In his final public appearance as governor of the Bank of England, Mark Carney said the work done to rebuild bank balance sheets after the 2008 financial crisis meant they could now be part of the solution to deal with the economic shock of the coronavirus. It had been prudence with a purpose and resilience with a reason, he said. The question facing policymakers now is whether he was right. Will the reserves built up by banks be enough to protect the real economy and survive themselves?
The true extent of the potential economic shock is starting to become clear. Some economists expect that US gross domestic product may fall by as much as 30-40 per cent in the second quarter; in the UK, the Office for Budget Responsibility produced a scenario suggesting the lockdown could lead to the deepest economic downturn since the early 18th century. At a more granular level, the damage can be seen in the job cut announcements by some of the world’s major airlines.
Governments have taken unprecedented monetary and fiscal policy action to help their economies survive the lockdowns. The banking system is at the heart of this effort to keep businesses and consumers afloat. Banks have more capital and liquidity than they did 12 years ago. Liquidity support from the central banks is also cushioning some of the risks. But banks’ resilience is being tested as never before. The danger is that large credit losses could prompt them to cut back their lending just when it is needed most.
Results for the first quarter from US and European lenders are giving some indication of the potential cost; the six largest US lenders increased their first-quarter loan provisions by a combined $25.4bn in April, a year-on-year rise of 350 per cent. HSBC, one of the world’s largest banks, last week warned loan provisions could reach $11bn this year, the highest since the financial crisis.
Regulators have already relaxed capital and audit rules to allow lenders to trim loss-absorbing buffers. Despite guidance from UK supervisors not to book large charges on souring loans — as required under new international accounting rules — the wide range of loan provisions reported is indicative of the tightrope banks are walking. The concern is that they may yet prove to be undercapitalised to deal with the scale of losses they face in the months ahead.
Relaxing the rules raises important issues for policymakers. Critics who said governments were too tough on banks in the wake of the 2008 financial crisis have been proven wrong. As today’s crisis is showing, higher capital was sorely needed. If the downturn worsens, regulators may have to consider recourse to further policy actions. The fact that so many banks needed government bailouts in 2008 spurred reform: special resolution regimes and bond bail-in powers were introduced to protect taxpayers in the future. Those facilities are there to be used if needed — even though they are untested.
In the meantime, banks must remain the channel of credit provision to a struggling economy. Where credit demand exceeds banks’ reasonable risk appetite, governments should provide guarantees, as some already have, for emergency loans. Legacy loans should remain banks’ affair. And if banks’ capital proves insufficient to absorb losses, the option of raising fresh equity should be explored. Many did so in 2008 and could again. Only if such measures fail should there be any talk of bail-in or bailout. Today’s banking system is stronger than it was and, for now, the banks are playing their role as a stress absorber rather than a stress amplifier. But today’s unparalleled crisis may yet stress the regulatory structure to its limit.
