The COVID-19 crisis and banking system resilience

Foreword by Greg Medcraft, Director, Directorate for Financial and Enterprise Affairs, OECD

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Over the previous twelve months the world has worked to contain the unprecedented health and economic crises brought on by the COVID-19 pandemic. At the time of this report’s release, the outlook for the pandemic and the path to economic recovery remain highly uncertain.

In this context, the ongoing health of the banking sector remains a primary concern for economic policy makers. Banks lending is critical to see businesses and households through the crisis, and finance investment as we move into economic recovery.

However, COVID-19’s economic impacts have contributed to a sharp rise in defaults of corporate and household debt that is eroding the asset quality of banks across OECD countries. As the pandemic continues into 2021, banks could face a substantial increase in non-performing loans (NPLs) due to the rise in household and company defaults and will be forced to increase their loan loss provisions and allowances. Such a deterioration in bank asset quality and earning performance could limit banks’ capacities to absorb higher loan losses over time, flowing through to their ability to intermediate credit and support the recovery.

It is thus critical for banking supervisors and monetary and fiscal authorities, in planning ongoing response and the eventual unwinding of support, to have a clear picture of bank asset performance under different scenarios. This paper supports these considerations with a simulation analysis that assesses the extent of the potential rise in bank NPLs, under different assumptions: a scenario of extensive monetary and fiscal support; versus a scenario without continued support measures, in line with conditions that prevailed in 2008-2009 Global Financial Crisis. The paper also investigates the subsequent implications for bank capital and discusses whether policy responses may be needed to address the declining asset quality and reduced capital buffers.

At the first glance, this analysis suggests that aggregate capital ratios would remain above regulatory minimums – however, a modest number of banks are likely to see respective capital adequacies being challenged, especially if existing stimulus policies are abruptly diminished. At the same time, a weaker than expected economic recovery or premature end to monetary and fiscal support measures, coupled with growing vulnerabilities in the non-financial private sector may give rise to higher bank NPLs. Therefore, financial authorities in several countries should consider additional policy steps to enhance supervisory assessments of loan quality and improve resolution and recovery regimes to address the potential challenges associated with elevated NPLs.

Strengthening bank resilience requires international cooperation to limit regulatory arbitrage and harmonise regulatory standards. The OECD will continue to pursue this goal through its financial policy communities, and its wider work supporting an international policy environment to provide relevant policy recommendations for banking institutions and markets.

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