Bank resolution and bail-in in the EU: selected case studies pre and post BRRD. Working Paper 112265. World Bank.

Footnotes[+]

Footnotes
↑1 Professor of Banking and Finance, The Business School (formerly Cass), City, University of London, Director, Florence School of Banking and Finance, European University Institute, and Research Fellow, CEPR.
↑2 See ESRB (2021) for more detail on support measures in the EU.
↑3 For a more extensive discussion on exit strategies, see Beck, Bruno and Carletti (2021

Filed Under: 2021.1

Banking and COVID: Past, Present, and Future

May 12, 2021 by Giorgio Barba Navaretti, Giacomo Calzolari and Alberto Franco Pozzolo

Authors

Giorgio Barba Navaretti[1]University of Milan., Giacomo Calzolari[2]European University Institute., Alberto Franco Pozzolo[3]Roma Tre University.

 

1. The function of banks in emergency

“This time banks are not the problem but part of the solution.”[4]Statement by the General Manager of BIS Agustín Carstens in his interview with Martin Wolf at Financial Times – The Global Boardroom 2nd Edition: Shaping the recovery, 13 November 2020 and … Continue reading This is a statement with several implications and inherent meanings, that we explore in-depth in this issue of European Economy (EE).

First, the absence of wrongdoing. This is an economic crisis that started as an exogenous shock (the pandemic) and not because of financial mismanagement by banks and financial companies: the plaintiff is empty-handed this time. In the aftermath of the great financial crisis (GFC), the leitmotif was that banks’ profits were private and their losses public, as many had to be bailed out by taxpayers. The subsequent reforms in regulation and supervision, the steep rise of capital requirements, and the restrictions on public bailouts were precisely based on the principle that also losses had to be private, borne mainly by shareholders and junior creditors with the ultimate aim to reduce moral hazard in lending and financial allocations. This time, not only the initial shock was exogenous to the banking sector, but it also happened at a time when the industry was acting in good health on safe grounds, as clearly emphasised by Campa and Quagliariello in this issue.

Second, the solution. Banks were crucial in channeling funds to firms and families, indeed so in Europe. Loans to non-financial corporations and households rose substantially in most EU countries during the first half of 2020, as firms needed working capital to withstand a steep reduction in sales and started amassing liquidity as a safety measure, given the remarkable rise in uncertainty (as thoroughly reported by Falagiarda et al. in this issue). Moreover, banks granted moratoria and considerably extended the duration of outstanding exposures. Bank loans also increased in the US, even though firms relied more on the issuance of corporate bonds than their European counterparts. According to Darmouni and Siani in this issue, both investment-grade and high-yield markets reached historical heights after March 2020. Yet, small firms still relied on bank loans. No other economic or financial, or public institution would have been equally pervasive to reach the broad public of firms and households like banks while being thoroughly regulated and supervised to assure the correct implementation of a centrally coordinated nation-wide and EU-level action.

Third, being able to afford to be the solution. As argued, banks were sufficiently capitalised, liquid, and well managed at the outburst of the pandemic (at least a large number of them) to be able to expand their assets without an excessive depletion of prudential capital. Also, because of the restrictions in distributing dividends and because of the moratoria extended to loans, Tier 1 capital, liquidity ratios, and the share of non-performing loans all improved during the crisis (as all the tables and figures reported in the Number section clearly illustrate, and as also argued in the papers by Angeloni and Campa and Quagliariello in this issue).

Fourth, this was possible because banks are subject to strict regulations, in Europe under a common regulatory framework. This had a double advantage. First, the quality of banks’ balance sheets and the extent of their ability to act were well known to the authorities. Second, regulatory authorities knew there were sufficient margins to release many of the prudential provisions of the pre-COVID-19 regulatory framework (e.g., capital buffers) and to introduce some ad hoc prudential measures, such as the restrictions in the distribution of dividends. And also, there was political consensus to do so. Consequently, it was possible to launch a public-private joint action between supervisory authorities, central banks, governments, and the banks themselves, which were at the forefront as the final actors and the enablers of the support operations. Banks would not have been able to act on similar grounds and to a similar extent in a pre-2009 environment. A tighter prudential regulatory framework was essential in creating the preconditions for banks’ “social” action. Also, this could not have happened in Europe if there had not been a Banking Union (although yet to be completed). Ring-fencing and uncoordinated supervisory procedures would have prevented a swift action under comparable conditions within the Union.

Fifth, being part of the solution. For well capitalised and healthy that they were, banks could have never been a solution without several levers of extensive public support: massive liquidity from central banks; extensive public guarantees on new loans; comprehensive regulatory responses, allowing banks to use their capital, liquidity, and countercyclical buffers; suspension of State Aid rules. In Europe, no such action could have been carried out in a pre-2009 environment and in the aftermath of the financial crisis. Governments could not have enacted expansionary measures of support and increased public debt without a massive program of purchase of government bonds by the ECB. At the time, there was no, and there would not have been political consensus for the ECB to carry out a quantitative easing (QE) program first and then the Pandemic Emergency Purchase Program (PEPP). Also, without a Banking Union, it would not have been possible to carry out a coordinated action throughout Europe and also construct sufficient political consensus to soften the prudential requirements set up after the GFC and the Sovereign Debt Crisis and use them countercyclically.

But the next critical challenge is to avoid the solution becoming a problem. For banks to act as responsible social actors during the pandemic, it was necessary, as argued, to considerably smooth the existing regulatory framework. Yet, such a framework was essentially designed to avoid moral hazard, when the banks were indeed the problem: i.e., to provide the right incentives to avoid irresponsible economic behaviour and potential episodes of insolvency. Future problems will be less likely if banks during the pandemic have acted as both economically and socially responsible actors. For example, if the standards applied to the allocation of loans backed by a state guarantee have been adequately stringent. Or if credit forbearance has been granted only to solvent borrowers. Hence at the moment we do not know if banks have carried out economically responsible actions even in the absence of adequate regulatory incentives to do so.

Clearly, to avoid the solution becoming a problem, a crucial aspect is the timing of the steps to go back to normality, which needs to be phased with the evolution of the pandemic and the uncovering of its effects. The legacy of the crisis, the exit strategy, the long-term impact on the banking and financial sectors, and what we have learned from a regulatory perspective are the main issues discussed below.

 

2. The legacy of the crisis and the exit strategy: notes of caution

The aftermath of the pandemic.  

The legacy that the pandemic crisis will leave on the banking sector cannot be underestimated. As argued above, the size and scope of policy interventions have been pervasive, including: (i) monetary policy measures, such as ECB’s Targeted Long-Term Refinancing Operations III (TLTRO III) and Pandemic Emergency Purchase Programme (PEPP); (ii) fiscal policy measures, such as national public guarantee schemes; (iii) prudential and supervisory measures, releasing capital and liquidity buffers, easing the classification of loans and their risk provisioning, and allowing for moratoria on lending. While these measures have been crucial to contrast the effects of COVID-19, they will also have substantial short- and long-run consequences on the banking sector and the economy as a whole.

The moral hazard problems at the core of the debate after the GFC appear not to be an issue in the current situation. Schnabel (2020) explicitly said that “the pandemic has not raised concerns of moral hazard.” Of course banks had no bearing in the economic crisis triggered by the pandemic and were instrumental in supporting households and firms. However, it is not clear whether credit allocation has been biased towards riskier creditors by lifting several prudential conditions. At the same time, cheap credit, moratoria on bank loans, and government guarantees are helping firms to survive, but at the cost of increasing their indebtedness. When support measures will finally be lifted, many borrowers will find themselves more indebted and in a direr condition than before the crisis.

Expansionary monetary policies and government guarantees make it very easy for banks to grant credit, as it is necessary to contrast the pandemic. But they also raise the risk that banks lend to zombie firms, which most likely will not be able to pay back their debts, and the survival of which causes significant distortions in the allocation of economic resources. This would hamper the reorganization of economic activities necessary for an effective process of creative destruction to unfold (Beck et al., 2021). Not all banks have the same incentives to lend to zombie firms, and the available evidence shows that the weaker and less capitalized banks are precisely those that are more likely to do so (Dursun-de Neef and Schandlbauer, 2020; Schivardi et al., 2021 ).
Like all crises, also the pandemic will have a cleansing effect. The acceleration of some trends that were already unfolding will cause a substantial reshaping of profitability across and within economic sectors. Strong firms will sail such rough waters and possibly strengthen their position, while weaker firms will be in trouble. Entrepreneurs should base their decisions on realistic assumptions about their business perspectives, avoiding leveraging on the availability of easy credit to bet for resurrection.

Public spending has increased substantially all over the world in the last year. According to the IMF, the ratio of government debt to GDP in advanced economies has soared by 16.3 percentage points between 2019 and 2020, to 120.1 per cent (by 12.9 per cent in the euro area, to 96.9 per cent). Contingent liabilities related to the guarantees offered on bank loans (see Figure 10, in the Numbers section) may cause a further increase in the coming years.

Expansionary fiscal policies were needed to contrast the effects of the pandemic, and they will undoubtedly be effective in the short run, given the large output gap and the depressed aggregate demand. But government policies need to have a sufficient long-term perspective and the recovery must be sustainable, protracted and sizeable enough for firms to pay back their debts without triggering government guarantees. Adding further concerns to this scenario, moratoria are more widespread in countries with a higher debt-to-GDP ratio (see Figure 17, in the Numbers Section). If government spending during the pandemics and the recovery programs in the aftermath had no impact in the longer term, the unfolding of a new doom-loop between banks and sovereigns might become a possible scenario in the coming years.

Closely related is the issue of NPLs. While their level is still low, they might rise substantially. As reported by Campa and Quagliariello in this issue, the volume of loans classified under IFRS 9 stage 2 – those that are still performing but for which there was a significant increase in credit risk – increased by 24% in 2020. As argued by Angeloni in this issue, banks should set aside adequate provisions to cover for credit risk and keep screening their clients even when government guarantees cover the loans they grant. This is even more so because of the link between NPLs, moratoria, capitalization and profitability: the country share of loans under moratoria which are classified as Stage 2 is higher than the average share of loans classified as Stage 2 (see Figure 12, in the Numbers section), the share of loans under moratoria is larger in countries with higher NPL ratios (Figure 16) and where banks have lower Tier 1 capital ratios (Figure 18) and profitability (Figure 19). Careful attention must thus be paid that banks do not postpone uncovering their losses.

To this aim, asset management companies can be an effective tool to make it easier to sell NPLs at a fair price, avoiding inflated losses because of thin markets or fire sales (which, in turn, could hamper the incentives to uncover them), as suggested by Campa and Quagliariello and Beck in this issue (building on the proposal made by Enria, 2017, in a previous issue of this journal).[5]Although NPLs which will derive from the pandemic are not a legacy of past misbehaviours by bankers, as in the case of GFC, the proposal is nonetheless encountering some opposition at the European … Continue reading

The pandemic crisis also leaves us with a less stringent regulatory framework than what was agreed after the GFC. While this was necessary, an exit strategy must be devised. As argued by Beck in this issue and Beck et al. (2021), the right balance must be found between acting too soon, thus causing a credit crunch during the recovery phase, and acting too late, thus increasing the risk of moral hazard. To help banks and firms make credible budget plans for the coming years, a “forward regulatory guidance” should be provided, setting a clear path ahead. Given current and future uncertainties, such guidance would be more credible and effective if it were state-contingent (i.e., based on economic conditions) rather than time-time contingent (i.e., based on fixed dates in the future).[6]Andrea Enria (2021) in a recent speech suggested a mixed strategy. He argued for the need to move ahead as planned for completing and implementing the Basel III framework on capital requirements, and … Continue reading

Long-run implications  

All the measures described above aim at tackling the short-run legacies of the pandemic crisis, setting the road for a stronger recovery and a sounder financial sector. But long-run legacies of the crisis will also unavoidably affect governments, banks, and firms alike.

Many governments will need to find a way of reabsorbing their massive debts, especially when central banks will phase out the QE. Firm over-indebtedness, especially with banks, will also be a major problem in the medium-run, since it will harm their investment ability. Even more so in the highly productive but riskier activities necessary to reach sustained economic growth.

During the pandemic, some firms have found easier access to the bond market than in the past, as shown by Darmouni and Siani, in this issue (partly thanks to the effects of central bank purchases). Also, in Europe, the number of firms issuing bonds has increased and their average size has declined (Darmouni and Papoutsi, 2020). Bond financing may become a problem if firms cannot roll-over their debt when the next crisis comes.

For firms to have more extensive access to arm-length financing, a larger number of investors should be willing to change their preferences towards higher risk-return strategies. This would be a crucial step to foster the reallocation of activities needed to recover from the COVID-19 pandemic and face future challenges, such as environmental problems. While all obstacles should be removed to facilitate firms’ access to equity markets, including SMEs, a renewed cultural approach to financial investments is also needed. Policies helping firms to switch from government guaranteed bank debt to equity financing, for example along the lines of the proposal made by Boot et al. (2020), would help in this direction. Set within the Capital Market Union framework, their effectiveness would be further enhanced (see Barba Navaretti et al., 2019).

Banks could also play a more active role in helping firms to access the financial markets directly. Margins on traditional banking activities are shrinking due to the current low-interest environment and increased competition from non-bank financial intermediaries, such as in the payment business.[7]As suggested by the results of Bolt et al., in this issue, competition in the payment business is likely to increase in the coming years, due to the acceleration in the diffusion of digital payments … Continue reading A large amount of liquidity available in the financial markets may give way to fintechs to increase lending, for example, through peer-to-peer platforms. Since investment banking has higher margins than traditional lending, underwriting services should be seen by banks as a profit opportunity, rather than as an activity that reduces their loan portfolios’ size.

Also, the evolution of the entire financial intermediation sector, with new players such as fintechs and bigtechs, will undoubtedly push pressure on banks’ profitability. Fintechs had apparently a temporary step-back during the pandemic. This is partly related to the fact that many of these new players like peer to peer landing platforms had no access to relief measures and funding sources and that the public preferred to fly to safety in hardship (see Davies in this issue).

Possibly this has been a temporary accident, as fintechs were not ready yet and diffused enough in Europe to act pervasively during the crisis. But they may come back soon, given the earlier observed speed in the expansion of their business. Also, not all activities faced a set-back. Bolt et al. in this issue have shown that within a few months in lockdown individual payments’ habits have changed and probably permanently at a speed that usually would have taken several years.

The low profitability of traditional banks cannot last forever, with very low, if not still declining, book-to-value records for European banks.[8]Market capitalization of Apple in 2018 was roughly half the combined European listed banks’ capitalization. In 2020, the situation is reversed with Apple now valuing more than the double of the … Continue reading The articles in this issue of European Economy have discussed how banks can regain profitability (see Davies). Overall, there are not so many options available. A combination of traditional approaches, such as cost containment, national and cross-border M&As, and more transformative changes are the likely outcomes.
Excess capacity is still a characteristic of some, although not all, domestic banking sectors in Europe. In some countries, the concentration in the banking sector is already high (notably Spain), and there are narrow margins for other M&As. In others, there are options, notably in Germany and Austria, and also in France and Italy.[9]See https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200608_ssi_table~3054d55051.en.pdf But in this period of uncertainty with an unclear picture on the extent of future NPLs, the value of banks’ assets is uncertain and difficult to assess.

Also cross-country M&As could help to boost banks’ efficiency, and they would be an interesting way forward also in light of the hopeful completion of the Capital Markets Union. But, as highlighted by Davies in this issues, also, in this case, the uncertainty in the value of assets, the yet uncompleted Banking Union (a still missing European Deposit Insurance Scheme) and some potential political opposition, higher than usual in these COVID times, may hamper this pattern in the short/medium term.

Another source of efficiency can come from the adoption of digital technologies, especially for customer engagement applications and the use of artificial intelligence and Big data that can help in credit allocation and asset management modelling. Adopting transformative digital technologies not only opens different sources of profitability but also a re-organization of the banking activities, with a rebalancing of revenues towards non interest based sources (fees and commissions), a useful shift in a negative interest rates environment.

Financial intermediaries would be more of a matching entity, that gains when a transaction takes place. Bigtechs have a similar business model where in many cases profits come from flat-rate subscription fees and the ability to retain customers. The current banking business model is very far from all this, but it could be now the right moment to move more in this direction. Yet, the pace of adoption rate of these technologies by traditional banks is not of the speediest. In this respect, as argued in an earlier issue of this journal on fintechs, banks may rely on third parties such as cloud computing for data storage and analysis rather than developing these technologies.

For regulation and supervision, this will be a process to monitor closely. If regained profitability may stabilize the banking sector, a new business model may come with different risks. It has been shown, for example, that relying more on fees enhances the operating risk of banks.[10]See DeYoung and Roland (2001) and more recently Köhler (2014). Also, as regulators have already noted, outsourcing crucial banks’ activities to third parties implies new risks.

 

3. What have we learnt? Rules as an anticyclical tool and the need for more European integration

Drawing conclusions on the effects of the pandemic on banking and financial markets at this stage is too early. However, the papers in this issue of European Economy help us identify some early observations about what we have learned.

The COVID is an unfortunate and prolonged stress test for the European banking sector and the regulations approved after the GFC, although the presence of unprecedented market interventions confound the test. We have learnt that rules have to be implemented with sufficient flexibility. They can work as powerful anticyclical measures. Using the available margins for releasing capital, liquidity requirements and State-aid rules has been essential to shelter as much as possible companies and households from the worst consequences of the pandemic.

As argued in the papers by Campa and Quagliariello, by Davies, and by Falagiarda et al., adequate capitalization levels were effective in fostering banks’ resilience. However, different banks in different countries will sail through the crisis in very different conditions. How they will exit it will depend not only on the quality of their loan portfolios and on their level of capitalization, but also on how their domestic countries have been hit by the pandemic: the severity of the lockdowns, the sectors of exposure, the effectiveness of the support measures, the state of the public finances etc.

In this framework, it will be difficult not to consider that the process of recapitalization initiated after the GFC was still incomplete. Rescuing banks in a post-COVID-19 banking crisis, if needed, will be just an act of realism: as it turned out to be necessary after the GFC, it would be even more so when the cause of the banking crisis is an exogenous shock like the pandemic.

In light of this, one could try to understand what would have been the COVID-19 crisis had it taken place before the Banking Union, and also what are the challenges ahead for the architecture of European banking supervision and regulation.

A first issue concerns the Single Resolution Mechanism. This was meant to reduce the risk of bail-out and the vicious cycle between banks and sovereigns. However, the bail-in of 8% of a bank’s balance sheet (contained in Banking Recovery and Resolution Directive, to access the Single Resolution Fund) has never been applied, de facto. Several reasons can explain why this Mechanism has not been used so far (see among other Dewatripoint et al. Vox 2021).[11]https://voxeu.org/article/urgent-reform-eu-resolution-framework-needed

What will happen now, in the aftermath of the COVID-19 crisis? In principle, hard hit and undercapitalized banks in need of recovery would face the 8% bail-in rule. However, given the current post-COVID-19 conditions, governments would likely invoke the financial stability exemption to rescue their banks. Especilly if the pandemic evolves into a systemic rather than an idiosyncratic crisis involving more than a small number of banks, as argued by Beck in this issue. Paradoxically, this could lead to a claim of the irrelevance of the Single Resolution Mechanism  – aside from the ex-ante disciplining effect on banks of the threat of its application. This would be an ill-judgement, given the extreme and exceptional conditions we are sailing through, yet it would certainly call for some deep rethinking on how to use public funds in rescuing banks in troubles within a common European framework.

A different perspective emerges if we instead consider jointly the Single Supervisory Mechanism and the Single Rulebook. If these two critical elements of the Banking Union had not been available, then probably the current situation, and the future, would be definitely darker. As we have seen, the increased capital requirements are now paying off. We can claim that, at least so far, even in the case of undercapitalized banks, they allowed for buying time for the public hands to support the economies, without having to worry too much for the banking sector, as far as the lockdowns will not continue in 2022. Also, the banking Union offered a framework for coordinating actions for granting the necessary flexibility in prudential requirements across the Union.

From the COVID-19 crisis we have also learned that it is not true that the only missing piece in the Banking Union is the European Deposit Insurance Scheme. There is still a lot to do in terms of coordination. As mentioned by Campa and Quagliariellio, payment moratoria and public guarantee schemes were launched from governments in a not sufficiently coordinated manner and significantly differed in terms of deadlines, coverage, and conditionality, notwithstanding the efforts of the ECB. This lack of coordination will impact the post-COVID-19 life of banks in Europe.

We also lack a functioning European AMC to deal with NPLs, as mentioned by Angeloni. The current European plans will most likely not materialize in time, and, retrospectively, we missed an occasion in the last phase of the GFC to introduce this tool. Had it been available now, this tense period when NPLs haven’t realized yet, but everybody predicts they will, would have been less haunted by uncertainty.

And we further lack a convincing framework for cross-border banks. This is not a detail. As we argued above, these banks could be a solution for the current situation as a driver of the efficiency of the European banking sector. However, cross-border mergers are unlikely, given the current conditions. Political pressure might oppose such mergers for fear of losing control of national banking systems. Also, the highly uncertain environment in case of resolution of a pan-European bank is a formidable impediment for a cross-border merger. As in the past, the difficulty here is to a conflicting interest of home and host jurisdictions. The Single Supervisory System has made cross-border European banks more likely, but it has not yet lifted several still existing impediments.

As we have argued many times in this journal, a further and stronger integration of European banking and capital markets is a crucial way to improve the banking sector in Europe and certainly for a rapid recovery from the dreads of the pandemic.

 

References

Angeloni, I. (2021). Non-performing loans: an old problem in a new situation. European Economy – Banks, Regulation, and the Real Sector, this issue.

Avgouleas, E., Ayadi, R., Bodellini, M., Casu, B., De Groen, W.P., and Ferri, G. (2021). Non-performing loans – new risks and policies? What factors drive the performance of national asset management companies? European Parliament. Available at: https://www.europarl.europa.eu/thinktank/en/document.html?reference=IPOL_STU(2021)651386 (Accessed on May, 6, 2021).

Barba Navaretti, G., Calzolari, G., Ottaviano, G., and Pozzolo, A.F. (2019). Capital Market Union and Growth Prospects for Small and Medium Enterprises. Development Working Papers 449, Centro Studi Luca d’Agliano, University of Milano. Available at: https://ideas.repec.org/p/csl/devewp/449.html (Accessed on May, 6, 2021).

Beck, T. (2021). Banking and COVID-19 – through the crisis and beyond. European Economy – Banks, Regulation, and the Real Sector, this issue.

Beck, T., Bruno, B., and Carletti, E. (2021). When and how to unwind COVID support measures to the banking system? European Parliament. Available at: https://www.europarl.europa.eu/RegData/etudes/IDAN/2021/659646/IPOL_IDA(2021)659646_EN.pdf (Accessed on May, 6, 2021).

Bholat, D., Thew, O., and Gharbawi, M. (2021). How Has the Covid-19 Crisis Impacted the Use of Machine Learning and Data Science in UK Banking? European Economy – Banks, Regulation, and the Real Sector, this issue.

Boot, A., Carletti, E., Kotz, H.H., Krahnen, J.P., Pelizzon, L., and Subrahmanyam, M. (2020). Corona and Financial Stability 4.0: Implementing a European Pandemic Equity Fund. VOXEU – CEPR. Available at: https://voxeu.org/article/implementing-european-pandemic-equity-fund (Accessed on May, 6, 2021).

Brescia Morra, C., and Guaccero, A., Pozzolo, A.F., Rojas Elgueta, G., Vardi, N., and Zoppini, A. (2021). Non-performing Loans – New risks and policies? What factors drive the performance of national asset management companies? Mimeo, Roma Tre Univesity.

Campa, J.M., and Quagliariello, M. (2021). Lessons from the regulatory response to the Covid-19 crisis. European Economy – Banks, Regulation, and the Real Sector, this issue.

Cartens, A. (2020). Central bank plans to create digital currencies receive backing. Financial Times. Available at: https://www.ft.com/content/428a0b20-99b0-11e9-9573-ee5cbb98ed36 (Accessed on May, 6, 2021).

Darmouni, O., and Papoutsi, M. (2021). The Rise of Bond Financing in Europe. SSRN Working Paper. DOI: http://dx.doi.org/10.2139/ssrn.3748002

Darmouni, O., and Siani, K.Y. (2021). Corporate Bond Issuance and Bank Lending in the United States. European Economy – Banks, Regulation, and the Real Sector, this issue.

Davies, H. (2021). The European Banking Union: Challenges ahead. European Economy – Banks, Regulation, and the Real Sector, this issue.

Dewatripont, M., Reichlin, L., and Sapir, A. (2021). Urgent reform of the EU resolution framework is needed. VOXEU – CEPR. Available at: https://voxeu.org/article/urgent-reform-eu-resolution-framework-needed (Accessed on May 6, 2021).

DeYoung, R., and Roland, K.P. (2001). Product mix and earnings volatility at commercial banks: Evidence from a degree of total leverage model. Journal of Financial Intermediation, 10 (1), 54-84. DOI: https://doi.org/10.1006/jfin.2000.0305

Dursun-de Neef, Özlem, H., and Schandlbauer, A. (2020). COVID-19 and Zombie Lending of European Banks (March 24, 2021). Available at SSRN: https://ssrn.com/abstract=3681937 or http://dx.doi.org/10.2139/ssrn.3681937 (Accessed on May, 6, 2021).

Enria, A., Haben, P., and Quagliariello, M. (2017). Completing the Repair of the EU Banking Sector- A Critical Review of an EU Asset Management Company. European Economy – Banks, Regulation, and the Real Sector, 2017.1, 59-70.

Falagiarda, M., and Petra Köhler-Ulbrich, P. (2021). Bank lending to Euro area firms – What have been the main drivers during the COVID-19 pandemic? European Economy – Banks, Regulation, and the Real Sector, this issue.

Köhler, M. (2014). Does non-interest income make banks more risky? Retail- versus investment-oriented banks, Review of Financial Economics, 23 (4), 182-193. DOI: https://doi.org/10.1016/j.rfe.2014.08.001

Ramos, D., and Lamandini, M. (2021). Non-performing Loans – New risks and policies? What factors drive the performance of national asset management companies? STUDY Requested by the ECON committee of the European Parliament. Available at https://www.europarl.europa.eu/RegData/etudes/STUD/2021/645734/IPOL_STU(2021)645734_EN.pdf (Accessed on May, 6, 2021).

Schivardi, F., Sette, E., and Tabellini, G. (2021). Credit Misallocation During the European Financial Crisis. The Economic Journal, ueab039, DOI: https://doi.org/10.1093/ej/ueab039

Schnabel, I. (2021). The sovereign-bank-corporate nexus – virtuous or vicious? European Central Banks Speech. Available at: https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp210128~8f5dc86601.en.html (Accessed on May 6, 2021).

Footnotes[+]

Footnotes
↑1 University of Milan.
↑2 European University Institute.
↑3 Roma Tre University.
↑4 Statement by the General Manager of BIS Agustín Carstens in his interview with Martin Wolf at Financial Times – The Global Boardroom 2nd Edition: Shaping the recovery, 13 November 2020 and also by Felix Hufeld, then the President of the Bafin, the German financial regulator, in June 2020.
↑5 Although NPLs which will derive from the pandemic are not a legacy of past misbehaviours by bankers, as in the case of GFC, the proposal is nonetheless encountering some opposition at the European level, as argued by Angeloni in this issue. For a thorough analysis of AMCs, see also Brescia Morra et al. (2021), Lamos and Lamandini (2021) and Avgouleas et al. (2021).
↑6 Andrea Enria (2021) in a recent speech suggested a mixed strategy. He argued for the need to move ahead as planned for completing and implementing the Basel III framework on capital requirements, and at the same time grant other elements of flexibility, like for the Pillar 2 capital requirements.
↑7 As suggested by the results of Bolt et al., in this issue, competition in the payment business is likely to increase in the coming years, due to the acceleration in the diffusion of digital payments during the pandemic and the likely introduction of central bank digital currencies.
↑8 Market capitalization of Apple in 2018 was roughly half the combined European listed banks’ capitalization. In 2020, the situation is reversed with Apple now valuing more than the double of the entire European banking sector.
↑9 See https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200608_ssi_table~3054d55051.en.pdf
↑10 See DeYoung and Roland (2001) and more recently Köhler (2014).
↑11 https://voxeu.org/article/urgent-reform-eu-resolution-framework-needed

Filed Under: 2021.1, From the Editorial Desk

A Bird Eye (Re)view of Key Readings

May 6, 2021 by José Manuel Mansilla-Fernández

This section of the journal indicates some and briefly commented references that a non-expert reader may want to cover to obtain a first informed and broad view of the theme discussed in the current issue. These references are meant to provide an extensive, though not exhaustive, insight into the main issues of the debate. More detailed and specific references are available in each article published in the current issue. 

 

On the economic impact of epidemics and pandemics

The current Covid-19 pandemic has vividly shown that public health issues can significantly impact the financial system due to its enormous economic costs. Notably, related containment and social distancing measures are likely to shatter the productive sector, households’ behaviour, and financial institutions’ performance through various transmission channels (Angelini et al., 2020).

Before the Covid-19 outbreak, we may find previous research warning us to anticipate the economic costs of possible future epidemics and pandemics. Accurately, Bloom et al. (2018) discuss the economic concerns that are now at the forefront after the Covid-19 outbreak, specifically increasing costs to the health system, medical treatment of infected patients and outbreak control, loss to employee productivity, or the impact on tourism, social distancing measures which may well disrupt economic activity, and impact on foreign direct investment. Interestingly, Fan et al. (2018) estimate that pandemic risks cost approximately 0.6% of global income per year. Nevertheless, the cost of the Covid-19 crisis exceeded this threshold at the time of writing this note (Goodell, 2020).[1]Goodell (2020) describes the repercussions of past pandemics such as the impact of the HIV/AIDS outbreak or the cost of future pandemics. Likewise, Haacker (2004) shows that the capacity of … Continue reading

The current literature endeavoring to forecast the Covid-19 dynamics is built on Kermack and McKendrick’s (1927) seminal work. In particular, Eichenbaum et al. (2020) investigate the equilibrium interactions between economic decisions and epidemics based on Dynamic Stochastic General Equilibrium (DSGE) models. Interestingly, Eichenbaum et al. find that, although reducing consumption and work mitigates the severity of the epidemic, the magnitude of the recession might be accentuated. In other words, the competitive equilibrium is not socially Pareto efficient as the infected group do not completely internalize the effects of their decisions about consumption and work. Their benchmark model predicts that the optimal containment policy tightens the severity of the recession but saving roughly half a million lives. Similarly, Chronopoulos et al. (2020) analyses consumer spending response to the onset and spread of the virus[2]The SARS-CoV-2 virus is the agent that causes the coronavirus disease, namely COVID-19. and the subsequent lockdown imposed in Great Britain (England, Scotland, and Wales). They find that consumers remained relatively stable during the initial phases of the Covid-19 crisis. Then, discretionary spending declined as consumers anticipated the lockdown and continued to do so after being announced. Lastly, a temporary decline in consumer spending was registered in Great Britain after the ‘stay alert’ announcement.

Importantly, it should be noted that previous authors who demonstrate that contagious disease outbreaks were contained to a lesser level than their potentiality (Bloom and Canning, 2004; Lewis, 2004; Madhav et al., 2017; Tam et al., 2016, Yach et al., 2006). Accurately, Thomas (2018) describes that the lethal outbreak of the respiratory disease Nipah in India created a significant global health issue.[3]The World Health Organization lists contagion diseases outbreaks from 1996, including Middle East Respiratory Syndrome coronavirus (MERS), Zika, Ebola virus disease, Severe Acute Respiratory Syndrome … Continue reading Interestingly, the World Health Organization (2020) report warned that the world was insufficiently prepared to take on the Covid-19 pandemic, particularly global collective actions, coordination and engagement with global systems, and financing.

 

On the impact of Covid-19 on the banking sector

The foremost financial literature shows that deteriorations in public health conditions might induce aggregate risks, thus subsequently impacting financial development and the banking sector’s stability. Undoubtedly, banks are vulnerable to aggregate risk, which might increase the likelihood of accumulating non-performing loans, and bank runs. In this regard, Lagoarde-Segot and Leoni (2013) carry out a theoretical model that shows that the banking industry of a developing country is relatively more likely to fail as the prevalence of large epidemics increases. Indeed, most of microfinance institutions and banks’ lending to the poor will be pressured by the aggregate risk (Binswanger and Rosenzweig, 1986; Skoufias, 2003). Particularly, Leoni (2013) finds that the spread of HIV in developing countries is associated with large deposit withdrawals attributed to patients’ need to pay for individual treatments.

Nowadays, economists are concerned about the impact of the Covid-19 crisis on financing points out firms’ need for liquidity and the capacity of banks to meet liquidity demand. In the first weeks of March 2020, non-financial businesses drew funds from banks’ credit lines, anticipating possible disruptions to cash flow and taking on deteriorations in funding conditions. Consequently, commercial and industrial (C&I hereafter) credit exploded on banks’ balance sheets. Indeed, the three first weeks of March 2020 were an unprecedented stress test on banks’ capacity to supply liquidity. Li et al. (2020) show that both bank and market characteristics explain the growth mentioned above of lending. Interestingly, large banks experienced relatively greater drawdowns than smaller ones. Besides, drawdowns came mainly from larger firms, which typically borrow from large banks (see Prior, 2020; Prior et al., 2020). Consequently, the largest banks granted C&I credit relatively faster than other banks.

One might raise the question of whether banks’ ability to meet the unforeseen increase in liquidity demand depends on their pre-shock financial conditions. Earlier research suggests that combining deposits and off-balance sheet credit commitments creates diversification synergies that might allow banks to hold less cash (Kashyap et al., 2002). Gatev and Strahan (2006) find that synergies are beneficial during periods of market stress because deposits flow into banks while borrowers’ liquidity demands peak.[4]Although Ivashina and Scharfstein (2010) find consistent results, Acharya and Mora (2015) highlight that banks pay higher rates to attract deposits.

Remarkably, previous studies analysing liquidity distress following the 2008 Financial Crisis converge on certain similarities with the Covid-19 crisis, which draws a stimulating theoretical framework for future research. In this regard, Cornett et al. (2011) study a related show that banks adjust to shocks to liquidity demands by reding new credit origination, and changes in credit supply depend on banks’ access to financial resources. Accurately, banks more reliant on core deposits, holding more liquid assets, and better capitalized are more prone to increase lending –and reduce less their credit supply-. Consistently, Ippolito et al. (2016) find that banks relatively more exposed to wholesale funds experienced more significant credit-line drawdowns during the European sovereign debt crisis. In addition, Li et al. (2020) find that, during the Covid-19 crisis, aggregate deposits inflows were enough to fund the increase in liquidity demand, explaining why the size of banks’ pre-crisis deposit base was independent of lending across banks. Interestingly, their results suggest that liquidity movements from off balance-sheet onto bank balance sheets will automatically increase risk-weighting assets, thus moving closer the regulatory minimum capital ratios. Furthermore, increases in loan loss provisions due to expansionary credit and risks going forward, are bound to reduce capital ratios.

Consequently, shortage of capital might constrain credit supply unless banks reduce capital distributions -i.e. dividends– and/or raise new equity. In this regard, Blank et al. (2020) conduct simulations for the future path of bank capital following the Covid-19 crisis. Their results suggest that significant declines in capital ratios could severely limit future credit supply.

Significantly, literature is growing towards the effects of debt and liquidity on non-financial firms following the Covid-19 outbreak. In this regard, O’Hara and Zhou (2020) find that the bond-market liquidity collapsed in early March but recovered after the Federal Reserve announced its intention to intervene. Fahlenbrach et al. (2020) show that a firm with more financial flexibility performs comparatively better. De Vito and Gómez (2020) find that firms would deplete their cash holdings in an interval of two years, consistent with non-financial firms relying upon bank liquidity. Importantly, Acharya and Steffen (2020a,b) document that the access to bank credit lines during the Covid-19 crisis was helpful for non-financial firms, based on stock return analysis. Acharya and Steffen (2020a,b) investigate the role of access to liquidity financing from the borrower (demand-side) perspective, whereas Li et al. (2020) do it from the bank (supply-side) view.

 

On the impact of the Covid-19 on financial markets

Little is known about how financial markets react following epidemics outbreaks, setting aside pandemics.[5]So far, investors are found to respond to other natural disasters such as volcanos, earthquakes, or terrorist acts (Bosch et al., 1998). Nevertheless, the Covid-19 outbreak has impacted … Continue reading The spillover associated with other previous natural disasters provides valuable insight into the impact of the Covid-19 on the financial markets. Previous authors examining the impact of terrorist events on financial markets might provide a parallel view since they create a widespread impact on the public mood. In particular, the analysis of the ‘spillover effects’ of terrorist events suggests abroad-based or ‘systematic’ contribution to overall risk (Karolyi, 2006). Although this evidence is limited, he has conducted few tests which assess volatility or beta risks with asset-pricing models. Previous authors show that the September 11 events affected shifts in market betas (Choudhry, 2005) and increase correlation among global markets (Chesney et al., 2011; Corbet et al., 2018; Hon et al., 2004; Nikkinen and Vähämaa, 2010).

As discussed above, the Covid-19 crisis has been found to deleteriously impact domestic demands. Thus, financial markets neglect to price the potentiality of tail-risk events that would not be survivable anyway. Consequently, a long-term impact on firm financing and the costs of capital is expected. Firms located in relatively more disaster-prone areas are shown to be less levered (Elnahas et al., 2018). In line with the trade-off theory of capital structure, firms being impacted in disastrous areas increased their costs of capital and tightened financial flexibility (Huang et al., 2018).

Recent empirical papers investigate the stock market reactions to the pandemic, finding a strong response of equity prices to news about the virus and increases in market volatility (Acharya et al., 2020; Alfaro et al. 2020; Baker et al. 2020; Caballero and Simsek, 2020). Some studies compare how different types of stocks react to the pandemic. Ding et al. (2020) show that firms more exposed to the global supply chain fared worse, whereas Ramelli and Wagner (2020) find that exposure to international trade is related to poor stock performance.

 

On the impact of Covid-19 on FinTech companies

The pandemic contributed to developing alternative forms of financial intermediation. The Financial Technologies (FinTech hereafter) has increased in different credit and other financial services by both unregulated non-banking firms and regulated banks (Erel and Liebersohn, 2020).[6]Scarce access to traditional bank credit is one of the main reasons for borrowers to approach FinTech loans (Butler et al., 2016; Cole et al., 2019; Galema, 2020). Interestingly, FinTech companies … Continue reading Stulz (2019) discusses two well-acknowledged FinTech companies, LendingClub and Kabbage, making traditional small-business lending through a bank subsidiary or a funding bank. Remarkably, FinTech companies have been found to compete aggressively on the funding side of financial institutions’ balance sheets (Abrams, 2019).

A thought-provoking research question that can be raised is whether FinTech companies responded differently to the Covid-19 crisis than traditional banks. Furthermore, FinTech is experiencing a growing path within the financial sector, which might induce changes in the supply of financial services due to this expansion. Erel and Liebersohn (2020) study the response of FinTech to financial services demand created after the implementation of the Paycheck Protection Programme (PPP) in the United States. The role of FinTech in PPP provision is comparatively more relevant in locations where the economic effects of Covid-19 were more severe. They show that borrowers were more likely to obtain a FinTech-enabled PPP loan where local banks could not originate it. Likewise, Cororaton and Rosen (2020), for a sample of firms using the PPP, document that only 13% of eligible firms end up participating. Using preliminary data, Granja et al. (2020) investigate whether areas more affected by the pandemic, measured as declined hours worked or business shutdowns, and get more allocations.

To sum up, the interaction and competition of FinTech companies and traditional banks during the Covid-19 pandemics is a fertile field for the ongoing research agenda.

 

References

Abrams, E. (2019). Assessing bank deposit market power given limited consumer consideration. University of Chicago Working Paper. Available at: https://knowledge.uchicago.edu/record/2233

Acharya, V. V., Engle, R., and Steffen, S. (2020). What explains the crash of bank stock prices during Covid-19? The role of health, financial and oil price risks. Working Paper, New York University. Available at: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/corporate_dash.pdf

Acharya, V. V., and Mora, N. (2015). A crisis of banks as liquidity providers. Journal of Finance, 70, 1-43.

Acharya, V. V., and Steffen, S. (2020a). ‘Stress tests’ for banks as liquidity insurers in a time of Covid. Working Paper, New York University.

Acharya, V. V., and Steffen, S. (2020b). The risk of being a fallen angel and the corporate dash for cash in the midst of Covid. Review of Corporate Finance Studies, 9, 430-471.

Alfaro, L., Chari, A., Greenland, A.N., and Schott, P.K. (2020). Aggregate and firm-level stock returns during pandemics, in real time. Working Paper, Harvard Business School. Available at: https://www.nber.org/papers/w26950

Angelini, E., Damjanović, M., Pariès, M.D., Zimic, S. (2020). ECB-BASIR: a primer on the macroeconomic implications of the Covid-19 pandemic. ECB Working Paper Series No 2431. Available at: https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2431~aab2650200.en.pdf

Baker, S. R., Bloom, N., Davis, S.J., Kost, K.J., Sammon, M.C., and Viratyosin, T. (2020). The unprecedented stock market impact of Covid-19. NBER Working Paper 26945. Available at: https://www.nber.org/papers/w26945

Balyuk, T., Berger, A., and Hackney, J. (2020). What is fuelling FinTech lending? The role of banking market structure. Emory University Working Paper. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3633907

Binswanger, H.P, and Rosenzweig, M.R. (1986). Behavioural and material determinants of production relations in agriculture. Journal of Development Studies, 22, 503-539.

Blank, M., Hanson, S., Stein, J., and Sunderam, A. (2020). How should U.S. bank regulators respond to the Covid-19 crisis? Working Paper, Harvard University. Available at: https://www.hbs.edu/faculty/Publication%20Files/WP63_Blank-et-al_FINAL%20(002)_0c6f4eae-bd55-4213-8487-b0e20438e052.pdf

Bloom, D.E, and Canning, D. (2004). Epidemics and economics: Interactions between global change and human health. Scripta Varia, 106, 304-331.

Bloom, D.E., Cadarette, D., and Sevilla, JP. (2018). Epidemics and economics: New and resurgent infectious diseases can have far-reaching economic repercussions. Finance and Development, 55, 46-49.

Bosch, J.-C., Woodrow, E.E., and Singal, V. (1998). The competitive impact of air crashes: Stock market evidence. Journal of Law and Economics, 41, 503-519.

Butler, A., Cornaggia, J., and Gurun, U. (2016). Do local capital market conditions affect consumers’ borrowing decisions? Management Science, 63, 3999-4446.

Caballero, R.J., and Simsek, A. (2020). Monetary policy and asset price overshooting: A Rationale for the wall/main street disconnect. NBER Working Paper 27712. Available at: https://www.nber.org/papers/w27712

Carlin, B., Olafsson, A., and Pagel, M. (2020). FinTech and consumer well-being in the information age. UCLA Working Paper.

Chesney, M., Reshetar, G., and Karaman, M. (2011). The impact of terrorism on financial markets: An empirical study. Journal of Banking and Finance, 35, 253-267.

Choudhry, T. (2005). September 11 and time-varying beta of United States companies. Applied Financial Economics, 15, 1227-1242.

Chronopoulos, D.K., Lukas, M., and Wilson, J.O.S. (2020). Consumer spending responses to the Covid-19 pandemic: An assessment of Great Britain. Working Papers in Responsible Banking and Finance Nº 20-012. Available at: https://www.st-andrews.ac.uk/business/rbf/workingpapers/RBF20_012.pdf

Cole, R., Cumming, D., and Taylor, J. (2019). Does FinTech compete with or complement bank finance? SSRN Working paper. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3302975

Corbet, S., Gurdgiev, C., Meegan, A. (2018). Long-term stock market volatility and the influence of terrorist attacks in Europe. Quarterly Review of Economics and Finance, 68, 118-131.

Cornett, M. M., McNutt, J.J., Strahan, P.E., and Tehranian, H. (2011). Liquidity risk management and credit supply in the financial crisis. Journal of Financial Economics, 101, 297-312.

Cororaton, A., and Rosen, S. (2020). Public Firm Borrowers of the US Paycheck Protection Program. SMU Working Paper. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3590913

De Vito, A., and Gómez, J.P. (2020). Estimating the Covid-19 cash crunch: Global evidence and policy. Journal of Accounting and Public Policy, 39, 106741.

Ding, W., Levine, R., Lin, C., and Xie, W. (2020). Corporate immunity to the Covid-19 pandemic. NBER Working Paper 27055. Available at: https://www.nber.org/papers/w27055

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Footnotes[+]

Footnotes
↑1 Goodell (2020) describes the repercussions of past pandemics such as the impact of the HIV/AIDS outbreak or the cost of future pandemics. Likewise, Haacker (2004) shows that the capacity of governments to cope with the HIV/AIDS epidemic eroded as the mortality and morbidity increases. Similarly, Santaelulàlia-Llopis (2007) find that HIV/AIDS prevalence delays the transition from agricultural to industrial regimes by about 105 years and reduce per capita consumption by 12% at the peak of the epidemic. Hansen and Prescott (2002) develop a population model that relates the age distribution of the population and to preceding fertility. Lastly, Yach et al. (2006) discusses the impact of obesity and diabetes on economic growth.
↑2 The SARS-CoV-2 virus is the agent that causes the coronavirus disease, namely COVID-19.
↑3 The World Health Organization lists contagion diseases outbreaks from 1996, including Middle East Respiratory Syndrome coronavirus (MERS), Zika, Ebola virus disease, Severe Acute Respiratory Syndrome (SARS), Rift Valley fever, among others (see URL: https://www.who.int/csr/don/archive/year/en/).
↑4 Although Ivashina and Scharfstein (2010) find consistent results, Acharya and Mora (2015) highlight that banks pay higher rates to attract deposits.
↑5 So far, investors are found to respond to other natural disasters such as volcanos, earthquakes, or terrorist acts (Bosch et al., 1998). Nevertheless, the Covid-19 outbreak has impacted heterogeneously across industries and affected extremely domestic demands worldwide (Goodell, 2020).
↑6 Scarce access to traditional bank credit is one of the main reasons for borrowers to approach FinTech loans (Butler et al., 2016; Cole et al., 2019; Galema, 2020). Interestingly, FinTech companies can serve the ‘unbanked’ and fill the gap in lending, when it has been contracted due to regulatory reasons during and after a financial crisis. FinTech companies offer relatively faster processing through an advanced technology (Fuster et al., 2019). They also offer relatively lower interest rates and bank fees, and unsecured debt, thus increasing consumers’ wellbeing (Carlin et al., 2020). On the other hand, although FinTech companies can substitute transactional-based lending, they might be unable to compensate the loss of soft-information lending from in-market banks (Balyuk et al., 2020).

Filed Under: 2021.1, From the Editorial Desk

Institutions 

May 6, 2021 by José Manuel Mansilla-Fernández

Basel Committee’s response to the Covid-19 crisis

The outbreak of the ongoing Covid-19 pandemic has tragically familiarized us with enormous costs in lives since the beginning of 2020. At the time of writing this article, Europe sees the third wave of infections. Recent research forecasts that the lockdowns in many European countries and containment measures could be fuelling an economic depression that might impact the real and the financial sectors (Angelini et al., 2020; Atkenson, 2020; Bodenstein et al., 2020). Consequently, the authorities have developed responses to support economic activity, preserve financial stability, and ensure transparency (Borio and Restoy, 2020).1

The Basel Committee regularly revises the implications of the Basel III standards for banks. Although the last published results do not reflect the impact of the Covid-19 pandemic on banks, recent estimates predict that banks have made positive progress in meeting capital and liquidity requirements in the last five years. Indeed, the volume of CET[1]Appendix A summarizes the government measures aimed at supporting the real sector in the foremost European economies, whereas Appendix B focusses on bank-specific measures. capital held by the largest banks doubled since 2011, whereas pool high liquid assets and inflows increased to near 12% since 2012 (EBA, 2020c). Consequently, banks entered the Covid-19 crisis in a relatively good position compared to the 2008 Great Financial crisis (BIS, 2020c, Enria, 2021). Notably, the Committee is evaluating the Basel III reforms that have been implemented to date. In September 2020, the Committee approved an updated work plan to evaluate the post-crisis reforms, incorporating lessons learned from the Covid-19 crisis. This analysis is to evaluate: (i) the effectiveness of the post-crisis reforms; (ii) the interactions between Basel III and other reforms; and (iii) the existence of gaps in the regulatory framework.

Notably, the outbreak of the Covid-19 crisis induced capital and liquidity measures to support banks’ lending and liquidity to the real sector. Most of these focus on the flexibility embedded in the Basel Framework while other measures remain temporary in nature. The revised Basel III standards were to take effect on the 1st January 2022.[2]The regulatory instrument best suited to supporting the supply of credit during a downturn is the Basel III countercyclical capital buffer, which was designed to induce banks to accumulate capital … Continue reading Nevertheless, in March 2020, the Group of Governors and Heads of Supervision (GHOS) launched a swathe of actions to provide additional capacity for banks and supervisors to respond to the immediate financial stability concerns. These actions comprise: (i) the deferral of the Basel III standards to 1st January 2023 so as not to disrupt the business cycle even more. The accompanying transition agreements for the output floor have been postponed to 1st January 2028; (ii) The revised market risk framework to the 1st January 2023; and (iii) The revised Pillar 3 disclosure to 1st January 2023 (Svoronos and Vrbaski, 2020). However, the deadline might be extended until 2028 since, nowadays, there is not a common legislative proposal from the European Commission, and the legislatives processes might take on between two and a half and four and a half years. In this regard, Enria (2021) advocates that further delays might stoke uncertainty and postpone necessary adjustments in the banking sector.

Importantly, unlike previous reforms, the current package is not aimed at fitting all the banks equally. The impact of reform would depend on banks’ business models, size and reliance on their internal models. As a structural reform, delaying or watering down Basel III standards in Europe might create assymetries among banks and put at risk reliance on internal models (Enria 2021). In particular, European regulators should avoid unclear criteria for capital standards or double-accounting of model risk at the bank level because it might introduce confusion and uncertainty for market participants.

Importantly, many jurisdictions announced that banks’ liquidity coverage ratio (LCR) may fall below 100% and that banks may take additional time to restore their LCR. This measure is oriented to provide banks flexibility to meet their liquidity needs and support their business activities. Additionally, the publication of Pillar 3 reports was deferred to extend deadlines provided to banks to file their financial statements (BIS, 2020a,b; FSB, 2020).

 

Enhancing the flexibility of the IFRS-9 accounting standards

Accounting standards are aimed at providing for an accurate representation of the banks’ accounting situation. Simultaneously, prudential regulation is devoted to ensuring financial stability. Both objectives might not be consistently achievable. Indeed, accounting standards relying heavily on market valuations might induce excessive procyclicality in the financial system (Borio, 2019; FSF, 2009) and reinforce liquidity-price spirals (Borio, 2020a,b). In this context, the Covid-19 outbreak intensified the debate about the repercussions of prudential regulation indicators, which rely on accounting valuations and may encourage banks to behave procyclically. However, prudential authorities can partly offset procyclicality through backstops or filters (Borio, 2019; Restoy and Zamil, 2017). Arguably, backstops might be able to transparently reconcile prudential regulation and accounting (Restoy, 2010).

The two principal accounting codes, the International Financial Reporting Standards (IFRS 9) and the US Generally Accounting Principles (US GAAP), have recently adopted a more forward-looking approach focused on expected losses due to loan loss provisioning. Both codes entered into force in January 2018 and December 2019, respectively. However, these new schemes cannot perform their functions in unexpected shocks such as the Covid-19 pandemic since, by definition, provisions are expected losses. The regulatory authorities responded by including at least one of the following initiatives. First, banks will be allowed to suspend the application of the new standards momentarily. Second, improving the current arrangements to sterilize the impact on regulatory capital and, lastly, issuing practical implementation guidance to avoid excessively rigid interpretations could foster provisions (Borio and Restoy, 2020).

The Basel Committee highlights the importance of the expected credit loss (ECL) accounting frameworks as a forward-looking measure of credit losses. Furthermore, the Committee has consulted international accounting and auditing standard-setting boards, audit firms, and market regulators regarding the impact of Covid-19 on such frameworks. The Committee concluded that ECL frameworks are not designed to be applied mechanistically. Banks are expected to use the flexibility inherent to accounting frameworks to mitigate the impact of the Covid-19 crisis (BIS, 2020a). In the European context, banks will have to use their judgment when determining if ECLs are required. In this regard, banks are not expected to apply the ECLs approach automatically in an exceptional situation such as the Covid-19 crisis (EC, 2020a).

 

Public Guaranteed Schemes

Public guaranteed schemes (PGS hereafter) transfer, totally or partially, the risk of default from the lender to the State. They are commonly implemented in countries where market failures prevent firms from accessing bank credit. This measure has been essential to small and medium enterprises (SMEs) since the Covid-19 outbreak until the time being.[3]Approximately 40 countries launched this programme which was aimed at providing liquidity to SMEs. The total volume of lending under PGS varies across countries (see the Numbers section). In jurisdictions where PGSs were in place before the Covid-19 crisis, countries had to make legal changes to adapt these schemes to the specific needs related to the pandemic, e.g., Spain. However, most jurisdictions decreed primary laws so as to amend the current PGS framework or to create new schemes, and to authorise fiscal backstops for the scheme. Countries with secondary legislation (e.g., the Netherlands) authorized a fiscal backstop in primary legislation. Significantly, these legal avenues depend on the country’s characteristics, and legal frameworks should be aligned with public financial management (Emre et al., 2020).

Outstandingly, moratoria and PGS share two common points. First, they are decided by governments or lawmakers, not by regulatory authorities. Second, both are complementary tools but can have very different effects in terms of borrowers’ incentives. Although the moratoria are intended to support borrowers’ short-term repayments, they can undermine credit discipline. Therefore, PGS is meant to ease capital pressures by reducing risk-weighted assets. They should also protect banks against credit risk and incentivize further lending or loan restructuring. In other words, government guarantees can be a valuable tool in the face of a sizeable exogenous shock but might also give rise to moral hazard. They might impact recovery if scarce resources end up in firms that might not be ultimately viable or do not need support. Shielding banks from bearing the risk of their lending could lead to granting credit to over-indebted borrowers (Borio and Restoy, 2020).

 

Restrictions on dividend payments and share buybacks

The restrictions on dividend payments in Europe were imposed by Recommendation ECB/2020/19 of 27 March 2020, which recommended that significant credit institutions avoid distributing dividends or share repurchases to remunerate shareholders during the Covid-19 economic crisis. Subsequently, Recommendation 2020/7 of 27 May 2020 of the European Systemic Risk Board (ESRB) extended such restriction on dividend payments to the whole financial system. Recommendation ECB/2020/19 was subsequently repealed and extended to 1 January 2021 by Recommendation ECB/2020/35 of 27 July 2020. Then, on 15 December 2020, due to persisting uncertainty regarding the evolution of the pandemic, the ECB considered banks needed to extend restrictions on dividend payments or repurchasing shares, at least for amounts up to 15% of their accumulated profits in 2019 and 2020, or more than 20 basis points of their Common Equity Tier 1 ratio. Reflecting this, Recommendation ECB/2020/62 repealed the previous Recommendation and extended the restrictions on dividend payments to 30 September 2021 (Martinez-Miera and Vegas, 2021).

Restrictions on dividend distributions preserve capital that can be used to absorb losses and support lending, but it might impair investors’ confidence, increasing banks’ cost of capital and making equity access more costly (Kongsamut et al., 2021). Preserving capital across the whole banking sector is aligned with previous measures undertaken to stabilize the economy. Furthermore, bank supervisors have fully exercised flexibility by encouraging banks to restructure loan repayments, easing regulatory regimes, and allowing banks to draw down their buffers (Awad et al., 2021). Importantly, any bailout after being allowed to pay dividends would be controversial, although they might be necessary in specific cases.

 

Contingency plans and bank resolution in the context of the Covid-19 crisis

As the pandemic’s impact across social and industry sectors has been intense, one should expect that some loans might not be repaid and NPLs increase in the most impacted cohorts, even in a recovery scenario. Consequently, banks exposed to weak borrowers might cast some doubts about their viability even under the most optimistic scenarios. If problems in the financial sector persist, creditors and investors may no longer distinguish between viable and unviable financial institutions, thus undermining confidence in the whole sector and triggering liquidity problems.

Past crises teach us that financial systems might be more resilient with a well-developed safety net and good planning. Regulatory authorities should be aware that actions oriented to strengthen safety nets -e.g., central banks, financial supervisory and regulatory agencies, resolution authority, deposit insurers, and Ministry of Finance- must have clear mandates and enough operational independence to be able to operate and execute their task under pressure.

Notably, bank resolution might be assumed undesirable and unpracticable during a health crisis. Indeed, regulatory authorities are encouraged to enhance their resolution plans for contingencies, which should be aimed at responding to potential systemic crises and in anticipation of a return to normalcy. Given the unprecedented nature of the Covid-19 outbreak, accelerating too rapid recognition of banks’ losses might constrain their ability to absorb the shock. As in the previous crisis, assessing the viability of individual banks is a crucial task, but it can only be credible when the lasting and the scope of the pandemic were clarified. Bank resolution and restructuring options can be identified once the size and distribution of losses have been quantified. Furthermore, capital needs might differ significantly across banks depending on business models and risk appetites and incentives to hide problems and losses, which might deleteriously reduce profitability and capital.

 

Legislative proposals in Europe: the moratoria and the classification of NPLs

European Banking Association (EBA) Guidelines on legislative and non-legislative loan repayment moratoria were published on 2nd April 2020 to ensure that banks would grant payment holidays to customers to avoid the automatic classification of exposures under the definition of forbearance or defaulted under distressed restructuring. After the second Covid-19, the EBA decided to reactivate the Guidelines on the 2nd of December to guarantee that loans, which have not been benefited from the moratoria, can now do it. However, the EBA has introduced the following two limitations to ensure that the support provided by the moratoria is limited to bridging liquidity shortages triggered by containment measures without operational restraints on the continuous supply of credit. First, only loans that are suspended, postponed or reduced under general payment moratoria not more than 9 months in total, including previously granted payment holidays, can benefit from applying the Guidelines. Second, banks are requested to document to their supervisors how they will assess that the exposures to general payment moratoria do not become NPLs. This requirement will allow supervisors to take appropriate actions if necessary (EBA, 2020a,b).

The legacy of the past financial crisis has been a high stock of NPLs in Member States banks. However, it should be emphasized that important progresses have been made to reduce their weight in banks’ balance sheets and improve their operational efficiency. Indeed, government guarantees and payment moratoria are key measures to support borrowers’ who might be significantly affected by the pandemic. From the regulatory point of view, the definition of default and loan forbearance under the Capital Requirement Regulation (Regulation (EU) No 575/2013) may stand in the way of widespread use of these measures. The Communication (COM/2020/112 final) clarifies that the prudential regulation rules on the classification of NPLs can accommodate in line with the ECB’s rules (EC, 2020a).

Importantly, exit strategies should be cognizant of other non-regulatory support measures to avoid compound cliff effects. Then, coordination between national and supranational authorities will be vital. Importantly exit strategies should be multifaced and adapted to country-specific characteristics to address solvency issues and distinguishing among impaired assets. There is no one-fits-all strategy to bank restructuring or NPLs resolution, and domestic regulators are encouraged to diagnose detailly before recommending systemic solutions such as public management companies, which are not suitable for heterogenous credits. Furthermore, exit strategies should include intertemporal trade-offs between increasing credit provision in the short term and maintaining long-term resilience given the associated risks (Kongsamut, 2021).

 

The ECB’s monetary policy decisions

The scale and the nature of the Covid-19 crisis called for an extraordinary monetary policy response. The European Central Bank introduced a wide-ranging package of measures that acted through two dimensions: (i) asset purchases and (ii) liquidity operations. Regarding asset purchases, an extra 120 billion euros was added to the ongoing Asset Purchase Programme (APP) on the 12th March 2020. Subsequently, the third Targeted Longer-Term Refinancing Operations (TLTRO III) programme became one of the main liquidity provisions (Borgioli et al., 2020). Borrowing rates can be as low as 50 basic points below the average interest rates on the deposit facility between 21st June 2020 and 23rd June 2021, and as low as the average rate on the deposit facility during the rest of the life of the respective TLTRO III. Accurately, the Decision ECB/2020/25 and Decision (EU) 2020/614 modify the lending performance threshold, a new lending assessment period and changes in the interest rate to be applied to TLTRO III; whereas the Decision ECB/2020/13 modifies the borrowing allowance and the bid limits per operation to be applied to TLTRO III and allows an earlier repayment option after one year of settlement starting in September 2021 (Altavilla et al., 2020).

The Pandemic Emergency Purchase Programme (PEPP) was launched on 18th March 2020 and is conceived as a temporary asset purchase programme of private and public sector securities. The cornerstone of this programme is that the national central banks will flexibly conduct purchases of public debt. The Government Council will offer four additional pandemic emergency longer-term refinancing operations (PELTROs) in 2021, which will continue to provide an effective liquidity backstop.

 

References

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Kongsamut, P., Monaghan, D., and Riedweg, L. (2021). Unwinding COVID-19 Policy Interventions for Banking Systems. International Monetary Fund. Special Series on COVID-19.
Martinez-Miera, D., and Vegas, R. (2021). Impact of the dividend distribution restriction on the flow of credit to non-financial corporations in Spain. Bank of Spain Analytical Articles. Available at: https://www.bde.es/bde/en/secciones/informes/boletines/articulos-analit/ (Accessed on April 29, 2021).

Restoy, F. (2020). Central banks and financial stability: A reflection after the Covid-19 outbreak. Financial Stability Institute Occasional Paper No 16. Bank for International Settlement. Available at: https://www.bis.org/fsi/fsipapers16.htm (Accessed on April 29, 2021).

Restoy, F. (2010). Accounting, convergence, governance and regulation. Speech at the IASC Foundation IFRS Conference, June. Available at: https://www.esma.europa.eu/document/accounting-convergence-governance-and-regulation-speech-given-fernando-restoy-ifrs (Accessed on April 29, 2021).

Restoy, F., and Zamil, R. (2017). Prudential policy considerations under expected loss provisioning: Lessons from Asia. FSI Insights on policy implementation No 5. Bank for International Settlement. Available at: https://www.bis.org/fsi/publ/insights5.pdf (Accessed on April 29, 2021).

Svoronos, J.P, and Vrbaski, R. (2020). Banks’ dividends in Covid-19 times. FSI Briefs No 6. Available at: https://www.bis.org/fsi/fsibriefs6.htm (Accessed on April 29, 2021).

 

Legislation cited

Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Investment Bank, and the Eurogroup. Coordinated economic response to the COVID-19 Outbreak (COM/2020/112 final).

Decision (EU) 2020/614 of the European Central Bank of 30 April 2020 amending Decision (EU) 2019/1311 on a third series of targeted longer-term refinancing operations (ECB/2020/25).

Decision (EU) 2020/407 of the European Central Bank of 16 March 2020 amending Decision (EU) 2019/1311 on a third series of targeted longer-term refinancing operations (ECB/2020/13).

Recommendation of the European Central Bank of 27 March 2020 on dividend distributions during the COVID-19 pandemic and repealing Recommendation ECB/2020/1 (ECB/2020/19) 2020/C 102 I/01.

Recommendation of the European Central Bank of 27 July 2020 on dividend distributions during the COVID-19 pandemic and repealing Recommendation ECB/2020/19 (ECB/2020/35) 2020/C 251/01.

Recommendation of the European Central Bank of 15 December 2020 on dividend distributions during the COVID-19 pandemic and repealing Recommendation ECB/2020/35 (ECB/2020/62) 2020/C 437/01.

Recommendation of the European Systemic Risk Board of 27 May 2020 on restriction of distributions during the COVID-19 pandemic (ESRB/2020/7) 2020/C 212/01.

Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012.

 

Appendix A. Summary of government measures oriented to support the real sector.

 

France

State-Guaranteed Loans

Moratorium

Liquidity Shortage

Law No. 2020-289 and ministerial order of implementation dated 23 March 2020:

The State-guaranteed loan is a one-year treasury loan and will have a grace period over this period.

It could support corporate bank financing to the tune of EUR 300 billion.

Ordinance n. 2020-306 dated 25 March 2020 on the extension of time limits and adaptation of procedures during the Emergency Period (as defined below) has been taken and supplemented by ordinance n. 2020-427 dated 15 April 2020. Bpifrance and the government finance 50% of the consulting costs concerning the WCR cash module.

Credit Mediation / Lines

Public Credit

Support from the State and the Bank of France (credit mediation) to negotiate with his bank a rescheduling of bank loans.

The Credit Mediation Department may accept companies in amicable procedure, in safeguard or receivership, and exceptionally in compulsory liquidation.

Amended Finance Bill for 2020, Law #2020-473, 25 April 2020:

State-granted loans when they have not benefited from State-guaranteed loans.

Banks will have to write reasons for refusing loans lower than EUR 50 thousand to companies.

 

Germany

State-Guaranteed Loans

Moratorium

Liquidity Shortage

The KfW (Kreditanstalt für Wiederaufbau) offers a fast track loan for the companies with more than 10 employees. This loan is 100% secured by the German Federal Government guarantee. The obligation to file for insolvency is suspended retroactively from 1 March 2020 until 30 September 2020 for companies which are suffering economic difficulties or have become illiquid because of the pandemic. Joint protective shield amounting to EUR 30 billion from the Federal Government and credit insurers to secure supplier credits of German companies. Substantial participation of credit insurers, who bear losses of up to EUR 500 million.

Credit Mediation / Lines

Public Credit

Introduction of a shopping line coverage whereby the credit lines of foreign customers from various exporters are combined into credit tranches with a uniform repayment profile and counted towards the Hermes-covered credit line. The German Federal Government has adopted a package of measures to help companies cope with the coronavirus crisis. The role of the state-owned development bank KfW in this crisis is to facilitate the short-term supply of liquidity to companies.

 

Italy

State-Guaranteed Loans

Moratorium

Liquidity Shortage

Central Guarantee Fund (“Fondo centrale di garanzia”):

Less than 72 months loans of amounts equal to those set forth by the decree no. 23/2020 may be guaranteed by the Central Fund up to 90% (in case of direct guarantee) or up to 100% (in case of reinsurance), subject to the approval of the European Commission.

The Central Fund and Confidi guarantee also 100% of loans (with a limit of 25% of the total turnover of the beneficiaries) granted to companies with less than EUR 3.2 million of total turnover.

The Italian Banking Association has announced an agreement with various professional associations to set up a large-scale moratorium on debt repayment, including mortgages and repayments of small loans and revolving lines of credit. It will concern loans taken out by companies until 31 January 2020. The National Promotional Institute and the development finance institution have increased the funding limit for the banking system, from EUR 1 million to EUR 3 million.

Credit Mediation / Lines

Public Credit

SACE S.p.A. issues guarantees for loans granted to companies of any size (EUR 200 billion of which EUR 30 billion for SMEs). SACE guarantees between 90% and 70% of the granted loans’ amount; the guarantees’ amount depends on the number of companies’ employees in Italy and on the relative annual turnover (with at least 5000 employees and until EUR 1.5 billion, between EUR 1.5 billion and EUR 5 billion or greater than EUR 5 billion annual turnover). The National Promotional Institute and the development finance institution have increased the funding limit for the banking system, from EUR 1 million to EUR 3 million.

 

The Netherlands

State-Guaranteed Loans

Moratorium

Liquidity Shortage

Enlargement of the Corporate Financing Guarantee Scheme (Garantie Ondernemersfinanciering; GO-C) for SMEs and larger firms. The amount for which the government stands as guarantor has been increased up to EUR 150 million. Small firms are offered a six-month delay in repayments of micro loans through Qredits, with interest rates lowered down to 2%. Borgstelling MKB-kredieten (BMKB(-C)):

The credit guarantee has been increased up to 90% of 75% of a line of credit and the percentage for the premium due is lowered from 3.9% to 2% for a maximum period of 8 quarters and 3% for a period of 9 to 16 quarters. The BMKB(-C) guarantee ceiling is EUR 1.5 billion.

Credit Mediation / Lines

Public Credit

The Growth Facility Scheme, which makes it easier for SMEs to raise capital, will be extended by one year, to 1 July 2021. SMEs with relatively small financial needs are, under conditions, eligible for a bridging loan of up to € 50,000 under the Small Credits for Corona Guarantee Scheme (Klein Krediet Corona garantieregeling; KKC) with the State as guarantor for 95% of loan.

The term of the loan is at most 5 years against an interest rate of max. 4%, with a one-time premium of 2%. This measure has a guarantee ceiling of EUR 713 million.

 

Spain

 

State-Guaranteed Loans

Moratorium

Liquidity Shortage

Royal Decree-8 2020:

Approval of a EUR 100,000 million line of state-backed guarantees credit line whereby the State shall cover the financing extended by financial institutions to companies and self-employed persons.

Royal Decree-8 2020:

Moratoria is applied to mortgage-backed loan agreements when the debtor is in a situation of economic vulnerability, as well as the guarantors of the main debtor.

Notaries’ fees for intervention in contracts formalising the temporary suspension (moratorium) of contractual obligations under any of the non-mortgage-backed loans or credits referred to in Royal Decree-Law 11/2020.

Royal Decree-Law 8/2020:

Approval of a credit line whereby the State shall cover the financing extended by financial institutions to companies and self-employed persons. The Ministry of Foreign Affairs and Digital Transformation will grant up to EUR 100,000 million in guarantees for funding provided by credit institutions (Art. 29).

Credit Mediation / Lines

Public Credit

Royal Decree-Law 15/2020:

The counter-guarantee granted by Compañía Española de Reafianzamiento Sociedad Anónima (CERSA) has been consolidated to increase the guarantee capacity of Reciprocal Guarantee Company.

Provisions made to cover promissory notes included on the Spanish Brokers’ Association (AIAF) Fixed Income Market and the Alternative Fixed income Market (MARF).

Raising of the net indebtedness limit of the Spanish official credit institute (ICO) to increase credit facilities aimed at financing SMEs and the self-employed.

The General State Budget Law allows ICO to raise EUR 10,000 million to provide additional liquidity to the above-mentioned agents.

 

United Kingdom

State-Guaranteed Loans

Moratorium

Liquidity Shortage

The Coronavirus Business Interruption Loan Scheme (CBILS) -for business with turnover lower than GBP 45 million- UK businesses with annual turnover of no more than GBP 45m can borrow up to GBP 5m interest-free for 12 months under a British Business Bank (BBB) scheme where the Government provides the lender with a guarantee for 80% of each loan (subject to a per-lender cap on claims) and covers the cost of the first 12 months of interest.

For large businesses, the CBILS involves a government guarantee of 80% to enable banks to make loans of up to GBP 25 million (CBILS was capped at GBP 5 million) to businesses with an annual turnover of between GBP 45 million and GBP 250 million. Firms with a turnover of more than GBP 250 million can borrow up to GBP 50 million from lenders.

The government guarantees 80% of the finance to the lender.

Regulations will provide for application to:

a) Charitable Incorporated Organisations.

b) Co-operative and community benefit societies

c) Limited liability partnerships

Where entities currently benefit from a special administration regime (for example providers of social housing, gas and electricity supply companies and financial institutions) regulations can be made to modify application of or disapply the moratorium for those entities.

Bounce Back loan scheme for small businesses:

On 27 April, the government announced a fast-track finance scheme for small businesses, allowing firms to apply for Bounce Back loans worth up to 25% of turnover, with a maximum payment of GBP 50,000, and access the cash within days.

The government will provide lenders with a 100% guarantee for the loan and pay any fees and interest for the first 12 months. No repayments will be due during the first 12 months. After that the interest rate will be set at 2.5% a year.

Credit Mediation / Lines

Public Credit

The COVID-19 Corporate Finance Facility (CCFF) has been created to provide funding to large businesses through the purchase of short-term corporate debt in the form of commercial paper.

The CCFF launched on 23 March 2020 and Bank of England data released on 2 April 2020 showed that GBP 1.9 billion of commercial paper has been purchased under this facility already and according to a HM Treasury release on 3 April 2020 a further GBP 1.6 billion has been committed.

Future Fund for high-growth companies:

The Future Fund was initially endowed with GBP 500 million loan scheme aimed at ensuring that high-growth companies in the UK receive the investment they need to continue during the crisis.

The government confirmed that given the high number of applications it would be expanding its financial commitment to the fund.

Delivered in partnership with the British Business Bank.

Source: Own elaboration from KPMG’s website (https://home.kpmg/xx/en/home/insights/2020/04/government-response-global-landscape.html).

 

Appendix B. Regulatory measures appliable to banks as of April 2021.

 

Country

 

Regulatory measures

 

France

Reducing the countercyclical capital buffer to 0% (an increase from 0,25% to 0,5% was to become in April 2020).

Germany

Releasing the countercyclical capital buffer for banks from 0,25% to 0%.

Further EUR 100 billion to refinance expanded to refinance expanded short-term liquidity provision to companies through the public development bank (KfW) in partnership with commercial banks.

Italy

The Bank of Italy announced a series of measured to help banks and non-bank intermediaries, in line with those undertaken by the ECB and the EBA.

Including the possibility to operate below selected capital and liquidity requirements, as well as rescheduling on-site inspections.

Promoting the use of credit claims as collateral to incentivize lending to SMEs.

The Netherlands

The De Nederlandsche Bank (DNB) reduced systemic buffer requirements for the three largest banks.

The DNB is also taking measures to provide less regulatory relief to less significant banking institutions. Banks directly supervised by the DNB are allowed to exclude specific central banks exposures when calculating leverage ratios.

Introducing a floor for mortgage loan risk weighting is postponed. Dutch banks agreed to grant SMEs a six-month postponement of their loan repayment.

On the 6th October 2020, the authorities adopted a law to facility debt restructuring for companies facing financial difficulties. This law is intended to avoid bankruptcies.

Spain

The Bank of Spain will allow the banks under its supervision to adapt the settings of transition periods and the intermediate minimum required own funds and eligible liabilities (MREL) targets.

Banks will be allowed to apply expert judgement for the credit-risk classification of forborne exposures.

United Kingdom

The Prudential Regulatory Authority (PRA) set out expectations that banks suspended dividends and buybacks until end-2020, cancel 2019 dividends and pay no cash bonuses to senior staff.

The PRA indicated all Pillar 2A requirements will be set as nominal amount despite a percentage of Risk Weighted Assets (RWA).

The PRA will allow companies to offset the increase in RWA due to the application of a higher value-at-risk (VaR) multiplier through a reduction in risks-not-in-VaR (NVAR) capital requirements.

The Financial Conduct Authority (FCA) introduced a package of targeted temporary measures to support customers affected by coronavirus, including payment freeze on loans and credit cards for up to three months.

Source: Own elaboration from the IMF Policy Tracker (URL: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#G).

Footnotes[+]

Footnotes
↑1 Appendix A summarizes the government measures aimed at supporting the real sector in the foremost European economies, whereas Appendix B focusses on bank-specific measures.
↑2 The regulatory instrument best suited to supporting the supply of credit during a downturn is the Basel III countercyclical capital buffer, which was designed to induce banks to accumulate capital during growth times so that they can draw it out in crisis times. The countercyclical capital buffer is calibrated as a function of risk-weighted assets, within a range of 0-0.25% according to the economy’s phase within the financial cycle and helps to mitigate procyclicality of banks’ behaviour (Restoy, 2020). Furthermore, Basel III introduced the capital conservation buffer, which is intended to be drawn in bad times to allow banks to maintain their intermediation function.
↑3 Approximately 40 countries launched this programme which was aimed at providing liquidity to SMEs. The total volume of lending under PGS varies across countries (see the Numbers section).

Filed Under: 2021.1, From the Editorial Desk

Lessons From the Regulatory Response to the Covid-19 Crisis

April 27, 2021 by José Manuel Campa and Mario Quagliariello

Authors

José Manuel Campa and Mario Quagliariello[1]European Banking Authority (EBA). This article is based and elaborates on José Manuel Campa’s speech “The regulatory response to the Covid-19 crisis: a test for post GFC reforms” at the … Continue reading

 

1. Introduction

Since the Great Financial Crisis (GFC), the European banking sector has made significant progress in restoring resilience and market confidence. At the beginning of 2020, while there were still significant challenges ahead – not least the structurally low profitability and pockets of idiosyncratic vulnerabilities particularly in mid-sized banks – the positive trend was robust and consolidated. Banks and supervisors were actively addressing remaining weaknesses, and market participants were expecting decisive steps towards the completion of the balance sheet repair.
The outbreak of the Covid-19 pandemic was an unprecedented test for the economy and made any forecasts outdated and obsolete. Organisations, professionals and individuals have gradually adapted to the new conditions and learnt how to mitigate the operational difficulties and emerging risks of a worldwide pandemic. Yet, with the vaccination campaigns progressing at uneven pace in different jurisdictions and widespread uncertainty on the start and speed of economic recovery, many challenges lie ahead. This is true for the health systems, the economies as well as the banking sector.

The exceptional measures adopted globally in response to the first wave of the epidemic have brought the global economic activity to a sudden freeze. Because of the various forms of population confinement – such as lockdowns and social distancing – the Gross Domestic Product (GDP) has markedly declined in the EU and at the global level and the path to recovery remains uncertain.
The impact of Covid-19 largely depends on how successful governments are going to be in their vaccination campaigns, limiting the spread of new variants and preventing further waves. The effectiveness of the actions taken to support the economy will also determine the pace of economic recovery.

Banks were not the source of this crisis, nor have they been the most affected sector. Thanks to strong starting positions and unprecedented public measures to support the economy, the banking sector proved able to absorb the initial shock, remain resilient, and provide liquidity to struggling households and firms.

The combination of inner strength and prompt supervisory responses allowed banks to play an important role in supporting the economy during the heights of the crisis also thanks to the exceptional monetary and fiscal policies. EU supervisory authorities demonstrated the capacity to act quickly, resolutely, and effectively to mitigate the impact of the crisis on the financial sector. The European Banking Authority (EBA) took a number of steps, first, to facilitate banks to continue providing financing to households and corporates at a very difficult juncture and, second, to monitor the evolution of the crisis in order to adjust its measures as deemed necessary.

However, as the pandemic continues to affect the economy, a legitimate question arises of whether banks will be able to absorb the full impact of the crisis as they continue providing adequate lending to the economy. Unquestionably, the crisis will also have longer-term implications on the future shape of the banking sector. There are some additional questions on whether the regulatory framework is fit for purpose to allow banks to pursue these goals.

In this article, we try to address these questions with a focus on the European Union. We describe how banks entered the crisis, explain the rationale for the actions taken as the immediate response, provide some initial thoughts on the lessons learnt and try to look forward and sketch some possible implications for future policy-making.

 

2. Banks at the start of the crisis

European banks entered the Covid-19 epidemic with relatively high capital levels and abundant liquidity buffers, particularly when compared to the recent past. The solvency level of EU banks had improved significantly since the GFC (chart 1) and, more importantly, the cross-sectional dispersion reduced materially, with banks in the lower quartile catching up steadily. In December 2019, EU banks’ Common Equity Tier 1 ratio (CET1) was 15.1% on average and banks were comfortably above regulatory minima. The management buffer – which is the additional capital banks hold in excess of capital requirements, buffers and supervisory expectations – was 300bps. This trend of higher capital ratios – which is also visible when looking at the evolution of non-risk-weighted metrics such as the leverage ratio – has been driven by both deleveraging and the increase in own funds, also in connection with the gradual adjustment to the Basel 3 standards.

 

Chart 1 – EU Banks: Common equity tier 1 (CET1) ratio

 

Similarly, liquidity buffers were ample, with the Leverage Coverage Ratio (LCR) close to 150% (chart 2). Also in this case, the contraction of the interquartile range and the overall move upwards of the distributions are impressive and confirm that the progress was widespread. Banks’ funding mix was also more balanced and stable, with a steady increase of the share of household and non-financial corporation deposits since the GFC. In contrast to previous recent crises, available liquidity buffers increased even further in 2020, in connection with massive central banks interventions providing cheap funding to the banking sector. Banks also benefited from favourable conditions in wholesale funding markets in the quarters before the outbreak of COVID-19.

 

Chart 2 – EU Banks: Liquidity coverage ratio (LCR)

 

Banks had also significantly reduced non-performing loans (NPLs) and improved asset quality, with an acceleration after the approval of the Council’s NPL action plan in 2017. With the introduction of a common definition of NPLs, the EBA provided the regulatory framework and monitoring mechanism that allowed supervisors to push banks strategies.

Since 2014, NPL volumes have more than halved (chart 3) and the progress, while generalised, was more pronounced for countries with higher starting NPL ratios. The positive downward trend affected all sectors and asset classes and was achieved through both internal organic workout and disposals in secondary markets, either portfolio sales or securitisations. However, the pace of the adjustment in the sector could have been faster. The NPL ratio in 2019 stood at 3.1% on average, higher than in other advanced economies, with many countries still showing levels well above those recorded before the GFC.

 

Chart 3 – EU Banks: Non-performing loan (NPL) ratio

 

Despite the efforts put by banks in repairing their balance sheets and improving asset quality, a number of challenges remained in the industry.  Banks’ profitability had not recovered since the GFC, with returns remaining subdued amidst low interest rates and banks’ difficulties in reducing operating expenses (chart 4). For many banks, the return on equity has not covered the cost of equity for many years, as also reflected in their market valuations.

 

Chart 4 – EU Banks: Return on Equity (RoE)

 

Persistent low profitability, and remaining pockets of poor asset quality, along with competitive pressures coming from new digital players, are likely to be exacerbated by the current crisis. Supervisory measures adopted in 2020 provided an immediate response to short-term tensions and the sudden halt of economic activities. However, banks still need also to address long-term outstanding problems, which require structural reforms.

 

3. A review of the regulatory response

The immediate reaction of the supervisory community to Covid-19 and the gradual deployment of containment measures by governments aimed at ensuring business continuity in such difficult circumstances. It was important that banks were able to serve the economy and their customers, avoiding the collapse of credit to the real economy at the very moment when it was required to transmit fiscal stimulus to corporates and households.

The rationale of the measures adopted by the supervisory community was clear. The target was to safeguard business continuity in the sector, allow banks to use the capital and liquidity buffers accumulated over time, and remove any unintended obstacles to the widespread use of public support measures.

Regulators provided operational relief to banks, allowing them to shift resources where mostly needed. This decision was not made lightly. Postponing the ongoing 2020 EBA EU-wide stress test exercise by one year, delaying remittance dates for supervisory reporting, and putting on hold consultation processes determined a loss of valuable information, in particular on banks’ latest conditions, at the very moment authorities actually needed it the most. Nevertheless, this was the right thing to do in exceptional circumstances, with banks in great need to focus on critical functions and operational resilience.

The EBA recognised the need for a pragmatic approach in the 2020 Supervisory Review and Evaluation Process (SREP) as well as for recovery planning, and recommended that supervisory authorities focus their efforts on the most material risks and vulnerabilities driven by the crisis.

At the global level, the implementation of the Basel 3 standards finalised in December 2017 was deferred by one year to January 2023. In Europe, the EBA reminded that capital – and liquidity – buffers accumulated by banks over time were a reserve to absorb losses but also to ensure continued lending to the economy. In the same spirit, several macroprudential authorities released the countercyclical buffers and supervisors allowed banks to operate below their Pillar 2 Guidance (P2G). It was also clarified that part of the Pillar 2 requirements could be covered with instruments other than CET1.

With the Capital Requirements Regulation (CRR) ‘quick fix’, which was approved by the European Parliament in June 2020, the transitional arrangements for smoothing the impact on capital of the introduction of International Financial Reporting Standard (IFRS) 9 on own funds were extended by 2 years. Other measures already in the pipeline – for instance a revised and more generous supporting factor for lending to small and medium enterprises (SMEs) – were introduced ahead of schedule. The EBA also frontloaded the rules on the prudential treatment of software investments introducing their partial deduction from capital.

The corollary of capital relief measures was the recommendation to banks to follow prudent dividend distribution policies. Dividend restrictions and bans forced banks to preserve capital with an overall impact of about 40 billion Euros. This was a controversial measure, with a few stakeholders arguing that a case-by-case approach would have been better than a generalised restriction. However, a system-wide approach was proportionate to the severity of the crisis and the uncertainty on its effects. A case-by-case approach would have not achieved the same objective and the stigma effect on some banks could have adversely affected those intermediaries in more urgent need of support.

We have mentioned already that banks entered the crisis with good solvency positions and a management buffer of about 300bps of RWAs in December 2019 (chart 5).

Chart 5 – Evolution of management buffers in 2020

 

Capital related measures had the objective of further enhancing banks’ ability to finance the economy, thus creating additional headroom for lending. Taken together, these measures contributed to free up capital, with the management buffer increasing to 570 bps assuming the full use of P2G. However, the availability of buffers was uneven across the EU due to the different starting position of banks and to the diverse implementation of macroprudential measures across Europe.

The EBA also intervened to avoid any unintended reclassification in default status for debtors in temporary liquidity difficulties. In particular, there was a pressing need to address the prudential treatment of legislative and non-legislative payment moratoria, which were introduced by several countries as a support measure to provide payment breaks to borrowers. The EBA published guidelines[2]EBA (2020), Guidelines on legislative and non-legislative moratoria on loan repayments applied in the
light of the COVID-19 crisis.
to clarify that the payment moratoria do not automatically trigger forbearance classification and the assessment of distressed restructuring if they are based on the applicable national law or on an industry-wide initiative agreed and applied broadly by relevant credit institutions.

These guidelines were necessary for avoiding the automatic reclassification in forborne or defaulted status of loans under moratoria, but they also confirmed the necessity of a timely and accurate measurement of credit risk. They safeguarded borrowers with temporary liquidity problems, but did require the assessment of the long-term unlikeliness to pay.

The emergency determined by Covid-19 called for emergency measures. However, it was – and it is – important to preserve the correct measurement of risks and the reliability and timeliness of risk metrics. Therefore, the EBA also put in place adequate tools in order to enable supervisors and stakeholders to monitor these exposures and adequately assess the evolving situation in the banking sector. The EBA introduced ad-hoc reporting and disclosure requirements for the exposures benefitting from moratoria and public guarantees. This allows supervisors to understand the materiality of the exposures as well as their classification for prudential and accounting purposes.

 

4. Is this time different?

Capital ratios have improved further since March 2020, NPLs have not increased and liquidity has remained ample. Compared with the previous crises, bank lending to the real economy has increased, particularly in the first half of 2020. In the early stages of the COVID-19 outbreak, non-financial corporations (NFCs), especially small and medium-sized enterprises (SMEs), made use of available loan commitments to secure liquidity and operational continuity. Later on, credit demand was mostly driven by government guaranteed loans.

The increase in lending, along with the surge in cash balances that followed central bank extraordinary liquidity allotments, has resulted in a 9% increase in total assets in the first three quarters of 2020. This figure could slightly underestimate the size of asset growth since, in some jurisdictions, fully guaranteed loans can be derecognised by banks and, thus, are not visible in their balance sheets.

In this section, we explore further the data available at the EBA, with a focus on banks’ use of moratoria and deposit guarantees and forward-looking indicators of asset quality[3] EBA (2020), First evidence on the use of the moratoria and public guarantees in the EU banking sector.. This should provide a more accurate picture of the future evolution of credit risk, beyond headline figures.

In September 2020, EU banks reported EUR 587 billion of loans under moratoria compliant with the EBA guidelines, which represents around 5% of the total outstanding loans to households and NFCs. Banks also reported that moratoria had expired for about EUR 350bn of loans. The use of moratoria was heterogeneous across countries, reflecting the different timing and impact of the epidemics as well as the variety of national support measures deployed by governments.

Loans under moratoria were around 6% for NFC, whereas 4% of household loans had been granted some form of payment holidays in September 2020, which is about half the amount recorded in June. Moratoria were more widely used by small and medium enterprises, which typically rely more on bank credit for financing their funding needs. About 55% of the moratoria had a maturity of less than 3 months, and around 85% of them were to mature before March 2020.

The EBA guidelines require banks to perform the usual due diligence on asset quality evolution and, in particular, on debtors’ likeliness to pay. Therefore, the evolution of credit risk for loans under moratoria provides valuable information on the quality of these loans as well as on banks’ risk management approach during the pandemic. In September 2020, about 20% of loans under moratoria were classified as stage 2, which is more than double the share for total loans. The NPL ratio for loans subject to moratoria was 3%, which is slightly higher than the EU average (2.8%). This is, however, not surprising considering that some national schemes included only performing loans as eligible for payment moratoria. In our view, this suggests that banks, to some extent, have been proactive in assessing the unlikeliness to pay – in the absence of past-due criterion for the loans under moratoria – as well as any material increase in credit risk triggering the migration of loans from Stage 1 to Stage 2. On the other hand, this is also in line with the evidence that moratoria reached the intended recipients – i.e., the economic sectors most affected by the crisis – which tend also to be riskier.

The use of public guarantees (PGS) was also widespread. In September 2020, newly originated loans subject to PGS amounted to around EUR 289 billion. This volume represents a relatively small share of the stock of total loans on average (about 1.6%) but is material for some banks and jurisdictions. Public guarantees were granted predominantly for loans to NFCs, which represented almost 94% of all new loans benefitting from PGS. PGS impact on banks’ lending was rather significant in the countries more affected by the first wave of Covid-19 contagion.

Public guarantees have the potential to reduce significantly banks’ RWAs. In September 2020, banks reported RWAs of EUR 45 billion for exposures subject to PGS of EUR 289 billion. This implies an average risk weight of around 16%, which can be compared with an average risk weight for banks’ NFC exposures of 54%[4]EBA (2020), Risk Assessment of the European Banking System. According to estimates, this corresponds to a benefit in terms of CET1 ratio ranging between 10 and 20 basis points.

Overall, public support measures – both on the fiscal and prudential side – along with very low interest rates did shield the banks from the first round effects of the crisis. NPL ratios and volumes remained low and the declining trend was confirmed, even though at slower pace than pre-Covid-19.

However, there are also early signals of asset quality deterioration, particularly looking at more forward-looking indicators. The volume of loans classified under IFRS 9 stage 2 – those that are still performing but for which there was a significant increase in credit risk – increased by 24% to EUR 1.2bn in 2020, bringing their share to 8% of total loans. A similar trend was observed for forborne loans, which can at some point turn into non-performing status if the conditions of the restructured debtors worsen further.

This dynamic was also reflected in profit and loss accounts. Banks have booked substantial provisions on performing loans that resulted in a material increase in the cost of risk, albeit with significant dispersion. As a result, the cost of risk – the ratio between the flow of impairments and total loans – was significantly higher than in 2019 (0.74% in Q3 2020 vs 0.46% in Q3 2019). Profitability deteriorated quickly due to increased provisions and plummeted to zero in Q1 2020, with a moderate recovery in the following quarters. Pressure on interest margins will not decrease anytime soon, as the low or negative interest rate environment is expected to persist for even longer.

While it is difficult to make accurate forecasts on the timing and materiality of asset quality deterioration, all these elements point to a new wave of NPLs in the coming quarters. According to a sensitivity analysis carried out by the EBA for assessing the impact of COVID-19 on EU banks, stage 3 assets could increase to levels comparable to 2014 and credit risk losses could determine a decline of CET1 ratios between -230bps to -380bps, without taking into account the mitigating impact on impairments of PGS[5]EBA (2020), The EU Banking Sector: First insights into the COVID-19 impacts.. EU banks would have, on average, enough capital buffers for absorbing these losses, but there could be cases requiring corrective measures. While we are cautious in interpreting these results given the uncertainty on future economic conditions and the mitigating impact of the government support measures, this is an area that requires close monitoring, proactive actions and enhanced policy toolkit.  Currently, the EBA is performing its biennial stress test exercise of European banks, which will provide a more detailed account on the status of the banking sector and its ability to weather a severe downward macroeconomic scenario.

There are ways to mitigate the impact of the expected increase of credit risk on financial stability. First, it is for banks to proceed with the early and transparent recognition of any deterioration of asset quality. It is imperative that investors do not lose their trust in the EU banking sector as in the aftermath of the GFC, when banks – notwithstanding the strengthening of capital positions – were perceived to be hiding losses in their balance sheets. Banks need to have enough provisions. This crisis may be less harmful than we expect or the recovery faster but, at this stage, it is safer to err on the conservative side and reverse provisions later.

Low for long interest rates can have a positive mitigating impact on credit risk, but it should not lead to unjustifiable delays of non-viable firms, nor to the delay in recognition of potential non-performing exposures.  The same principle should apply to the banking sector itself. The low interest rate environment should also not delay a long-due restructuring of the sector and the orderly exit of weaker banks. In addition, low for longer interest rates will make it harder to regain profitability through credit intermediation. Banks need to redefine their business models, find other income sources, partly embracing innovation but also leveraging on their traditional competitive advantage in serving their customers, offering advice and higher value added services, and supporting their migration towards a greener economy.

 

5. Lessons for regulation

All crises are different but they also share similar patterns. In the midst of the turmoil, economic agents tend to react looking primarily within their private interests and cooperation and coordination suffer. At the national level, this results in actions being taken pursuing national objectives and, at times, with insufficient coordination. This is understandable when there is an urgency to act under time pressure and uncertainty, but it is far from optimal and can jeopardise the overall economic recovery and the level playing field.

The reaction to this crisis shows a mix of national bias and a strong, genuine effort to provide a common EU response with stronger coordination. On the one hand, the actions at the European level have been unprecedented, particularly when compared with previous crises.  The monetary policy, macroprudential and supervisory responses were quick and well-coordinated. More importantly, the EU agreed on a long-term budget that, coupled with NextGenerationEU, represents a strong commitment to deliver an EU-wide post-crisis stimulus package financed through the EU money.

On the other hand, the immediate public support provided to the economy was diverse across countries and commensurate to the fiscal capacity of the single Member States. Payment moratoria and public guarantee schemes affecting the banking sector were launched from national initiatives with little or no supranational coordination, different deadlines, coverage and conditionality. The EBA tried to provide with its guidelines on moratoria a harmonised framework for the prudential treatment of such measures. However, the policies implemented remain different in many aspects.

Going forward, it is important that the interaction of these policies with the need for orderly restructuring of the corporate sector as a result of the crisis does not result in a fragmentation of the single market and an uneven playing field within the EU banking sector.

The crisis has also proven that the regulatory reforms agreed at the global level in the aftermath of the GFC have been successful in strengthening banks’ resilience. While the long-term impact of Covid-19 is still to be determined, high capital, ample liquidity, improved asset quality, enhanced digital capacity, stronger risk management helped banks to respond to the emergency. This confirms the importance of a sound regulatory framework and its effective implementation. Globally agreed standards have helped us manage this crisis and have confirmed their overall usefulness. This is a lesson for the future.

Regulatory authorities have proved to be up to the challenge and willing to make full use of the flexibility permitted in the prudential and – to the extent possible in their remit – the accounting frameworks. Flexibility was increased by the legislator where it was deemed necessary. Some rules, particularly on the treatment of non-performing assets, required some fine-tuning, but, overall, we did not change their philosophy confirming the need to timely recognise and measure risks, while avoiding automatisms that can determine unintended consequences in case of systemic crisis and system-wide support measures.

Authorities allowed banks to support the economy, while demanding the preservation of reliable risk metrics. The distinction between short-term liquidity difficulties and insolvency – or unlikeliness to pay – was crucial in squaring this circle and proved fit for purpose. The evidence on the classification of loans under moratoria provides some initial reassurance that banks have implemented supervisory guidance as required. However, it is important that credit risk is monitored carefully so to ensure that banks identify any early signal of borrowers’ distress and provision against potential losses accordingly.

Authorities have been also proactive in triggering the countercyclical features embedded in the Basel 3 framework. Since the onset of the crisis, micro- and macroprudential, European and national authorities provided the unequivocal message that capital is there to be used. Relaxing capital requirements and encouraging banks to make use of their liquidity buffers in a crisis do not come natural to supervisors, but they are key to allow the banking sector to act as a stabiliser rather than an amplifier of the shocks. This was the very purpose of including a macroprudential perspective in the prudential standards.

Banks have, so far, made limited use of this flexibility. Until the third quarter of 2020, there is no sign of a decline in the CET1 ratio, at least on average at the EU level, and banks – with a few exceptions – are still able to meet their overall capital requirements. A first observation is that there is some confusion on the concept of buffer “usability”. Banks can use buffers to absorb losses and still be able to meet minimum requirements. This implies that buffers are used when losses are recognised. Banks can also use buffers to absorb the increase of risk-weighted assets in a crisis without reducing lending. If credit is flowing fine to the economy and the supply matches customers’ demand, then there is no need to use the buffers.

At this stage, it is too early to say whether the issue of buffer usability is material. We documented that credit did increase in the aftermath of the crisis. Banks also increased provisions, but below some analysts’ expectations.

Still, this is an important discussion looking forward. There is a view that banks are reluctant to use the buffers for reasons beyond supervisory expectations. If this is true, it is important to understand those specific concerns, their relevance, and consider whether adjustments to the framework are needed.

On the one hand, there could be a general apprehension related to the market stigma associated with the use of buffers or even with the simple decline of capital ratios. This would indicate the reluctance of market participants to accept fluctuations of capital ratios in banks as a normal – cyclical – event.

On the other hand, the scarce usability of the different buffers can be linked to the function they are expected to perform. In the prudential framework, some buffers – e.g., the countercyclical capital buffer (CCyB) – are inherently countercyclical since authorities can activate and deactivate the requirement depending on the evolution of economic conditions. Countercyclical, releasable buffers are designed to be used for macroeconomic adjustments.

Other buffers – e.g., the capital conservation buffer – are instead structural and work as automatic stabilisers since banks failing to meet the requirement are automatically subject to capital conservation measures.  Banks can be hesitant to use the structural buffer since this may undermine their ability to payout dividends and coupons if they are at risk of breaching the overall capital requirements and, thus, triggering maximum distributable amount rules.

The relative size of the buffers determine their usability for the different economic policy objectives.  This can also call for a recalibration of the buffer structure, with a greater role for buffers that can be switched off by the authorities. However, since countercyclical buffers have been built up only in a limited number of jurisdictions and to relatively limited levels, the question is whether we should also harmonise the way these buffers are deployed, pushing for a faster and larger accumulation in good times. While buffers should continue to reflect national financial conditions, some centralisation of their use at the EU level would be warranted, particularly in crisis times.

The toolkit of macroprudential authorities is also relatively weak when it comes to preserving capital in the system. While microprudential supervisors can prevent institutions for distributing dividends on a case-by-case basis, no binding instrument is available for imposing system-wide payout restrictions.

Finally, the crisis has also confirmed the urgency to complete the Banking Union and remove any obstacles to the free flow of capital and liquidity in the Single Market.  National policies to address national stability concerns can often impede the free flow of funding across the union. Ring-fencing generates inefficiencies and eventually results in the inefficient allocation of resources, poor incentives to cross-border consolidation, and higher costs for customers.

 

6. Conclusions

The EU banking sector has been resilient so far but there are challenges ahead. The strong capitalisation and liquidity profile, coupled with the decisive response of the regulators and supervisors, have enabled the European banks to cope with the immediate impact of the crisis, while supporting their customers and governments’ efforts to push liquidity in the system. Looking forward, the key question is whether banks will be able to withstand the likely increase of credit risk losses and maintain adequate lending volumes, particularly when moratoria, public guarantee schemes and other support measures expire.

With the legacy and the experience from the GFC, it is important to be ready with credible, long-term tools to deal with the deterioration of asset quality. The 2021 EU-wide stress test will allow authorities to better assess the consequences of the crisis on banks, start discussing the appropriate way forward, and set supervisory expectations on capital planning.

Banks should do their part assuring the accurate and transparent assessment of credit risk. Capital buffers provide headroom for prudent provisioning and there is no reason for delaying risk recognition.

The Commission’s NPL action plan shows that this time is different and authorities want to be proactive rather than reactive. Asset management companies can be part of a broader toolkit within well-functioning efficient NPL secondary markets to transfer non-performing assets out of the banking sector and, while they are often associated to state-aid and resolution rules, they have a broader role to play particularly in case of widespread deterioration of credit quality. Early and proactive engagement with borrowers must be undertaken in a way that is customer centric if we are to retain public trust in financial services.

The Covid-19 crisis has also made some weaknesses in the EU banking sector more visible and accelerated some trends affecting the industry. In this sense, the crisis can represent a catalyst to restructure and make EU banks more resilient and efficient. Some issues are generalised across the sector, while others may be more idiosyncratic. The EBA analyses show that the sector is overall resilient, but banks that entered the crisis with lower capital levels, poor business models and riskier exposures may face greater challenges. In addition, further waves of contagion and a delayed economic recovery could further weaken the banking sector. Deteriorating asset quality and the ‘lower for longer’ interest rate environment are expected to weigh on an already subdued profitability.

The need to address overcapacity and advance with banking sector consolidation will become ever more important and supervisors are supporting measures to facilitate such process. A coherent and consistent application of the European resolution framework is a precondition of an orderly exit for those banks that become non-viable in the crisis. Although the challenges ahead are huge, the crisis can be the catalyst to address pre-existing vulnerabilities.

Finally, digitalisation and the use of ICT was able to progress rapidly  in the crisis thanks to the work of regulators and a further acceleration could be a game-changer for banks. It could bring costs down and allow them to move towards more sustainable business models, but this should go together with careful management of ICT risks and careful consideration of the environmental and social implications of enhanced use of digital channels and machine led offerings.

The crisis triggered by the Covid-19 pandemic put the post GFC reforms in the banking industry to test, a real-life stress test of the system. We believe that the experience so far has vindicated the reforms. The philosophy behind the post-GFC regulation – more demanding requirements in normal times that can be relaxed in bad times – has been successful. This does not mean that there are not some aspects of the existing framework that may require a critical review. Changes may be necessary, but we see this as a fine-tuning and calibration of the framework rather than a fundamental rethinking of it.

We would also advocate taking enough time to reflect, discuss and make decisions. Changing the rules while the crisis is ongoing would be premature, imprudent and could be interpreted as a signal of weakness of the banking sector, at a time when markets are volatile and investors nervous. Once the health crisis is – hopefully – under control and the emergency over, it will be natural to make a stock-take of the elements that have worked well and those deserving some adjustments.

We also learnt that some flexibility in regulation may be necessary, but we should avoid reinstating national discretions. We believe it would be also advisable to go back to the roots of the Lamfalussy’s reform, with primary legislation setting only the overarching principles and leaving the technical details – which may need quick fixes – to level 3 regulation. Supervisory judgment is also important, but only if exercised under a consistent EU umbrella.

Footnotes[+]

Footnotes
↑1 European Banking Authority (EBA). This article is based and elaborates on José Manuel Campa’s speech
“The regulatory response to the Covid-19 crisis: a test for post GFC reforms” at the Italian Banking
Association, Rome, September 21, 2020. We are grateful to Valerie de Bruyckere, Valentina Drigani, and
Achilleas Nicolaou for useful discussions and support. The opinions expressed are those of the authors and
do not involve either the EBA or its Board of Supervisors.
↑2 EBA (2020), Guidelines on legislative and non-legislative moratoria on loan repayments applied in the
light of the COVID-19 crisis.
↑3 EBA (2020), First evidence on the use of the moratoria and public guarantees in the EU banking sector.
↑4 EBA (2020), Risk Assessment of the European Banking System
↑5 EBA (2020), The EU Banking Sector: First insights into the COVID-19 impacts.

Filed Under: 2021.1

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