The impact of the Covid-19 pandemic on credit institutions and the importance of effective bank crisis management regimes

The economic crisis provoked by the Covid-19 pandemic is soon expected to also hit the banking and financial sector, mainly through a massive increase of non-performing loans resulting from bank borrowers’ inability to repay their debts. Regulators and supervisors have already put in place a number of measures in response to the current situation mainly aimed to facilitate banks continued lending. It is still difficult to forecast whether bank capital will be sufficient to absorb the shock if the non-performing loans risk materializes. Bail-in conversion powers remain largely untested and bail-in is accompanied by unintended negative contagion effects to credit supply and on the real economy, possibly hitting upon corporates and small and medium sized enterprises (SMEs), The economic crisis provoked by the Covid-19 pandemic is soon expected to also hit the banking and financial sector, mainly through a massive increase of non-performing loans resulting from bank borrowers’ inability to repay their debts. Regulators and supervisors have already put in place a number of measures in response to the current situation mainly aimed to facilitate banks continued lending. It is still difficult to forecast whether bank capital will be sufficient to absorb the shock if the non-performing loans risk materializes. Bail-in conversion powers remain largely untested and bail-in is accompanied by unintended negative contagion effects to credit supply and on the real economy, possibly hitting upon corporates and small and medium sized enterprises (SMEs), including the sectors most affected by Covid-19. Access to resolution funding is available in the European Union but, in a severe system-wide crisis, with rather neglectable firepower. Having effective bank crisis management regimes in place, which may possibly also rely on public intervention, will be key to limiting spill-over effects that could pave the way to another global financial crisis. The current public interest test leads to the application of different conditions for access to resolution financing and the provision of public support, depending on whether the BRRD or the banking state aid framework under national insolvency rules is followed. This leads to uncertainties and an unlevel playing field for investors and banks. Moreover, the obligatory 8% prior bail-in rule before use of public support under the BRRD is not clear-cut in particular as regards to the bridge bank tool. Covid-19 highlights the need for an overhaul of the public interest test and the development of a homogeneous set of resolution-like tools to smaller banks (under national insolvency) enabling authorities to take fast action and keep troubled bank’s franchise value and critical functions, as is the case in the US and Italy. In order for bank crisis management regimes to work properly, more flexibility in financing by deposit guarantee schemes beyond pay-outs or simple loss contributions under resolution will be required to facilitate transfer tools.