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How is coronavirus affecting the banking sector?

While the banking sector will be negatively affected by the pandemic, it is also critical for economic recovery. But the crisis will strengthen competitive pressures on banks by accelerating trends towards digitalisation and new financial service providers.

The lockdown to prevent the spread of the Covid-19 has stopped economic activity across many sectors, with important repercussions for firms and households. Firms relying on direct customer contact – such as hospitality and transport – are losing revenue sources; and households working in these sectors are losing employment income.

The banking sector is also affected, although mostly indirectly. While banking services can be provided remotely and do not rely on direct customer contact, the linkage of the sector with the real sector as provider of payment, savings, credit and risk management services extends the negative effect of the Covid-19 crisis to banks and other financial institutions.

At the same time, the banking sector has the role of supporting firms and households during this period of lower revenues and incomes, which has triggered important policy actions by financial supervisors and governments.

How does the crisis affect banks?

First, firms that have stopped working miss out on revenues, and therefore might not be able to repay loans. Similarly, households with members who have lost their jobs or are furloughed have less income, and therefore might not be able to repay their loans. This will result not only in lost revenue but also in losses (if repayment capacity is permanently impaired), negatively affecting profits and bank capital. And as a swift recovery becomes less likely, banks can expect further losses, resulting in the need for additional provisions, further undermining their profitability and capital position.

Second, banks are negatively affected as bonds and other traded financial instruments have lost value, resulting in further losses for banks. There might also be losses from open derivative positions that have moved in unexpected directions due to the crisis.

Third, banks face increasing demand for credit, as especially firms require additional cash flow to meet their costs even in times of no or reduced revenues. In some cases, this higher demand has presented itself in the drawdown of credit lines by borrowers.

Fourth, banks face lower non-interest revenues, as there is lower demand for their different services. For example, there are fewer payments and transactions to be done with lower economic activity, and fewer security issues by corporates reduce fee income for investment banks.

Losses and lower capital buffers in banks can have negative spillover effects, which might make banks’ solvency position even worse and might also undermine the broader economy. Banks might sell bonds and other traded financial instruments to improve their liquidity position or to make up for losses, with prices of these instruments falling as a consequence and negatively affecting other banks that hold them.

Banks might reduce credit provision to the economy, thus negatively affecting firms relying on such buffers, undermining their survival. We saw similar spillover effects during the 2008/09 global financial crisis. This could make the economic shock even worse.

Related question: Is the banking sector safer than in the global financial crisis?

What has been the policy response?

These potentially negative effects of the pandemic on the banking system have motivated supervisory authorities across Europe to take precautionary and mitigating actions very early on, in late March and early April.

Specifically, supervisory authorities in the UK and the euro area have reduced certain mandatory capital buffers that were built up before the crisis, thus reducing the minimum capital ratio that banks have to observe and avoiding banks reducing lending when it is most needed.

Supervisory authorities have also encouraged banks not to pay out dividends or buy back their own shares during the crisis, operations that would further undermine their capital position. The regulators have also delayed the implementation of new loan loss provisioning rules (often referred to as IFRS 9) that would force banks to create provisions for loans that are currently impaired due to the crisis.

Central banks have reduced interest rates and extended the purchase of bonds. This makes refinancing for banks cheaper, and provides the necessary liquidity for banks to continue providing loans to the real economy.

As important for the banking sector are policy measures taken by governments across the globe:

  • First, governments have provided firms and workers with direct payments to substitute for their lost revenues. While this does not directly affect the banking sector, it allows borrowers to continue serving their loan repayments, and thus have an indirect positive effect on banks as losses are avoided.
  • Second, there are direct support measures that positively affect banks, including loan guarantees. These guarantees imply that part (or all) of the loan losses incurred if the borrower is unable to repay would be covered by the government.

Related question: Which firms and industries have been most affected by Covid-19?

What needs to be done during the recovery phase?

These different supervisory and fiscal policy measures have helped to avoid any bank failures over recent months. They have also helped to support the banking sector in its critical function of keeping the economy running.

But they will not avoid the losses that will result from the failure of some businesses, the necessary restructuring of balance sheets of others (implying write-down of some debt) and the inability of some households to serve their loan repayments. The critical question is who will bear these losses. In some cases, and to a certain extent, these losses might be covered by the government guarantees discussed above. In other cases, banks might incur these losses directly.

As banks will have a critical role not only during the pandemic containment phase but also during the economic recovery phase, sufficient capitalisation will be important as economies will have to reallocate resources across sectors from ‘losers’ to ‘winners’.

For example, sectors that rely heavily on physical provider-client contact will decline in their importance, while sectors focusing on remote and/or digital service delivery will grow. Banks will have an important role funding the expansion of the winner sectors, but they can only do so if losses incurred on loans to shrinking sectors does not impair their lending capacity.

Once economies have returned to a ‘new normal’ and it has become clear which firms (and thus borrowers) are viable and which are not, it is important that non-viable firms are liquidated quickly, loan losses recognised swiftly and banks recapitalised where necessary, be it by private investors or with government support.

What are the long-term implications of the crisis?

It is a little too early to make clear predictions about the likely long-run effects of the Covid-19 recession on the banking system, but there are some trends that are already clear:

First, low interest rates, close to zero or even negative, are here to stay for much longer. This will certainly put further pressure on banks’ profitability.

Second, the trend towards digitalisation might increase even further, as social distancing might become the new norm, and personal interactions between bank and client carry even higher costs. This might imply the closure of further branches and stronger reliance on telephone and internet banking.

Third, the crisis will further strengthen competition for banks from ‘fintech’ (financial technology companies) and especially Big Tech companies, such as Alibaba or Tencent in China and Facebook, Google, Apple and Amazon in the Western world. These large platform providers are likely to come out of the crisis further strengthened, with a large cash pile and in a strong position (and possibly with a big appetite) to expand into financial service provision. This might put additional competitive pressure on banks in their core business lines.

These three trends started before the pandemic but they might accelerate due to the crisis. Consequently, we might see further competitive pressures on banks, thus requiring an innovative reaction by them.

Related question: How have Big Tech and other digital platforms fared in the crisis?

Where can I find out more?

The bank business model in the post-Covid-19 world: The latest CEPR report on the future of banking discusses how the current crisis and three trends – persistently low interest rates, enhanced regulation, and increased competition from shadow banks and digital entrants – will shape the future of the banking sector.

How banks affect investment and growth: new evidence: Thorsten Beck and colleagues suggest that in the new ‘knowledge economy’ banks will have a more limited role, compared to other types of financial intermediaries and markets

Finance in the times of coronavirus: Thorsten Beck argues that while banks are not the cause of the current crisis, they stand to be severely affected by the crisis.

Finance in the times of Covid-19: what next? Thorsten Beck proposes a set of measures that should be considered for banks, markets and other financial institutions.

System-wide restraints on dividend payments, share buybacks and other pay-outs: This report by the European Systemic Risk Board discusses the rationale for pay-out restrictions in the context of Covid-19 as well as other supervisory measures.

Who are experts on this question?

Author: Thorsten Beck
Picture by Davide Catoni on iStock
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