The 2007-2009 financial crisis has taught us that the undercapitalization of large financial institutions and subsequent bankruptcies can limit the supply of credit across segments and have a significant impact on the real economy. 3.09 billion economically active people fought back then to bring the world back to its rail. Bailout policies, frameworks, and overall regulatory tightness did help as well. Regardless, those events did leave a lasting change during the decade that followed.
History repeats, but this time with a bigger bang. 3.46 billion people (370 million more) across 190 countries have laid down their tools to secure themselves and the other half of the population, barring around 59 million healthcare workers globally taking care of millions who are affected by the virus. We are seeing rising unemployment, declining markets, volatile prices, the exodus of capital, spiking poverty after a period of consistent decline, reduction in aggregate demand, global trade, etc.
In response to this murkiness, EBA, ECB, ESMA, PRA, have published guidance on the regulatory and accounting implications of the pandemic so as IASB in the form of documents to support consistent application of accounting standards with regards to expected credit losses (ECL). They are broadly consistent with the regulators and also note the unclear approach under IFRS 9 in computing the significant increase in credit risk (SICR) or the method to arrive at ECL using forward-looking scenarios. Nevertheless, these recommendations are to help banks maintain liquidity for households and businesses. Governments and national regulators have laid out new recovery policies where the politics of nations reflect on some of them, while others have a more balanced international approach. The world had just begun to see some global homogeneity in regulatory & risk management in the banking industry. Several countries were just short of honing or implementing Basel III that would have helped during this crisis. With this disaster defining the political future in some nations, banks can become a tool and will stretch within the prudential norms or use temporary flexibilities.
We agree that the actual default rate on a bank’s outstanding debt may go beyond the maximum target rate selected by management. However, learning from the past, the banks may want to consider the pre-Covid-19 regulatory requirements as a base to be able to set aside higher loan loss reserves to prepare for the expected losses (for example JPMorgan and Wells Fargo).
Leverage, liquidity, capital, or stress test requirements ideally should not be eased when we are unable to predict the future or at least an end to the pandemic. Now since the regulators have shown the way, banks may at the least continue stress-testing against the original norms as an internal health check by the risk managers. Also, expected losses vary over time; its value changes over time and maybe well covered by the reserve requirements based on the existing ECL framework. Stress-tests have not prepared the industry for an impact of this size. Allowing flexibility to supervised thresholds makes the sector further vulnerable to the moving variables.
The literature of capital allocation often recommends setting economic capital equal to unexpected losses. Unexpected losses are losses over expected losses or are the average total loss over and above the mean loss. After all, true capital is what is needed to achieve targeted solvency rates. One possible capital allocation strategy may be to stop paying dividends or buying back shares, in turn, using this economic and regulatory capital to help banks sustain unexpected losses. Increasing capital requirements is crucial during these unpredictable times to be able to handle adverse scenarios.
If banks were the reason for the 2008 meltdown, this time, they could be saving the economy. Banks must reflect their inherent strength, score healthy on their systemic risk measure during this prolonged market decline. The flexibility provided by the authorities can always be applied, just that the banks may want to choose an appropriate time to do so as well as continue measuring themselves by the highest standards to exhibit its capital sufficiency, ability to leverage and help during economic catastrophes.
Wishing everyone safe health.
