2) This time is different: the crisis is a global health crisis hitting the real economy hard, but it did not originate in the banking sector. Yet, spillovers could be severe.
The current crisis had its origin in the real side of the economy. In contrast, the 2008 global financial crisis started in the financial sector and therefore led to significant losses through exposure to financial markets. Hence, it is plausible to assume that losses could be more contained. Yet, given the potential severity of the recession, banks may still face significant strains, both through a deterioration in financial markets and credit asset quality (NPLs).
Following the 2008 crisis, European banks experienced further losses through their exposure to sovereigns. A repetition of this “doom loop” cannot be entirely excluded at this stage, as shown by the increase in sovereign bond yields in the first weeks of March. Nevertheless, the prompt policy intervention of the ECB and the policy packages put in place by national authorities have so far provided much-needed support to both banks and sovereigns (See Section 2 of weekly briefings).
Non-performing loans are expected to increase at a faster pace than in past crisis episodes given that the expected fall in GDP could be much bigger, concentrated in time and broad based (households, micro, small and medium enterprises and corporates are all taking a hit and many economic sectors are going to be affected simultaneously). Non-performing loans tends to lag GDP growth by 12-18 months, but this time the reaction function could be steeper as entire economies across Europe (and the world) come to a (almost) sudden stop. Still, this increase is likely to be more concentrated in some sectors and could potentially be reversed, if GDP growth recovers in 2021. This seems the most likely scenario if containment measures are effective at eventually halting the virus spread and policy support measures are swiftly implemented to mitigate the economic fallout.
3) Policy matters: measures proactively implemented by central banks and financial regulators can go a long way in strengthening banks’ resilience to the crisis. But more is needed to support the real economy.
Several policy measures have been implemented already at EU level and by MS to help mitigate the impact of the crisis on the capital position of European banks (See also Section 2):
Dividend freezes - The ECB updated its recommendation to banks on dividend distributions. To boost banks’ capacity to absorb losses and preserve their capita position, they should not pay dividends for the financial years 2019 and 2020 until at least 1 October 2020. Banks should also refrain from share buy-backs aimed at remunerating shareholders. Some national regulators also introduced similar measures.
Credit guarantees - An unprecedented broadening of credit guarantee instruments have been announced by various MS, as well as by EU institutions, including the ECB. Such guarantees can help to take some of the increased credit risk off the balance sheet of the banking system and provide capital relief at the same time. The ECB announced that loans that become non-performing and are under public guarantees would benefit from preferential prudential treatment in terms of supervisory expectations about loss provisioning.
Treatment of compulsory loan repayment moratoria - The European Banking Authority stated that generalised payment delays due to legislative initiatives and addressed to all borrowers should not lead to any automatic classification as default, forborne or unlikeness to pay. Individual assessments of the likelihood to pay should be prioritised.
Flexible use of existing capital buffers - Capital and liquidity buffers have been designed to allow banks to withstand stressed situations like the current one. The European banking sector has built up a significant amount of buffers since the last crisis, but various measures were now allowed1. Relaxation of the capital buffers does not improve the capital position of the banks per se. However, flexibility by the regulators limits the potential stigma associated with using these buffers, and the possible negative market reactions.
Limiting pro-cyclical assumptions in loan loss provisioning - To avoid excessive pro-cyclicality in the regulatory capital and published financial statements, the ECB recommends that all banks avoid pro-cyclical assumptions in their models to determine provisions.
To summarise, we argue that while the current economic shock poses significant risks for banks, a number of factors could mitigate the negative impact. In comparison to the 2008-2009 financial crisis, we note that: (a) the initial shock will most likely be shorter if the policy response remains strong, timely and well-targeted, (b) the crisis is not originating in the banking sector, (c) banks have sounder capital and liquidity positions than in 2008 on the back of the policy and regulatory measures undertaken following the financial crisis. On the other hand, the contraction in GDP may be more significant than during the global financial crisis and could trigger a more immediate impact on non-performing loans, as entire economies are being shut down. All in all, we expect European banks to remain resilient. Yet, uncertainty remains huge, and a prolonged or sharper recession would not leave banks unscathed.
1) For example, it allows them to operate temporarily below the level of capital defined by the Pillar 2 Guidance (P2G), the capital conservation buffer (CCB) and the liquidity coverage ratio (LCR). These measures are enhanced by the relaxation of the countercyclical capital buffer (CCyB) by the various national macro-prudential authorities. In addition, banks will also be allowed to partially use capital instruments that do not qualify as Common Equity Tier 1 (CET1) capital, such as additional Tier 1 or Tier 2 instruments, to meet the Pillar 2 Requirements (P2R).