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During the last few weeks, the spread of COVID-19 has rattled the global economic prospects and financial markets. Growth and employment forecasts for the global economy have been revised substantially downward to recession levels for the next two quarters; global stock prices have declined, especially for banks and other financial intermediaries; credit spreads have surged, notably for junk-rated paper in developed economies; and central banks have reacted with substantial rate cuts and/or liquidity provision and asset purchase programs.
The root of the present stress is different compared to the primary cause of the 2008-2009 global financial crisis (GFC). Importantly, the present stress did not originate in the banking system, as was the case for the GFC; pre-GFC, the banking system was over-leveraged with poor underwriting decisions in the housing sector, and the household sector was over-leveraged too. The root cause of the current stress is a pandemic.
Containing the virus and the drastic steps (from social distancing to isolation) that governments need to undertake have an immediate impact on the real economy through the simultaneous occurrence of both demand and supply shocks, with attendant financial sector spillovers and side-effects such as the oil-price war. In particular, debt repayments will come due as usual, but liquidity appears to be quickly evaporating for both small and large companies as economic activity grounds to a virtual halt.
If firms experience liquidity problems or are uncertain about future liquidity needs or availability, they might use the insurance arranged with banks and start drawing down their credit lines. Worse, liquidity needs can potentially become highly correlated among firms and they could start running on their banks en masse. Banks could then experience substantial liquidity problems themselves, which could be further elevated if other short-term creditors of banks stop rolling over their funds.
Moreover, drawdowns require additional bank capital as they manifest as loans on bank balance sheets, constraining the ability to provide further, new loans to the economy, and in some cases, potentially also bringing banks closer to insolvency. Liquidity problems can this way quickly morph into solvency problems.
It thus makes sense as a ‘liquidity stress test’ to quantify the likely insurance function banks may have to provide involuntarily at this stage of the COVID-19 scenario and how large it looks relative to their balance-sheet buffers in terms of capital and liquidity needs. It is also useful to investigate what the past stressed experiences for bank credit-line drawdowns can tell us about the likely outcomes in terms of financial markets and real lending.