28 April 2021

SUERF: The Impact of COVID-19 on European Banks

Despite Europe’s largest economic contraction since the Second World War, swift policy action has averted a financial crisis. However, the risk of a prolonged, partial, and uneven recovery amid a highly uncertain outlook weighs on European banks, which are heavily exposed to economic sectors that have been hard hit by the pandemic.

 This article examines how the COVID-19 crisis is likely to impact banks’ capital considering the mitigating effect of a wide range of pandemic-related policy support measures. Our analysis suggests that while banks remain broadly resilient, some of them might struggle to meet their threshold for the maximum distributable amount (MDA), which could create funding pressures related to hybrid capital. Effective policies are powerful in reducing both the extent and variability of capital erosion under stress. Based on these findings, the paper recommends: (1) continued but more targeted pandemic-related borrower support; (2) clear supervisory guidance on the availability and duration of capital relief and conservation measures; (3) swift balance sheet repair through debt restructuring and streamlined insolvency procedures; and (4) improved operational efficiency to raise structurally low bank profitability.

A robust post-COVID-19 recovery will depend on banks having sufficient capital to provide credit. Despite the combined health and economic crises, banks have so far been able to raise loan loss provisions and slowly absorb rising loan impairment charges without significant changes in their capital adequacy.

While unprecedented borrower support and regulatory flexibility have cushioned the immediate crisis impact on banks, these policies have not eliminated an underlying increase in credit risk as aggregate demand remains weak and economic slack is sizable. The deferral of insolvency proceedings has delayed defaults but also created a legacy risk of pent-up creditor claims and reduced asset recovery prospects [Figure 1]. The phasing-out of support measures could result in a surge of bankruptcies and rising loan impairments, further depressing banks’ already low and shrinking profitability. This could amplify deleveraging pressures on weakly capitalized banks and those most exposed to highly affected sectors.

Traces of asset quality deterioration have already emerged, causing credit conditions to tighten on the back of higher risk perceptions. Many banks have significantly increased their loan loss provisions on precautionary grounds, and lending to non-financial corporates has slowed. Although non-performing loan (NPL) ratios continue to decline, other asset quality metrics show signs of weakening.1

Insolvency moratoria have suppressed defaults but also created a
potential backlog of bankruptcies that could slow NPL resolution.

Sources: European Banking Authority; Eurostat; Haver Analytics; KPMG; Linklaters; Organisation for Economic Cooperation and Development; and IMF staff calculations.
Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

 

In a new IMF study, we assess the impact of the pandemic on European banks’ capital through three channels - profitability, asset quality, and risk exposures. Our approach differs from other recent studies by the European Central Bank and European Banking Authority, because it incorporates a wide range of policy support measures.2 It also includes granular estimates of corporate sector distress and covers a larger number of banks: 467 banks in 40 European countries.3

We find that, while the pandemic will significantly reduce banks’ capital, their buffers are sufficiently large to withstand the likely impact of the crisis. Using the IMF’s January 2021 growth projections as a baseline, most euro area banks will remain resilient to the deep recession in 2020 followed by the partial recovery in 2021. The aggregate common equity Tier 1 (CET1) capital ratio is projected to decline from 14.7 percent to 13.1 percent by the end of 2021 provided policy support is maintained [Figure 2]. No bank will breach the current prudential minimum capital requirement of 4.5 percent, even if policies do not operate as effectively as expected. But there will be considerable cross-country variation, with the change in bank capital sensitive both to the size of the macroeconomic shock and the initial condition of a bank’s balance sheet and its profitability. We find a larger capital impact on banks in countries that have been hit especially hard by the pandemic, and for banks with higher initial NPLs and large exposures to highly affected sectors....

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