Stress tests of major banks in 2019 suggested that the sector was sufficiently capitalised and had enough liquidity to withstand big economic shocks and continue to meet the financing needs of households and firms. But is it safer than 10 years earlier? And is it safe enough to cope with economic damage from coronavirus?
Prior to the pandemic, there was a consensus that banks were in a stronger financial position relative to the 2008/09 global financial crisis. This is attributed to the extensive regulatory reforms that boosted bank capital and liquidity (among other things) following the crisis.
Unlike in the global financial crisis, the situation faced by banks this time is not of their own making. The pandemic is an unprecedented economic shock, and despite various policy interventions to mitigate its worst effects, in the coming months it will lead to: increased credit defaults by households and small and medium-sized enterprises (SMEs); illiquidity in various bank funding markets; and threats to bank stability. The question is whether banks have the necessary resilience to withstand such an unprecedented shock.
Since the onset of the pandemic, increased uncertainty has led to a dramatic increase in financial market volatility. Regulators have instructed banks not to pay dividends and award bonuses, and they have granted some relief to capital requirements. Central banks have reduced interest rates and introduced new funding facilities. Banks have granted payment holidays or waived debt covenants for borrowers. Banks have also acted as conduits for distributing government-guaranteed loans to SMEs.
What does the research tell us?
In 2019, stress tests of major banks conducted by regulators in Asia, Europe and North America suggested that the banking sector was sufficiently capitalised and had enough liquidity to withstand major adverse economic shocks, and service the financing needs of households and firms.
The performance of banks on equity and debt markets since the Covid-19 outbreak has been similar to that experienced after the collapse of Lehman Brothers in 2008 (Aldasoro et al, 2020). But because of various supportive policy interventions, along with capital and liquidity strength and stable funding, no individual institution has yet failed, and banks remain in a position to allow firms facing liquidity pressures to draw down pre-existing credit lines and loan commitments on an unprecedented scale (Li et al, 2020).
In assessing how safe banks are in the face of the pandemic there are three key areas on which research can shed light:
- Bank capital is negatively related to bank risk and failure (Cole and White, 2012; Berger and Bouwman, 2013; Van Der Weide and Zhang, 2019; Conlon et al, 2020).
- Banks often hold capital buffers in excess of the regulatory minima; and they trade-off the costs and benefits of holding capital to arrive at an optimal ratio of capital to (risk-adjusted) assets (Allen et al, 2011).
- Banks target an optimal level of capital, and adjustment speeds to this optimal level are quicker in countries where regulation is tougher (Gropp and Heider, 2010; De Jonghe and Öztekin, 2015).
- Higher capital requirements constrain the ability of banks to lend to households and firms (Gropp et al, 2019)
- Even if banks have sufficient capital, the inability to obtain sufficient liquidity to meet deposit demands and other short-term obligations in a crisis period can lead to instability (Acharya et al, 2011).
- Liquidity shocks result in reduced lending (Iyer et al, 2014) and the reallocation of loans to lower risk firms (De Jonghe et al, 2020).
- Official liquidity support to banks has positive effects on bank lending (Berger et al, 2017).
- Various pandemic-induced liquidity spikes occurred in March 2020 in some wholesale funding markets, resulting in official support to alleviate pressure (Eren et al, 2020a; Eren et al, 2020b; Huang and Takáts, 2020).
Real effects on households and firms
- Negative shocks to the banking industry are transmitted via credit tightening to households, SMEs and large corporates (Berger et al, 2020).
- Credit tightening results in large declines in investment in industries that are dependent on bank financing (Buca and Vermeulen, 2017).
- Non-financial firms that are dependent on bank funding exhibit slower growth, investment and employment following a negative credit shock to the banking industry (Dwenger et al, 2020; Amiti and Weinstein, 2018).
- Adverse credit shocks reduce employment, labour productivity and wages at non-financial firms (Berton et al, 2018; Popov and Rocholl, 2018).
- Firms that are financially flexible and less indebted are more resilient following the onset of the Covid-19 crisis (Ding et al, 2020; Fahlenbrach et al, 2020).
Related question: What explains stock market reactions to the pandemic?
How reliable is the evidence?
We know that banks have been significantly recapitalised and hold more liquidity relative to the global financial crisis (World Bank, 2019). This makes banks more robust to negative economic shocks. But as we see from the research evidence, higher capital requirements can result in lower lending and funds being directed toward lower risk borrowers. Excess capital is also no guarantee against bank failure if severe liquidity shortages occur.
The 2019 stress tests of banks undertaken by UK and European regulators were supposed to take place again in 2020, but given the current environment, they have been postponed to 2021. The 2020 stress tests by the US Federal Reserve (the Fed) are still going ahead.
The scenarios used for the simulated shocks in previous stress tests are not as severe as those that are likely to result from the pandemic. The Fed’s most severe shock assumed an 8% fall in domestic GDP, a 10% fall in unemployment and a fall in residential property and commercial real estate prices by around 20%. The Bank of England’s 2019 stress tests had lower figures for GDP and unemployment declines, but larger numbers for property price falls. Stress tests carried out in the euro area were noticeably less onerous than those carried out at the Federal Reserve.
The sharp slowdown in economic activity brought on by the pandemic and uncertainties about its longevity could lead to greater effects on the banking industry than previously envisioned by regulators and financial commentators.
Banking research is mostly backward looking and does not offer a strong guide as to how the impact of how the Covid-19 crisis will play out. But we do know from prior research evidence that a prolonged and severe negative shock will result in larger than anticipated loan-losses, distress in the banking system and a credit crunch with resultant negative effects on households, SMEs and the corporate sector.
What further evidence is needed?
Predicting the impact of the economic shock resulting from the pandemic is difficult because the severity and length of the shock is currently unknown. At present, banks (helped by a relaxation in regulation and supervision) appear to be managing the situation without undue stress. But if the economic situation continues to deteriorate, and widespread corporate and household defaults occur, banks could experience significantly higher credit losses, loan write-offs and declining profitability.
The various stress tests mentioned above highlight the vulnerability of firms operating in the commercial property, travel and tourism and energy sectors to a credit shock. In the household sector, the higher risk areas are those linked to car loans, credit cards and mortgages.
There are also regulatory concerns about the exposure of banks to higher risk corporate borrowers. Further research is needed to gauge the exposure of banks to these sectors, and how this might affect banks and the real economy going forward.
Liquidity shocks could also pose an increased threat to banks. More research on liquidity shortages across a range of financial markets, and their impact on bank behaviour, is required.
A greater understanding of how central bank interventions alleviate short-term liquidity shortages is also required. Several central banks intervened in various money markets (commercial paper, CDs) in mid-March to alleviate pandemic-linked liquidity problems. More research is required to understand the transmission mechanism of such activities, and how they feed through into the banking sector. Finally, more research is required to understand the interplay between wholesale liquidity markets and bank funding.
Where can I find out more?
Effects of Covid-19 on the banking sector: the market’s assessment: Bank for International Settlements (BIS) Bulletin.
Interim Financial Stability Report: issued by the Bank of England, May 2020.
Finance in the times of coronavirus: Thorsten Beck examines the effect of the pandemic on the financial system.
Measures to reflect the impact of Covid-19: Assessment of the measures taken by the BIS Basel Committee on Banking Supervision.
How Fed swap lines supported the U.S. corporate credit market amid COVID-19 strains: Nicola Cetorelli, Linda Goldberg and Fabiola Ravazzolo examine how the Fed’s dollar swap line agreements with other central banks allowed foreign banks to supply credit via their US operations.
Financial Stability Review: issued by the European Central Bank, May 2020.
Financial Stability Report: issued by the Board of Governors of the Federal Reserve System, May 2020.
Global Financial Stability Report, issued by the International Monetary Fund, April 2020
Bank regulation and supervision a decade after the global financial crisis: World Bank assessment of bank regulation a decade after the financial crisis.
The bank business model in the post-Covid-19 world: the traditional banking model was being challenged pre-Covid by three trends: persistently low interest rates, enhanced regulation, and increased competition from shadow banks and digital entrants. This Future of Banking report explores the likely impact of those trends and the current crisis on the future of the banking sector.
Who are experts on this question?
- Franklin Allen, Imperial College London Business School
- Thorsten Beck, Cass Business School, City University of London
- Barbara Casu Lukac, Cass Business School, City University of London
- Neeltje van Horen, Senior Research Advisor, Monetary Analysis and Chief Economist Division, Bank of England
- Alistair Milne, School of Business and Economics, Loughborough University
- John O.S. Wilson, University of St Andrews