COVID-19 AND BANKING

Covid-19 is a new virus, more contagious and deadlier than normal flu. Due to its rapid global infection propagation, it is considered a pandemic by WHO. Given that it is a new virus, there is no cure and the probability of requiring intensive medical care or dying after contracting it is considerable. Since most people do not want to risk their lives and governments want to avoid a healthcare system collapse, voluntary and mandatory lockdowns have been put into place to reduce the rate of spread of the infection. As expected, this greatly hurts the economy; the industrial production considerably diminishes - Eurostat reports that, until June, the total cumulative decrease in industrial production in the EU since February amounts to 18.8%². This creates a negative shock to aggregate demand because firms’ lower earnings and investment lead to unemployment, in turn leading to less spending. The International Labour Organisation estimates that 12 million full-time jobs will be lost by the end of the year in Europe³. The service industry, especially tourism, will be worst affected. It is estimated that the EU’s tourism sector will lose 1 billion € per month and that global international tourist arrivals could decline by 20% to 30% this year⁴.

Banks, constantly monitor risks in order to conduct their activities, which are correlated with economic activity. Because covid-19 strongly damages the economy, it is important to think about the ways in which this pandemic might challenge the banks risk management activities and framework. Whereas a full journal paper could be written about this topic, this article mainly deals with the deterioration in the risk profiles of stock and potential clients. 

Regarding the stock of clients that have loans with a given bank, the pandemic and consecutive restriction measures automatically increase their overall level of risk. More specifically, all the components of the expected loss they were assigned when underwriting their loans instantaneously become larger. Many clients that were given loans at a moment when there was no pandemic will face financial stress and their probability of default will be higher than initially estimated. Furthermore, because their cash flows will face pressure, the drawing amount of their available credit lines will most likely increase, rendering CCF estimations insufficient and, thus, their exposure at default higher. Additionally, as they will be struggling to maintain the amount of funds they need on a regular basis, chances are that, if a default occurs, their loss given default will be higher. With regards to potential clients, the scenario is quite similar, although from an ex-ante point of view. Because economic conditions have worsened, banks now know that their available estimates of the probability of default, exposure at default and loss given default do not match the current context and need to be increased. Hence, banks have incentives to constrain credit supply.

Banks have a strong procyclical behaviour, which means that, when the economy is doing good they increase lending and, during recessions, restrict the amount of credit they are willing to grant⁵. One of the reasons behind this is that banks constantly monitor the level of risk of their obligors, which they consider lower during economic upturns and vice-versa⁶. Credit supply is a key variable for the economy, as it directly impacts the financial cycle, which is measured as the ratio of domestic credit to GDP. In this context, it plays a significant role in the generation or prevention of financial crises⁷. Recessions that arise when the financial cycle is contracting are usually more severe, as during such phases the decrease of GDP can be expected to be higher by a factor of 50%, relative to financial cycle expansion phases. Finally, it is also demonstrated that access to credit positively affects GDP growth8. Consequently, to ensure that credit supply does not drop is a key to fighting off the negative economic consequences of the pandemic and to prevent them from being even more severe. In a nutshell, making sure that the availability of credit is not negatively affected cushions the decline of GDP and helps to maintain financial stability, in a context where the pandemic increases volatility in the stock markets⁹.
 

Aware of how important credit supply is during crises, the governments and regulators have set up a regulatory framework, aimed at maintaining it during economic distress. Some of them have an ex-ante approach, whereas others were implemented once the pandemic was already active. As of June of 2020, it can be stated that so far, they have been successful.

Among the most important ex-ante regulations are the capital requirements regulation and stress testing guidelines, mainly based on Basel III. Under these rules, the banks are required to keep ratios of capital relative to risk-weighted assets (RWA) to cover future losses. The first buffer mandates banks to have a capital to RWA ratio equal to 4.5%. On top of that, two extra buffers are included. A capital conservation buffer that requires an extra 2.5% as a proportion of RWAs and a discretionary counter-cyclical buffer which can require as much as an extra 2.5% of capital. The European Systemic Risk Board also mandates an additional buffer for systemically important institutions. Stress testing requires simulations to be carried out to check what losses banks would experience in extreme situations, thus helping them to prepare for such events.
 

However, capital requirements may also have a procyclical effect since they restrict credit availability when it is most needed; the riskier the clients, the more capital is required and less funds are thus available for lending, worsening a recession. Authorities also responded to this by announcing many – so far 151 – flexibility measures regarding different capital and reporting requirements, as well as guaranteeing loans, following the onset of the pandemic. For example, on the 12th March, the ECB announced that it would lower capital required for systemic institutions. Furthermore, on the 20th March, it announced that banks would benefit from public guarantees for NPLs and from flexibility to determine which clients are classified as “unlikely to pay”.  On the 19th June, the ECB indicated it would ease rules for banks to lend to households¹⁰. In this context, both the European Commission and ECB concluded that banks face this crisis robust and well capitalised^{11 12}. Furthermore, it can be concluded that the regulatory flexibility measures had helped to partially offset the crisis, although uncertainty remains, and some sectors are facing a decrease in credit supply¹³. The July 2020 Bank Lending Survey states that, so far, the Covid-19 crisis has had much smaller negative effects than the last financial crisis. In fact, the net percentage of banks indicating that they expect to reduce credit to the enterprise sector equalled only 1% in 2020 Q2 and 4% in 2020 Q1. Nonetheless, net percentages of banks reporting credit tightening for housing purchase or consumer lending was considerable 22% and 26%, respectively.