Banks Are Back in the Thick of the Game as LendersTHE CRISIS WE ARE EXPERIENCING, UNLIKE THE PREVIOUS ONES, HAS AFFECTED THE REAL ECONOMY AND NOT THE FINANCIAL SECTOR. THE NEED FOR NEW LIQUIDITY FOR BUSINESSES AND THE RISKS ASSOCIATED WITH THEIR SOLVENCY HAVE GIVEN BANKS A LEADING ROLE. WILL THEY OVERCOME THE STRESS OF A POSSIBLE NEW WAVE OF NONPERFORMING LOANS?
by Elena Carletti, Full Professor of Finance, Bocconi University
Translated by Richard Greenslade
The Covid-19 outbreak in the early months of 2020 signaled a new watermark for the economy and, consequently, the financial industry. The Covid-19 crisis is profoundly different from the 2007-2009 financial crisis and the 2011-2013 sovereign debt crisis . First, it hits the real economy directly, combining supply interruptions due to global chain disruptions with demand freezes following lockdowns. Second, it constitutes an exogenous, sudden and symmetric shock to numerous economies. As such, it requires different policy responses than the previous crises. The most urgent need relates to the provision of liquidity to companies, of all sizes. This liquidity has been injected either directly through government lending and central bank financing policies or through the banking sector, mostly in the form of payment moratoria and state guarantees. For instance, in March 2020, the European Central Bank (ECB) eased the conditions of its Targeted Longer-Term Refinancing Operations (TLTRO III) to support firms’ access to bank credit, enlarged the list of corporate collateral eligible assets, and expanded the range of assets eligible for its purchases under the Corporate Sector Purchase Program (CSPP) to include non-financial commercial paper. At the same time, several Eurozone governments offered export guarantees, liquidity assistance, and credit lines to firms, through their respective national development banks, ranging from 38.6% of GDP in Germany and 29.8% of GDP in Italy, to 14% in France and 9.1% in Spain (Anderson et al., 2020).
Despite the massive policy responses, various important concerns remain. A first issue relates to firm solvency. As liquidity reaches companies through debt, it increases their leverage, hence raising their default risk and leaving them vulnerable, with little room to invest and grow. In addition, the crisis is likely to lead to a substantial drop in firm profits, thus reducing firm capitalization. For example, using a representative sample of Italian firms, Carletti et al. (2020) find that a 3-month lockdown entails an aggregate yearly drop in profits of €170 billion, with an implied equity erosion of €117 billion for the whole sample, and €31 billion for distressed firms, that is firms that would end up with negative equity book value after the shock. As a consequence of these losses, about 17% of the sample firms, whose employees account for 8.8% of total employment in the sample, become distressed. The equity shortfall and the incidence of distress are concentrated among small and medium enterprises, with a distress rate of 18.1% relative to 14.3% for the medium firms and 6.4% for the large firms, and in the manufacturing and wholesale trading sectors. These results highlight the urgent need to think about firm solvency, not just liquidity, and to inject new equity into viable firms.
Some governments are already moving in that direction. The German federal government has already allocated €100 billion to inject equity and buy stakes in (large) companies affected by the COVID-19 shock via the so-called Economic Stabilization Funds, €50 billion in direct grants to distressed one-person businesses and micro-enterprises, and €2 billion to expand venture capital financing to start-ups, new technology companies and small businesses. This federal funding is complemented with some regional initiatives. Meanwhile, the equity injections provided to firms by other Eurozone governments pale in comparison to the German figures, in particular due to the existing significant sovereign debt obligations in some of these countries. To overcome this asymmetry, Boot et al. (2020a, 2020b) have proposed the creation of a new European Pandemic Equity Fund (EPEF), in charge of providing equity support particularly to small and medium companies which would be unable to easily fund equity funding elsewhere.
A second important concern relates to the banking industry. Although the Covid-19 pandemic is not a financial shock in itself, it occurs at the end of a decade of deep transformation of the financial industry because of persistently low interest rates, stricter regulation and competition from shadow banks and new digital entrants. These phenomena have contributed to increase the solvency of financial institutions, but also to contain their profitability and consequently market valuation, in particular in Europe.
How the new crisis will play out for the banking industry is highly uncertain. So far, banks have coped quite well with the new situation despite the very adverse real shock. Even more, banks are back to the center stage of the intermediation chain as they are being seen as a useful tool (by central banks and fiscal authorities) to support the real sector liquidity and financing needs. In addition, they have significantly accelerate their digital transformation due to the need of smart working and remote operations. Yet, the severity of the crisis may put banks under stress going forward, in particular should large-scale insolvencies in the business sector as well as among households emerge, leading to a new surge of non-performing loans.