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).

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

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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

Altavilla, C., Barbiero, F., Boucinha, M., Burlon, L. (2020). The great lockdown: pandemic response policies and bank lending conditions. Working Paper Series No 2465. Available at: https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2465~c0502b9e88.en.pdf?182d24d01a250f174b18cbc01359378d (Accessed on April 29, 2021).

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 (Accessed on April 29, 2021).

Atkeson, A. G. (2020). What will be the economic impact of covid-19 in the us? rough estimates of disease scenarios. Working Paper 26867, NBER. Available at: https://www.nber.org/system/files/working_papers/w26867/w26867.pdf (Accessed on April 29, 2021).

Awad, R., Ferreira, C., Jociene, A., and Riedweg, L. (2021). Restriction of Banks’ Capital Distribution during the COVID-19 Pandemic (Dividends, Share Buybacks, and Bonuses).International Monetary Fund. Special Series on COVID-19.

Bank for International Settlement (BIS) (2020a). Basel Committee sets out additional measures to alleviate the impact of Covid-19. Press Release. Available at: https://www.bis.org/press/p200403.htm (Accessed on April 29, 2021).

Bank for International Settlement (BIS) (2020b). Capital treatment of securitisations of non-performing loans. Technical Amendment. Available at: https://www.bis.org/bcbs/publ/d511.htm (Accessed on April 29, 2021).

Bank for International Settlement (BIS) (2020c). Implementation of Basel standards A report to G20 Leaders on implementation of the Basel III regulatory reforms.

Bodenstein, M., Corsetti, G., and Guerrieri, L. (2020). Social distancing and supply disruption in a pandemic. Cambridge Working Papers in Economics CWPE2031, Cambridge University.

Borgiolli, S., Horn, C.W., Kochanska, U., Molitor, P., and Mongelli, F.P. (2020). European financial integration during the COVID-19 crisis. European Central Bank Economic Bulletin Issue 7, 2020. Available at: https://www.ecb.europa.eu/pub/economic-bulletin/articles/2020/html/ecb.ebart202007_02~b27e8089c5.en.html (Accessed on April 29, 2021).

Borio, C. (2020a). The Covid-19 economic crisis: dangerously unique. Also available in BIS Speeches: https://www.bis.org/speeches/sp200722.htm (Accessed on April 29, 2021).

Borio (2020b). The prudential response to the Covid-19 crisis. Also available in BIS Speeches: https://www.bis.org/speeches/sp200630a.htm (Accessed on April 29, 2021).

Borio, C. (2019). New loan provisioning standards and procyclicality. Financial Stability Review, Bank of Spain, Spring 2019. Also available in BIS Speeches: https://www.bis.org/speeches/sp181024.htm (Accessed on April 29, 2021).

Borio, C., and Restoy, F. (2020). Reflections on regulatory responses to the Covid-19 pandemic. FSI Briefs No 1. Available at: https://www.bis.org/fsi/fsibriefs1.htm (Accessed on April 29, 2021).

Emre, E., Gullo, A., Müller, C., Pineda, M., Tamez, T., and Vasquez, K. (2020). Legal Considerations on Public Guarantees Schemes Adopted in Response to the COVID-19 Crisis. IMF Special Series on Covid-19. Legal.

Enria, A. (2021). Basel III implementation: the last mile is always the hardest. Available at: https://www.bankingsupervision.europa.eu/press/speeches/date/2021/html/ssm.sp210503~1672b8b1f0.en.html (Accessed on May 5, 2021)

European Banking Authority (EBA) (2020a). First evidence on the use of moratoria and public guarantees in the banking sector. Thematic Note EBA/Rep/2020/31.

European Banking Authority (EBA) (2020b). Guidelines on legislative and non-legislative moratoria on loan repayments applied in the light of the COVID-19 crisis. Final report. Available at: https://eba.europa.eu/regulation-and-policy/credit-risk/guidelines-legislative-and-non-legislative-moratoria-loan-repayments-applied-light-covid-19-crisis (Accessed on April 29, 2021).

European Banking Authority (EBA) (2020c). Risk assessment of the European banking system. Luxembourg: Publications Office of the European Union. Available at: https://eba.europa.eu/risk-analysis-and-data/risk-assessment-reports (Accessed on April 29, 2021).

European Commission (EC) (2020a). Coronavirus response: Banking Package to facilitate bank lending. Supporting households and businesses in the EU. Available at: https://ec.europa.eu/commission/presscorner/detail/en/qanda_20_757 (Accessed on April 29, 2021).

European Commission (EC) (2020b). Digital Finance Package. Available at: https://ec.europa.eu/info/publications/200924-digital-finance-proposals_en (Accessed on April 29, 2021).

Financial Stability Board (FSB) (2020). COVID-19 Pandemic: Financial Stability Impact and Policy Responses. Report submitted to the G20. Available at: https://www.fsb.org/2020/11/covid-19-pandemic-financial-stability-impact-and-policy-responses/ (Accessed on April 29, 2021).

Financial Stability Forum (FSF) (2009). Report of the Financial Stability Forum on addressing procyclicality in the Financial System. April. Available at: https://www.fsb.org/wp-content/uploads/r_0904a.pdf (Accessed on April 29, 2021).

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).

This section of the journal indicates a few 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.