The recession of 2008–10 was triggered by a shock in the banking system. In fact, many economic downturns in the past 50 years, such as stock-market crashes and debt defaults, had financial-system origins. The current recession is different: it was triggered by a global pandemic, governmental and societal responses to it, and the resulting shocks to supply and demand.
But that does not mean that banking is not affected. The industry has already felt massive effects from the crisis, with more to come. And, as our colleagues have written recently, the banking systems in both Europe and the United States have roles to play in getting the economy back on track—for example, by providing loans to businesses that have suffered.
How effective a bank-supported economic recovery will be, however, depends on banks’ resilience and health. Losses from loan defaults and increases in risk-weighted assets will deplete banks’ capital. The extent will depend on the spread of COVID-19 and the effectiveness of the public-health response and mitigating interventions. Our new research considers three scenarios that business executives around the world consider most likely. We find that in two milder scenarios, in which GDP does not recover to its previrus level until 2021 or 2023, $100 billion to $400 billion in common equity tier-1 (CET1) capital would be wiped out in Europe, the United Kingdom, and the United States.
The good news is that the European and US banking systems in aggregate can withstand damage on that scale, though individual banks may not fare so well. Entering the crisis, CET1 ratios1 were 13 percent in Europe, 14 percent in the United Kingdom, and 12 percent in the United States. Should one of the two milder scenarios prevail, those ratios would fall to 8.5 to 10.0 percent in Europe, 11 to 13 percent in the United Kingdom, and 8.0 to 10.5 percent in the United States, all above regulatory minimums (standards that have seen some recent flexibility from regulators). Some institutions would slip below the minimums, perhaps to a level that threatens their viability, but the systems themselves would survive. In either of these scenarios, the prudential regulation of the past ten years will have succeeded—an achievement worth celebrating.
However, the milder scenarios are by no means a sure thing. Banks are taking massive provisions, and offering negative guidance for coming quarters. Should the more-pessimistic scenario take place, bank capital could fall by as much as an additional two to three percentage points, bringing the CET1 landing point close to 5 to 6 percent.
In any scenario, banking executives must prepare for the next normal to be very different from that of the past ten years. Banks in mature economies have built significant capital buffers and operate in what we call the “cushion zone.” In coming months and years, banks might pass into the “caution zone” and need to significantly change the actions they take to preserve and raise capital, and decisions about dividends and buybacks, compensation, and cost structures need to be reexamined. The level and type of support that banks are able to provide to the real economy would also come under scrutiny, given their tighter capital positions.
One of several expensive lessons of the global financial crisis is that building banks’ capital is not optional but a requirement. Other lessons include the speed at which the financial system’s plumbing can become clogged, the rapidity with which liquidity can disappear, and the difficulty of selling assets in a plunging market.
In this article, we share our research on capital losses; explain the actions that banks might consider taking to rebuild capital as they move from the cushion to the caution zone, and possibly even into the “danger zone,” in which a bank’s viability is in jeopardy; outline the ways that government can team up with banks to jointly propel the economic recovery; and offer some guidelines for executives to help navigate banking’s next normal. This article is the first in a series designed to provide a broad perspective on the economic impact of COVID-19 on banks, companies, financial markets, and policy makers.