Global Corporations and Politics
The Global Banking System in the Context of the Economic Crisis

Uncertainty about the size of the shock stressing the global banking system is high. But most likely the shock is in line with scenarios used in regulators’ stress tests, at least on a two-year basis, and therefore the situation is likely manageable. With lending having been subdued into the crisis and with banks also being much better capitalized than in 2007, an outright banking crisis is unlikely. Policy support is directed more to the banks’ clients than the banks themselves, but ample liquidity provision has resulted in calm funding markets. As a result, lending is very strong, contrasting with the credit crunch during the GFC. However, the extensive use of forbearance and zero or negative interest rates may hold back banks’ recovery for a long period of time. 

When thinking about the banks in the current crisis the obvious reference point is the great financial crisis (GFC) of 2008/09. While 2008 started out as a banking crisis, which then quickly engulfed Main Street, the current crisis is starting with Main Street, but could still lead to a banking crisis, if the shock is sustained for long enough.  In spite of this major difference, the current crisis is playing out along familiar lines. First, the banking system is hit by a significant negative shock. Then policy makers roll out support measures. In the final step, there can be changes to the regulatory framework to address the perceived weaknesses highlighted by the crisis. This essay examines some of the similarities and differences to the 2008 case with respect to the shock, the policy support as well as the likely aftermath in order to come up with a view of how the international banking system will come out of the COVID-19 crisis. 

Starting with the size of the shock, the analysis is extremely sensitive to assumptions on just how long the lockdowns are going to last, and whether there will be additional and substantive waves of COVID-19, especially in the Northern hemisphere winter of 2020. In particular, it is unlikely that the global economy can fully normalize before a vaccine has been developed and widely distributed. This is challenging before early 2021, at the very earliest, and this uncertain timing creates risks to the recovery.
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 A good starting point for the global growth outlook is the IMF’s April World Economic Outlook (WEO), which sees global GDP contracting by 3% in 2020, followed by a 4.8% bounce back in 2021 as its baseline. For this case, the IMF’s Global Financial Stability Report (GFSR) suggests that the scenario for banks in developed markets is considerably worse than the stress test the financial sector assessment program (FSAP) envisages. But encouragingly, this is only the case for year one of the shock. For year two, on a cumulative basis, the shock to banks is less than the FSAP assumptions, not only for the WEO’s baseline, but even for its adverse case. For emerging markets, the shock is slightly smaller than the FSAP stress test even in year one. However, there are downside risks to this assessment. Currently data is tracking more closely to the adverse WEO scenario than the baseline. Under the adverse scenario the shock for emerging market banks is also worse than the FSAP envisions, but again only in year one. Overall, solvency risks appear much reduced compared to 2008, but uncertainty is high.      

However, the relevant question is not just the size of the shock, but whether the banks are positioned to cope with it. Luckily, the global banking system is in meaningfully better shape than it was going into the 2008 crisis. There are two important reasons for this. First, 2008 occurred after a long boom in lending. In the US, bank credit in the five years leading up to the crisis rose by more than 10% per annum. During the most recent five-year period, lending rose by only 7.6% per annum. The difference is even starker for emerging markets: loans in EM recently grew by less than 9% p.a., while into the 2008 crisis loans grew by more than 20%. The extent of the loan growth going into a crisis is typically a good predictor for how large the loan losses are going to be, as exuberance often leads to poor lending decisions. The lower vulnerability due to lower loan growth is an unexpected upside from the more subdued growth environment post GFC, especially in emerging markets. Second, and largely as a result of more stringent regulatory requirements post GFC, the banks are much better capitalized than they were in the 2008 crisis. The GSFR notes that for the 29 countries with the most important banking systems, 25 have higher tier 1 capital ratios in 2019 than in 2007, and most of them are significantly higher. For EM banks overall the Tier 1 ratio is now close to 14%, up from around 10% in 2007. This increased strength is also visible in reserves. For EM banks, loan loss reserves as a percentage of NPLs in 2019 were almost twice as large as in 2007. Furthermore, EM regulators made sure that open USD exposures by local corporates and banks were sharply curtailed given that FX weakness in 2008 created major credit problems in several emerging markets. Some of the homework doled out to the banks by their regulators post GFC is now coming in handy.  

Given the high uncertainty about the size of the shock, it is interesting to see how markets assess the situation relative to 2008. Encouragingly, the market agrees that 2008 was the larger problem. Bank stocks in developed markets sold off on average by around 75% during the GFC, while this time it is closer to 55%. In EM, bank stocks were around 73% lower during the GFC, while this time around it is less than 50%, even though they were the second worst performing industry group (after energy). Maybe more importantly than the equity performance is the performance of bank credit, especially if we are worried about insolvency risk. Here the difference to 2008 is even clearer. Bank spreads of US IG issuers peaked at 680bp in early 2009 compared to a peak of 390bp in March of 2020. Lastly, the behavior of funding markets is also key, as funding stress accelerates any underlying problems. In this area, the current crisis is of a magnitude smaller for banks than it was during the GFC. The 3m Libor-OIS spread in the US peaked in October of 2008 at 360bp, while the COVID-19 peak was in March of 2020 at around 140bp – and is currently back to just 33bp, a level not reached in the GFC until July of 2009, well after the crisis was firmly in the rearview mirror. The spillover of US funding fears to other countries through the cross-currency basis was also more benign. For EUR, for example, stress levels in March 2020 were around 80bp compared to close to 200bp during the worst days of 2008. 

Of course, financial markets do not only reflect the size of the shock (still uncertain) and the initial position of the banking system (much stronger), but also the extent of policy support. 
After all, some banks passed some of the more extreme stress tests only due to meaningful policy support.

The first pillar of support this time by policy makers was to provide liquidity to the banking system. The Fed, for example, not only cut rates to zero, but also lowered the spread of the primary rate, used in their discount window, over Fed Funds, and also cut the reserve requirement ratio to zero. Through the Primary Dealer Credit Facility (PDCF) program, it offers low interest rate loans to primary dealers for 90 days. Banks in many other jurisdictions around the globe were given access to emergency central bank funds. A second pillar of support can be broadly classified as forbearance. In particular, many jurisdictions implemented waivers for credit payments for small companies or households.

Banks are being encouraged to restructure loans, but are exempt from the higher capital requirements that such restructured loans may have generated in the past. The implementation of Basel IV was postponed. Furthermore, banks are encouraged to dip into their various capital buffers built up after the GFC. The approach is working well so far. During the GFC, credit extension by the banks contracted until early 2010, in a credit crunch that made a difficult crisis worse. This time around, lending in the US is surging. Between early May and the end of January, lending by US commercial banks is up 8%. This is largely driven by companies drawing down their revolving lending facilities. While this lending reflects agreements made prior to the crisis, markets are also wide open for the safer companies, and bond issuance in March for US IG companies was extremely strong. Lending in some emerging markets, like China or Korea, has also been a source of strength, but this is far from universal in EM. Still, this lending behavior is a major, positive difference to 2008. We would note that forbearance is likely helpful for credit extension, but not necessarily for equity holders of banks who would often prefer the kitchen sink approach, of recognizing all losses in one go. More broadly speaking, this time around the support is much more focused on the banks’ clients rather than the banks themselves because banks are in better shape. It is reassuring that more direct support for banks has not been necessary. 

What about the aftermath of the crisis? After the GFC, regulators meaningfully changed the operating environment for the banks. This time around, with much less direct support for the banking system needed, and with past regulation having broadly worked as intended, there is much less scope for additional regulation. Banks are not the problem in this crisis. But this does not mean that life post COVID-19 will be easy for the banks. First, NPLs accumulated, but not fully recognized due to forbearance, will remain a major headwind for banks’ profitability. Second, interest rates are going to be stuck at the zero bound for a long time, and may still go into negative territory in more jurisdictions. Even some emerging markets have started to hit the zero lower bound. A further spread of negative interest rates would probably have the most profound impact on banks’ medium-term outlook as the result of the COVID-19 crisis. While the Fed is not going to go there in the short term, bank shareholders can only hope that this resolve is going to hold.
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