Economics in the Time of COVID-19
as a freezing of funding markets) that could be a direct source of bank fragility. Non-
performing loans, however, will not show up immediately, but rather (in a negative to
adverse scenario) in the second half of 2020.
One starting point to assess the impact of such a negative or adverse scenario are stress
tests undertaken by regulators across the globe, including by the Single Supervisory
Mechanism (SSM) and European Banking Authority (EBA) for the largest banks in
the euro area and EU. The 2018 stress test modelled a cumulative fall of 8.3% over
three years relative to the baseline projection in its adverse scenario and concluded
that even after such a shock, the average CET1 ratio would still be 10.1%, though
with a large variation across banks.^1 Obviously, there might be quite some variation in
such an adverse scenario across countries and banks, and there certainly could be bank
failures, especially among banks whose loan portfolios are concentrated in the areas
most affected.
Regulatory forbearance with respect to loan classification and thus loan loss provisions
would be the wrong response. Letting markets guess what the true financial situation
of banks is rather than providing such information can make things only worse. While
there is an ongoing academic debate on whether more transparency is always better,
experience from the early EBA stress tests in the EU – which turned out to be too
lenient, with banks that passed the test failing shortly afterwards – suggests that
pretending that things are just fine is not conducive to creating confidence. Rather than
allowing forbearance on loan classification and thus loan provisions, regulators should
instead allow banks to eat into their capital conservation and counter-cyclical buffers.
Such loan losses would not show up that quickly anyway and consequent losses would
not be expected before late 2020. At the same time, bank resolution frameworks might
be put to the test, as will the political willingness to let supervisors and resolution
authorities do their job.
Loan losses are only one source of fragility, though. Last October, the Hong Kong
Monetary Authority ran a crisis simulation exercise with its major banks, which included
the breakout of a disease like the Coronavirus, with the resulting operational challenges.^2
Operational risks can loom large in scenarios with widespread socioeconomic disruption,
and the better prepared central banks, regulators and financial market participants are,
the more limited the damage to the financial system and the real economy will be.
1 See https://eba.europa.eu/risk-analysis-and-data/eu-wide-stress-testing/2018
2 See https://www.reuters.com/article/us-china-health-hongkong-finance/hong-kong-banks-compare-pandemic-stress-
test-with-epidemic-reality-idUSKBN2070N2