Financial stability in the Corona crisis - leeway in banking supervision may have the opposite effect in the long term
In a SAFE White Paper, financial and legal researchers show that the looser regulations for banks in the Corona crisis conceal the actual risks in bank’s balance sheets - in the long term, this will unsettle investors and jeopardize financial stability
Easing the burden on banks in the Corona crisis so that the economy remains liquid is the declared goal that the European Central Bank (ECB), as the central supervisor in the Single Supervisory Mechanism (SSM), pursued with certain support measures. The release of capital buffers and the generous leeway in the application of the accounting standards IFRS 9 have very likely prevented another banking crisis. Nevertheless, prudential standards before Covid would have to be reapplied in a timely manner.
In a White Paper published by the Leibniz Institute for Financial Research SAFE, legal and financial experts show that especially the forbearance in loss provisioning distorts banks' balance sheets in a way that the support measures may have the opposite effect and jeopardize financial market stability and economic recovery.
In an analysis commissioned by the European Parliament, Tobias Tröger, Director of the Cluster Law and Finance at SAFE, and Rainer Haselmann, Professor of Financial Economics at Goethe University Frankfurt and SAFE Fellow, have examined how banks' capital would have evolved in the absence of supervisory support forbearance, and make recommendations on when and how support should unwind.
Actual solvency of banks concealed
In their study, the researchers calculate how a recession shock similar to that of the 2009 financial crisis would have affected the balance sheets of German banks and get to a low Common Equity Tier 1 (CET1) ratio that would not have covered about 16 percent of bank balance sheets. "The lowered capital requirements and more generous interpretation of accounting standards very likely prevented another banking crisis," Tröger explains. Thus, the ECB's measures would have achieved the goal of keeping banks liquid. However, the distorted capital ratio conceals the actual solvency of the banks.
The authors call for a return as soon as possible to the application of IFRS 9 for supervisory purposes that reflect actual macroeconomic developments, as before the outbreak of the Covid-19. Overly optimistic figures, such as those generated by the ECB measures, would not only unsettle investors but also keep undercapitalized banks alive. "Poorly capitalized banks will hardly be able to contribute to a quick economic recovery from the crisis," said Rainer Haselmann, "the 2021 bank stress test should be used to examine all banks and provide a realistic picture of their asset situation."
While banks unable to meet capital requirements after the Covid crisis would have to be resolved, all healthy banks, regardless of size, should be recapitalized by a supranational, Covid-specific fund. The model could be here the U.S. Troubled Asset Relief Program (TARP).
Cluster Director Law and Finance