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.