How European banks can support the recovery – IMF Blog
A robust post-COVID-19 recovery will depend on banks with sufficient capital to provide credit. While most European banks entered the pandemic with strong levels of capital, they are highly exposed to economic sectors hit hard by the pandemic.
A new IMF study assesses the impact of the pandemic on the capital of European banks through its effect on profitability, asset quality and risk exposures. The approach differs from other recent studies — in European Central Bank and European banking authority– because it incorporates the political support provided to banks and borrowers. It also incorporates granular estimates of corporate sector distress, and examines more European countries and banks.
With the right policies, banks will be able to support the recovery with new loans.
The analysis reveals that while the pandemic will severely deplete banks’ capital, their cushions are large enough to withstand the likely impact of the crisis. And with the right policies, banks will be able to support the recovery with new loans.
Using the IMF projections for January 2021 as a benchmark, euro area banks will remain broadly resilient to the deep recession in 2020 followed by a partial recovery in 2021. The aggregate capital ratio is expected to decline from 14.7% to 13.1% by the end 2021 if political support is maintained. Indeed, no bank will violate the prudential minimum capital requirement of 4.5%, even without political support.
But at least three important caveats are worth noting.
First, effective policies are important.
Supportive policies are extremely important in reducing both the extent and the variability of bank capital erosion. They considerably weaken the link between the macroeconomic shock and bank capital, and decrease the chances that banks will reduce their loans to conserve capital. In addition to regulatory capital relief, these policies include a wide range of borrower support measures, such as debt moratoria, credit guarantees and deferred insolvency proceedings. They also include grants, tax breaks and wage subsidies to businesses.
Beyond the eurozone, banks in Europe’s emerging economies are expected to experience higher capital erosion by 2.4 percentage points. In many of these countries, tighter public budgets meant a lower level of support.
Second, market-based capital thresholds are the most relevant benchmarks.
For many large banks, hybrid capital, which contains elements of both debt and equity, is likely to be an important source of funds at a time when the cost of capital remains high. But investors in hybrid capital typically rely on interest payments.
If policies are not effective, many banks could struggle to meet their so-called “maximum distributable amount” (MDA) capital thresholds, which are higher than their current minimum regulatory requirements. This would lead to restrictions on dividend distributions and hybrid capital interest payments, which could scare off investors. The large banks, which hold around 25% of the capital in these instruments, could be subject to funding pressures.
Third, the speed of recovery is critical.
A prolonged recovery could result in much larger credit losses and higher bad debt provisions. If GDP growth in 2020-2021 is 1.2 percentage points lower than the baseline forecast, the erosion of bank capital could become more pronounced. More than 5% of all banks would be at risk of exceeding their MDA thresholds, even with policies in place. And that share would double if policies don’t work as expected (see graph above).
Policies to keep banks healthy
These results suggest a strategy that focuses on the following areas:
Continue pandemic support policies until recovery is firmly established. A premature reduction in borrower support could create “cliff edge effects” and risk stifling the supply of credit when it is needed most. As the recovery accelerates, eligibility criteria should be strengthened and better targeted. Some direct equity support could also be considered for viable businesses.
Clarify prudential guidelines on the availability and duration of capital relief. Supervisors should clarify the timing of banks’ capital buffers. Banks should be allowed to gradually rebuild capital buffers in order to preserve their lending capacity. Restrictions on dividend distributions and share buybacks are expected to be maintained until the recovery is well underway.
Support balance sheet consolidation by strengthening the management of non-performing loans and the bank resolution framework. As the policy measures expire, the late recognition of losses is likely to trigger a wave of defaults. EU authorities should use the system-wide stress test, expected in July 2021, to assess the need for preventive recapitalizations. Insolvency regimes should be strengthened by addressing administrative constraints and establishing fast-track procedures to restructure debt.
Facing structurally low bank profitability. Banks will take several years to rebuild their capital organically through retained earnings, unless their profitability improves. Banks should therefore increase non-interest income and streamline their operations in order to improve their cost structures, in particular by making greater use of digital technologies. And consolidation could improve bank efficiency, while facilitating better allocation of capital and liquidity within banking groups.