Date published: Apr 2021
SUERF Policy Brief, No 76
by Shekhar Aiyar, Mai Chi Dao, Andreas A. Jobst,
Aiko Mineshima, Srobona Mitra and Mahmood Pradhan
International Monetary Fund (IMF)
Download: SUERF Policy Brief, No 76 (0.58 MB)
Despite Europe’s largest economic contraction since the Second World War, swift policy action has averted a financial crisis. However, the risk of a prolonged, partial, and uneven recovery amid a highly uncertain outlook weighs on European banks, which are heavily exposed to economic sectors that have been hard hit by the pandemic. This article examines how the COVID-19 crisis is likely to impact banks’ capital considering the mitigating effect of a wide range of pandemic-related policy support measures. Our analysis suggests that while banks remain broadly resilient, some of them might struggle to meet their threshold for the maximum distributable amount (MDA), which could create funding pressures related to hybrid capital. Effective policies are powerful in reducing both the extent and variability of capital erosion under stress. Based on these findings, the paper recommends: (1) continued but more targeted pandemic-related borrower support; (2) clear supervisory guidance on the availability and duration of capital relief and conservation measures; (3) swift balance sheet repair through debt restructuring and streamlined insolvency procedures; and (4) improved operational efficiency to raise structurally low bank profitability.
A robust post-COVID-19 recovery will depend on banks having sufficient capital to provide credit. Despite the combined health and economic crises, banks have so far been able to raise loan loss provisions and slowly absorb rising loan impairment charges without significant changes in their capital adequacy.
While unprecedented borrower support and regulatory flexibility have cushioned the immediate crisis impact on banks, these policies have not eliminated an underlying increase in credit risk as aggregate demand remains weak and economic slack is sizable. The deferral of insolvency proceedings has delayed defaults but also created a legacy risk of pent-up creditor claims and reduced asset recovery prospects [Figure 1]. The phasing-out of support measures could result in a surge of bankruptcies and rising loan impairments, further depressing banks’ already low and shrinking profitability. This could amplify deleveraging pressures on weakly capitalized banks and those most exposed to highly affected sectors.
Traces of asset quality deterioration have already emerged, causing credit conditions to tighten on the back of higher risk perceptions. Many banks have significantly increased their loan loss provisions on precautionary grounds, and lending to non-financial corporates has slowed. Although non-performing loan (NPL) ratios continue to decline, other asset quality metrics show signs of weakening.1
Insolvency moratoria have suppressed defaults but also created a
potential backlog of bankruptcies that could slow NPL resolution.
Sources: European Banking Authority; Eurostat; Haver Analytics; KPMG; Linklaters; Organisation for Economic Cooperation and Development; and IMF staff calculations.
Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.
In a new IMF study, we assess the impact of the pandemic on European banks’ capital through three channels - profitability, asset quality, and risk exposures. Our approach differs from other recent studies by the European Central Bank and European Banking Authority, because it incorporates a wide range of policy support measures.2 It also includes granular estimates of corporate sector distress and covers a larger number of banks: 467 banks in 40 European countries.3
We find that, while the pandemic will significantly reduce banks’ capital, their buffers are sufficiently large to withstand the likely impact of the crisis. Using the IMF’s January 2021 growth projections as a baseline, most euro area banks will remain resilient to the deep recession in 2020 followed by the partial recovery in 2021. The aggregate common equity Tier 1 (CET1) capital ratio is projected to decline from 14.7 percent to 13.1 percent by the end of 2021 provided policy support is maintained [Figure 2]. No bank will breach the current prudential minimum capital requirement of 4.5 percent, even if policies do not operate as effectively as expected. But there will be considerable cross-country variation, with the change in bank capital sensitive both to the size of the macroeconomic shock and the initial condition of a bank’s balance sheet and its profitability. We find a larger capital impact on banks in countries that have been hit especially hard by the pandemic, and for banks with higher initial NPLs and large exposures to highly affected sectors.
Under baseline conditions, most euro area banks are likely to preserve considerable capital buffers.
Sources: European Banking Authority; European Central Bank; European Systemic Risk Board; FitchConnect; S&P Global Market Intelligence; and IMF staff estimates.
Note: CCB = capital conservation buffer; CESEE= Central, Eastern and Southeastern European countries; CET1 = common equity Tier 1; MDA = maximum distributable amount (weighted average). Data labels in the figure use International Organization for Standardization (ISO) country codes. The grey shaded area of the boxplots shows the interquartile range (25th to 75th percentile), with whiskers at the 5th and 95th percentile of the distribution. Sample of 90 banks covered by the EBA Transparency Exercise ("EBA Coverage").
The analysis covers all three channels affecting the capital adequacy ratio under stress − profitability (net interest income and provisions), nominal assets (net lending and write-offs after reserves), and risk exposure (changes in credit risk weights).
*/ Debt repayment relief (moratoria) for businesses and households, public credit guarantees, deferred insolvency proceedings, and dividend restrictions (only in 2020).
Looking beyond the euro area, banks in Europe’s emerging economies are likely to see greater capital erosion. The aggregate capital ratio is projected to decline from 12.8 percent to 10.8 percent by the end of 2021. In many of these countries, the buffer provided by policy support is estimated to be smaller than for euro area banks due to tighter government budgets.
But at least three important caveats are in order.
Our results suggest a strategy that focuses on the following areas to ensure that banks can effectively support the recovery:
Effective policies help weaken the link between the macro shock and the impact on bank capital.
Sources: European Banking Authority; FitchConnect; and IMF staff calculations.
Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. CET1 = common equity Tier 1. */ Debt repayment relief (moratoria) for businesses and households, public credit guarantees, deferred insolvency proceedings, and dividend restrictions (only in 2020).
Banks would take a long time to restore their capital buffers even under baseline conditions.
Sources: European Central Bank; FitchConnect; and IMF staff calculations.
Note: CET1 = common equity Tier 1; RoA = return on assets.
*/ Long-term average until end-2019.
1/ Assumptions: average asset risk weight = 40 percent, taxes = 20 percent, dividend payout ratio = 15 percent.
Aiyar, Shekhar, Mai Chi Dao, Andreas A. Jobst, Aiko Mineshima, Srobona Mitra, and Mahmood Pradhan, 2021, “COVID-19: How Will European Banks Fare?,” Departmental Paper No. 2021/008, European Department, March 26 (Washington, D.C.: International Monetary Fund), available at https://www.imf.org/en/Publications/Departmental-Papers-Policy-Papers/Issues/2021/03/24/COVID-19-How-Will-European-Banks-Fare-50214.
About the authors
Shekhar Aiyar is the IMF’s Mission Chief for Germany. Previously he headed the Euro Area Division. He has worked on a broad range of countries in Europe, Asia, and Africa. His research interests encompass open economy macroeconomics, international finance, growth empirics and test cricket. He holds a PhD from Brown University.
Mai Chi Dao is a Senior Economist in the IMF’s European Department, where she works on the Germany desk. Her research interests cover broader issues of international macro, corporate finance, and labor economics. She holds a PhD in Economics from Columbia University.
Andreas (Andy) Jobst is a Senior Economist in the IMF’s European Department, where he covers the financial and monetary policy for the Euro Area. His main research interest is in macro-financial and macroprudential analysis, public investment management and sovereign debt sustainability, and climate change. He holds a PhD from the London School of Economics.
Aiko Mineshima is a Senior Economist in the IMF’s European Department, where she is a desk for Germany. Prior to joining the IMF, she was an economist at the Bank of Japan, where she spent most of her time in the Economic Research and Financial Markets Departments. She holds a graduate degree from Columbia University.
Srobona Mitra is a Senior Economist in the IMF’s European Department, where she is a desk for the Euro Area team and Mission Chief for Andorra. She works on financial stability issues and has done research on systemic risk, financial interconnectedness, capital flows, and macroprudential policies. She holds a PhD in Economics from the University of Washington in Seattle.
Mahmood Pradhan is a Deputy Director in the IMF’s European Department. He was earlier a Senior Advisor in the Asia Pacific Department and Mission Chief for Japan. Prior to joining the Fund in 2007, he was Chief Emerging Markets Strategist at Tudor Investment Corporation and subsequently an Emerging Markets Portfolio Manager at Wadhwani Asset Management, a macro hedge fund in London.
SUERF Policy Briefs (SPBs) serve to promote SUERF Members’ economic views and research findings as well as economic policy-oriented analyses. They address topical issues and propose solutions to current economic and financial challenges. SPBs serve to increase the international visibility of SUERF Members’ analyses and research. The views expressed are those of the author(s) and not necessarily those of the institution(s) the author(s).
Editorial Board: Ernest Gnan, Frank Lierman, David T. Llewellyn, Donato Masciandaro, Natacha Valla.
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