Concerted responses by fiscal, monetary and prudential authorities to the COVID crisis have successfully avoided a systemic financial crisis in the spring. But the impact of the crisis on banks’ balances sheets will only become fully visible, when the lagged effects on unemployment and firm insolvencies may strike, as governmental loan guarantees and moratoria expire.
It
will be important to avoid “cliff effects”. As loan quality will
deteriorate, banks will need to increase loan provisions, affecting
banks’ profits. To prevent an erosion of banks’ equity, the ESRB has
recommended banks not to pay dividends and not to buy back shares. These
rules are currently being reviewed. Looking ahead, first, both banks
and policy makers need to prepare for corporate insolvencies, and to
avoid that viable but illiquid firms fail. Second, to enhance banks’
capacity to absorb losses and to maintain banks’ lending to the real
economy, capital requirements and buffers will be reviewed. Third, for
banks hit particularly hard, recovery and resolution frameworks need to
be carefully assessed and applied, bearing in mind the crisis situation.
Fourth, in the short term, stress tests and balance sheet transparency
are key in building confidence in the banking system. More broadly, EU
banks need to further improve cost efficiency, in an environment of
structurally low interest rates. Developments in real estate markets
need to be watched carefully, bearing in mind lasting structural effects
from the COVID crisis on the demand for commercial and residential
property.
The economic contraction that we
have seen in 2020 has been unprecedented in recent history, excluding
war periods. The fall in GDP has been much larger than those seen in the
global financial crisis or even during the oil crisis in the 1970s.
At the same time, uncertainty prevails
and relates to two crucial aspects of the pandemic: (i) the evolution of
the pandemic itself (Europe is now fighting the second wave after a
summer with limited number of infections, and might be exposed to a
third one), and (ii) the impact of the containment measures on economic
activities and how economic agents will be able to adjust to them.
In view of these levels of uncertainty,
economic agents have behaved (and continue to behave) with caution. We
have seen savings of households reaching levels not seen before in
statistical time series. Consumption has decreased abruptly,
particularly in those sectors more sensitive to the pandemic, such as
accommodation or restauration.
The policy response has been
commensurate to the severity of the crisis and has involved fiscal,
monetary and prudential authorities. Through this effort, the
significant turmoil in March and April did not lead to a systemic
crisis, which would have worsened the dramatic effects of the pandemic.
The impact on banks
The impact of the COVID-19 pandemic is still not clearly visible in the balance sheet of European banks, mainly for two reasons.
The first one
refers to the usual timing of stress in the real economy to translate
into losses to be absorbed by banks. Increases in unemployment and
corporate insolvencies follow quickly after the onset of a recession. It
then takes time for the related households and non-financial
corporations to default on their bank loans. After all, the definition
of non-performing loans has as main criteria non-payment over 90 days
(the other criterion is the assessment of the borrower to be
unlikely-to-pay).
The second reason
is related to the policy response I have referred to before. The uptake
of loan guarantees and moratoria have eased financial stress of
households and non-financial corporations for some time. Indeed, if we
observe the number of reported bankruptcies in 2020, it is not possible
to find any sharp increase derived from the outbreak of the COVID-19
pandemic. But, at same point in the near future, the stress faced by
households and non-financial corporations will lead to an increase in
forborne (renegotiated) loans and non-performing loans. While
government-guaranteed loans shift the ultimate risk-bearing to the
government, the share of these loans over total loans differs
significantly from country to country and is small in comparison with
the outstanding amounts of loans.
From a financial stability point of
view, the finalisation of loan guarantees and moratoria is of particular
concern, as it may generate a “cliff effect” and increase the intensity
with which stress in the real economy is transmitted to the banking
system. The ESRB is looking carefully at the financial stability
implications of the exit strategy from support measures.
Deteriorating asset quality will
translate into higher provisions, taking a toll to the profit and loss
account of banks, and, indirectly, to the potential use of retained
profits to increase their capital position.
Restrictions to distribution of dividends
As part of the response by the ESRB to
the COVID-19 outbreak, a Recommendation was issued in May restricting
distributions by financial institutions in the EU. In view of the
significant uncertainty about the length of the COVID-19 crisis and
about its severity, the ESRB saw a need for financial institutions to
maintain a sufficiently high amount of capital to mitigate systemic risk
and contribute to economic recovery. The ESRB Recommendation is
precisely addressing those actions by financial institutions that can
result in a decrease in the amount and quality of their own funds or in a
reduction of their loss-absorbing capacity. These actions include
dividends, variable remuneration and buy-backs of ordinary shares.
The ESRB Recommendation is applicable
until 1 January 2021. The ESRB is currently weighing up the pros and
cons of further actions in this regard. In doing so, it is fully
coordinated with its member institutions, including microprudential
supervisors. The overarching principle remains the one of extreme
prudence, also in line with the above-mentioned uncertainty about
developments in the next months. I am confident that the ESRB will make
the results of its discussions soon public, certainly before its
previous recommendation expires.
Four COVID-related issues looking ahead
I would like to offer some thoughts
about the main issues affecting the EU banking system in the short to
medium run. Some of these issues are directly linked to the COVID-19
pandemic (corporate insolvencies, usability of capital buffers, recovery
and resolution frameworks, stress testing and balance sheet
transparency) while others had previously been identified.
1. Preparing for corporate insolvencies
Let me start with the main challenges faced by the banking sector derived from the COVID-19 pandemic.
As I have previously said, loan
guarantees, loan moratoria and other support measures to households and
to non-financial corporations will need, one day, to be phased-out.
These measures have been crucial to
contain the economic and financial impact of the pandemic, but they
cannot be in place forever. Since they are phased-out, the financial
soundness of non-financial corporations will be revealed, with the
potential to lead to a large wave of corporate insolvencies.
To the extent that bank lending is the
main source of funding of European corporations (particularly, for
SMEs), the expected large number of insolvencies can create substantial
stress in the financial system. In this regard, there are three
important questions which we, as macroprudential authorities, need to
answer.
First, what do we know about
the likely path of corporate insolvencies? Which sectors are going to be
more affected and at which pace? These are crucial issues to identify
the issue at stake, whether it is going to extend over time or whether
it is going to be one-off event. Some academic publications have tried
to look at this issue and have come with valuable findings for this
task.
Second, do insolvency
frameworks around Europe have the capacity (in terms of resources and
absence of bottlenecks) to deal with an elevated number of corporate
insolvencies? Here, it would be crucial as well to avoid bringing viable
but illiquid corporations into insolvency due to a flawed assessment of
the long-term viability of the corporation.
Finally, is there something we
can learn from each other in terms of best practices? This is the most
relevant aspect for policy-makers, since we could take policy actions
based on experience in other jurisdictions in the past.
2. Usability of capital buffers
Prudential
authorities have taken important policy actions to offer regulatory
relief to banks, in the expectation that they would use the own funds
associated with capital buffers to maintain the provision of credit to
the real economy in the current difficult circumstances. Despite this
effort, there is a perception that some capital buffers introduced by
the regulatory reform after the global financial crisis are not usable
in practice.
We need time and data to look carefully
at this and, if appropriate, consider how the current regulatory
framework can be improved so that capital buffers are used when needed.
Do not forget that the main goal of capital buffers is to absorb losses.
Finally, in this assessment, it is
important to consider how the risk-weighted capital requirements
interact with the leverage ratio and with the MREL (Minimum Required
Eligible Liabilities) requirement, to avoid unintended outcomes from the
combined application of the three.
3. Recovery and resolution framework in use
The
ambitious and large support measures taken by the governments to
support the economy in view of the COVID-19 pandemic have, for sure,
mitigated the impact on the financial system.
However, given the unprecedented size of
the shock created by the pandemic (and despite the action of monetary
policy), they might not be enough to avoid a weakening of the economic
environment and could therefore add pressure to the financial soundness
of banks, testing their resilience. For some banks, it may be possible
that there is a need to trigger recovery and resolution actions in a
short timeframe. Given these challenging perspectives, I think it is
necessary to carefully assess, from a macroprudential perspective
(considering the banking system as a whole), the different alternatives
to dealing with forthcoming difficulties in the banking system derived
from the COVID-19 pandemic.
The issues to consider here are
wide-ranging and important. For example, the current recovery and
resolution framework has not been used through a systemic crisis, with
several banks experiencing difficulties at the same time. It is
important to understand how the framework can work in such conditions
and whether there are actions to be taken to enhance it. Besides, other
solutions for ailing banks may involve precautionary recapitalisations
and asset management companies. For that to be fully operational when
needed (if needed), we need to make sure we are aware of the
implications of these actions in terms of State Aid.
There are many other issues to be
considered in this area, to help us understand the toolkit available,
the financial stability implications of each tool and the interaction
with other regulations. We need to use the time available to us to
advance in these areas, hoping that we will not need to put our findings
to work.
4. Stress test and balance sheet transparency
An
important element to consider when thinking about challenges for banks
(and regulatory and supervisory authorities) in the short-term refers to
stress test, to be conducted by the EBA with the ESRB designing the
adverse scenario.
While during normal times, stress test
try to identify possible build-up of risks, during crisis periods (like
the one we have now), stress test are key in building confidence among
market participants that banks subject to them are resilient enough to
absorb losses to materialise in the short-term.
Designing a scenario in these
circumstances is, more than ever, not an easy task. On the one hand, it
is clear that the scenario must reflect the impact of the pandemic on
banks and, also quite importantly, the scenario needs to find a balance
between severity and plausibility. Having a very severe scenario that
is, however, not plausible would make little service to financial
stability in the EU.
In order to gain confidence on the EU
banking system, transparency of bank balance sheets is a crucial and
complementary element to stress test. To that purpose, we must ensure
that financial information is accurate, timely and relevant,
particularly in the current times characterised by uncertainty.
Structural issues
In more structural terms, before the
outbreak of the COVID-19 pandemic, there were concerns about the EU
banking system. The macroeconomic environment (low interest rates, low
growth and low inflation) was fundamentally challenging the traditional
business models of many financial institutions across the EU.
In the case of banks, these challenges
were combined with existing structural weaknesses referred to legacy
assets from the global financial crisis, excess capacity (often referred
as overbanking) and inefficient costs structures. As a result,
profitability of EU banks had been much below international peers for
many years and equity valuations of EU banks were also subdued. The
majority of EU banks were trading with price-to-book ratios below 1,
typically seen as a signal of small confidence from investors.
Moving ahead, responding to these
challenges would be key for the EU banking system to emerge as sound and
to contribute to the recovery from the pandemic crisis.
Real estate
Real estate exposures are particularly
important in the lending portfolio of banks in Europe and, as
demonstrated in some countries during the global financial crisis, can
be an important channel of contagion between the real economy and the
financial system.
In 2016 and 2019, the ESRB issued
several warnings and recommendations to EU Member States focusing on
vulnerabilities related to residential real estate. In addition to them,
it has published several assessments in the last years, covering also
commercial real estate markets.
The ESRB is regularly assessing the
financial stability implications of developments in real estate markets,
also in the context of the assessment of compliance with its warnings
and recommendations. For the future assessment, the structural changes
imposed by the COVID-19 pandemic may need to be considered. For example,
the extension of remote working modalities may impact the demand for
commercial real estate. These are important developments that need to be
carefully assessed from a financial stability point of view.
Conclusions
Let me conclude. Our economies are
currently suffering an economic shock caused by the COVID-19 pandemic
that we have not seen in the last 100 years, excluding periods of war.
While banks have not yet suffered material losses from this shock, they
will become affected by it, as other financial institutions will be.
I have outlined four policy issues
directly related to the COVID-19 pandemic, where regulators and
supervisors (together with banks) need to take action to ensure the
banking system is best prepared to absorb the losses from the COVID-19
shock and to ensure the flow of credit to the real economy.
The way how banks absorb this impact and
how they address existing structural vulnerabilities (challenges to
traditional business models, excess capacity, legacy assets) is going to
determine the banking system of the future. I hope this is a banking
system that is sound and positively contributes to the economic recovery
from the COVID-19 pandemic.
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About the author
Francesco Mazzaferro
has been the Head of the Secretariat of the European Systemic Risk Board
(ESRB) since January 2011. Prior to that, he was the Project Manager of
the ESRB Preparatory Secretariat, which started work in March 2010. He
began his career in financial research in the Research Department of the
Istituto Bancario San Paolo di Torino (today part of Intesa Sanpaolo)
in Turin, Italy, in 1987. He joined the European Commission in Brussels,
Belgium, in 1992, starting his international career in the Directorate
General for Economic and Financial Affairs, where his work focused on
the European Currency Unit and preparations for the introduction of the
single currency. In 1995 Mazzaferro joined the European Monetary
Institute – which later became the European Central Bank – in Frankfurt
am Main, Germany, as the Officer of Policy Planning. In 1998 he became
the Senior European Relations Officer in the European Relations
Division. From 2000 he worked as Principal in the EU Neighbouring
Regions Division, becoming the Head of Division in 2003. Mazzaferro
studied law at the University of Bologna and wrote his Master’s thesis
on “EU law and legal aspects of the euro”.
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