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The Corona crisis and the stability of the European banking sector: A repeat of the financial crisis?

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The paper, published by Bertelsmann Stiftung and Jacques Delors Centre, suggests that the fortunes of European banking systems will depend on the course of the economic recovery. According to the authors capital ratios could drop dramatically in a number of EU member states well below what supervisors generally consider to be sound even under stress conditions. The presented scenario suggests that banking systems in a number of European countries would likely come under extreme stress and would probably fail a rigorous stress test.

Bertelsmann Stiftung | Jacques Delors Centre – Publication
15 June 2020
Source: Bertelsmann Stiftung

Publishers:
Bertelsmann Stiftung
Hertie School Jacques Delors Centre

Authors:
Frank Eich, Theresa Küspert, Philipp Schulz

The Corona crisis and the stability of the European banking sector: A repeat of the Great Financial Crisis?

Introduction:

The Corona crisis has had a devastating effect on the global economy and could end up being worse than the Great Financial Crisis (GFC). Some commentators have already suggested that the decline in economic activity could be the most marked for several centuries. Unlike the GFC, the Corona crisis was triggered by an external shock. Governments responded to this shock by offering liquidity to the real economy, either directly or indirectly by guaranteeing new bank lending.

So far European banks have weathered the storm but will they be able to withstand a prolonged economic downturn? The paper suggests that the fortunes of European banking systems will depend on the economic recovery we experience. If we witness a ‘V-shaped’ recovery as currently forecast by the European Commission, for example, then banks in the majority of EU member states might be able to survive unscathed. The picture could look very different if the recovery turns out to be more sluggish though. The paper suggests that capital ratios – one of the key benchmarks used to assess the stability of banking systems – could drop dramatically in a number of member states such as France and Spain to well below what supervisors generally consider to be sound even under stress conditions. With the situation looking less severe in other member states such as Germany or the Netherlands, this could renew political tensions seen last during the Euro area sovereign debt crisis.

The paper is structured as follows. Section ‘The Corona crisis’ presents the latest economic forecasts and contrasts the current crisis with the GFC. In Section ‘Could the Corona crisis undermine the financial stability of the European banking sector?’ the authors draw on the results of
the 2018 EBA adverse stress test. Comparing the 2018 EBA adverse scenario with a plausible ‘ticked-shaped’ recovery post-Corona, the paper presents illustrative impacts on capital ratios in a selected number of EU member states. Section ‘Concluding Comments’ looks at the role of European-wide policy responses to deal with the crisis and what the Corona crisis might mean for the future of the EU’s Banking Union and Capital Markets Union.

Concluding comments:

Europe faces unprecedented challenges, with some forecasters worrying that the Corona crisis could lead to the deepest recession in several centuries.

Unlike the Great Financial Crisis, the Corona crisis is the result of an exogenous shock. Like the GFC, its severity is likely to differ across European countries. This paper shows that in the absence of unprecedented fiscal responses to support the economic recovery, the Corona crisis could have devastating effects on banking systems in some EU member states but not necessarily in others.

The nature of the crisis suggests that supporting the economic recovery must be the best policy now available to protect banking systems from rapidly rising defaults. That said, fiscal room for manoeuvre in the countries most affected by the Corona crisis is limited, suggesting that a European response involving an element of redistribution might be required (Odendahl et al, 2020). The European Commission’s proposed Next Generation EU rescue plan – going beyond previously agreed EU-wide credit facilities – to support the most affected regions and countries could be a step in the right direction (European Commission, 2020c).

European solidarity might be tested in other areas too

If our illustrative calculations are at all indicative of what might happen to banking systems in EU member states over the coming years, then the Corona crisis can also be expected to have far-reaching implications for the future of European financial markets initiatives, in particular Banking Union and Capital Markets Union.

One lesson of the GFC for European policy makers was to make banks stronger and better supervised. The EU set up a banking union comprising single supervisory and resolution mechanisms to achieve that. A third element, considered by many as necessary to complete the union (Carmassi et al, 2018), would be a European deposit insurance scheme. Significant resistance from a number of EU member states has meant that such a scheme has been put on hold so far.

Given the likely divergence in fortunes across countries post-Corona, we should not be surprised if resistance to a European deposit insurance scheme (and other policies perceived to involve ‘risk sharing’ between EU member states) become even stronger.

What the Corona crisis means for the EU’s Capital Markets Union (CMU) initiative is less clear. On the one hand, the rationale for CMU is probably stronger than ever, especially if European banking systems struggle to cope with the Corona fallout: Europe needs strong capital markets to support a recovery. On the other hand, the Corona crisis has already bolstered the role of the public sector – as exemplified by the European Investment Bank – in providing funding across EU member states. What then is the role of the private sector going forward? Can we expect closer collaboration between the public sector and markets in future or have the latter been crowded out? Will policy makers, faced with the crisis aftermath, potentially including future banking crises, have the capacity to progress this project?

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