Financial Institutions and Covid-19

How are banks doing?

Although the initial economic shock caused by the Covid-19 pandemic primarily hit the real economy, the economic stress is inevitably flowing slowly into the banking system. Given the systemic importance of the financial sector, the question “How are banks doing?” is more and more important. We describe below the principal economic developments of the current situation and analyse the key challenges for financial institutions. These are not only economic in nature but are also driven by the regulatory and legal framework in which they operate.

The unfolding of an economic crisis

In its World Economic Outlook Update in June 2020, the International Monetary Fund (IMF) projected a global growth of -4.9% for 2020. The strongest contraction was expected in Q2 2020 with growth projections indicating that the economy would recover gradually in Q3 and Q4 2020. The largest hit is felt by the advanced economies for which the growth in 2020 was projected at -8.0%. Current numbers indicate an even deeper contraction with, for example, the UK’s economy contracting by 20.4% in Q2 2020.

On the other hand, emerging markets and developing economies were expected to face a lower contraction with a growth of -3.0%. Overall, this is – according to the IMF – the first time that all regions, i.e. advanced economies as well as emerging markets and developing economies, have a projected negative growth.

Although recovery was expected to strengthen gradually over the second half of 2020 and all the way through 2021, significant uncertainties remain in these projections. Naturally, the "second wave" that hit Europe at the end of 2020 and continued into 2021 increased the uncertainty around the further development but at the same time the start of wide-spread vaccination gives hope that the pandemic will be more manageable in the coming year.

One of the biggest challenges of the economic side of the Covid-19 crisis was the sudden halt of global commercial activity which not only cut off supply chains but also the global capital and cash flows and thereby put companies and households under severe financial pressure.

To avoid widespread bankruptcies in the first months of the Covid-19 pandemic, governments, financial regulators and financial institutions took unprecedented measures to support the real economy with funding and liquidity. To facilitate the numerous stimulus and support packages, the financial sector played and will continue to play a decisive role.

Stronger financial institutions able to act to counter the crisis

Although faced by operational challenges of their own, including switching within just a few days from on-site to remote working, banks actually increased their lending activities to provide companies and households with funding. In stark contrast to the experiences of the financial crisis of 2008, financial institutions were considered – by politicians and regulators alike – as part of the solution, with their ability to cushion the economic impact of the Covid-19 pandemic.

Financial institutions are much more strongly capitalised than in 2008, giving confidence to the regulators, and indeed the institutions themselves, that they have the resilience to face the Covid-19 crisis. In Q4 2019 for example, the significant institutions (“SIs”) supervised by the European Central Bank (“ECB”) had accumulated €1,532.54 bn. in equity which provided for a CET1 ratio of 14.87%. This strong capital base leaves the EU banking sector with some headroom to absorb losses from defaulting exposures.

Bank liquidity buffers have also increased significantly in recent years. In Q1 2020, the overall liquidity coverage ratio (LCR) for banks in the EU was close to 150% which is well above the regulatory required LCR of 100%.

These developments show that the regulatory measures of the last years – especially in the context of regulatory capital requirements – have increased the resilience of the financial sector as a whole. The improved ability of the financial sector to deal with an economic crisis is not only based on the quantitative growth of the institutions’ capital and liquidity base but also on the higher qualitative requirements for the components of regulatory capital and liquidity buffers. All in all, it seems that the regulatory reform packages of the last years addressed important aspects to prepare financial institutions regarding an inevitable economic downturn.

More challenges lie ahead

Even so, bank shares saw massive sell-offs in March / April last year. The stocks of financial institutions not only slumped together with the market but underperformed the average. From mid-March to mid-May 2020, the EURO STOXX Banks index clearly underperformed compared to the more general STOXX Europe 600 by a widening margin.

A look at the market’s perception of banks, however, also shows that the stock prices varied between the different financial institutions. A study by the Bank of International Settlement indicates that certain bank characteristics show which factors affect the stock prices of banks. The strongest positive drivers for stock prices are capitalisation and the profitability of the institutions but non-performing exposures (“NPEs”) also had an effect here. The negative impact on stock prices was the highest in case of a low capitalisation but, again, NPEs played a role here as well.

The clear implication of these market trends is that financial institutions face a challenging future. The regulatory reliefs in favour of a focus on the funding of the real economy points in the same direction. Consequently, the initial supervisory reliefs dealt particularly with the effects on the capital situation of financial institutions but also with NPEs and operational difficulties. For example, the ECB clarified that capital buffers could be depleted by SIs if necessary, to ensure on-going lending activities. 

To help financial institutions identify the regulatory and legal challenges that lie ahead, the Linklaters Financial Regulation Group and the Bank Sector Team have set up this page to share their thinking and observations about some of these issues and aspects in the context of the Covid-19 pandemic, particularly:

  • Regulatory Capital;
  • Asset Quality and NPEs;
  • Risk Management, Governance and AML; and
  • Impact on Business Models.

The way in which financial institutions master these challenges will not only have a direct impact on the recovery of the economy in the near future but will also shape each individual institution’s fortune. 

Click here to read our full briefings

Bank Capital – Why it matters

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Asset Quality and NPEs – Where Covid-19 infects banks

The financial crisis of 2008 has shown that banks and other financial institutions “feel” the impact of a crisis slightly delayed when asset quality starts to deteriorate and NPE levels increase. As this affects the capitalisation of banks and therefore their funding capabilities, the quality of the assets on bank balance sheets will have a strong influence on the economic recovery from the Covid-19 pandemic.

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Managing risks in times of crisis

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The financial sector after Covid-19

The economic and social impact of the Covid-19 will be one of the key drivers of change in the financial sector. And two areas which have already been the cornerstones for the transformation of the European financial sector – consolidation and digitalisation – are likely gather further momentum due to the pandemic.

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Further links

Key Contacts

x Covid-19 Resource Hub