The Silent Financial Catastrophe of COVID-19
The worldwide COVID-19 pandemic has led to rising infection rates, widespread lockdowns, record-breaking productivity reductions, and rising poverty levels. A quieter crisis currently gathering traction, in addition to these tendencies, might damage economic recovery hopes for years to come.
Bank runs and asset price collapses have a long connection with the phrase “financial crisis.” Several of these instances are documenting in Charles Kindleberger’s famous books The World in Depression, 1929-1939 and Manias, Panics, and Crashes, as well as the book done by Kenneth Rogoff and Carmen Reinhart This Time Is Different. In recent years, the phrase “Lehman moment” has become synonymous with the global financial crisis of 2007-09, inspiring a Broadway musical.
However, not all financial crises are as dramatic as the Lehman Brothers episode. When economic downturns linger, asset quality can deteriorate dramatically, especially when businesses and people are severely indebted. Furthermore, years of bank lending to inefficient private companies or state-owned industries (the latter is frequent in several developing nations) take a toll on balance sheets.
Even though fear and fleeing aren’t usually part of these situations, they nonetheless come with a price. For governments and taxpayers, bank restructuring and recapitalization to restore solvency may be costly, and new lending might stay low, impeding economic growth. The credit crisis has distributional implications, as it disproportionately affects small and medium-sized businesses and lower-income families.
To be sure, the COVID-19 pandemic continues to provide a lot of unwelcome drama, such as high infection rates, extensive lockdowns, record-breaking productivity reductions, and rising poverty. A quieter crisis is gathering traction in the financial industry, in addition to these developments. Even if there is no Lehman moment, it might harm long-term economic recovery hopes.
Financial institutions throughout the world will continue to see a significant increase in NPLs for the foreseeable future. The COVID-19 situation is regressive and disproportionately affects low-income people and small businesses with fewer assets to protect them from insolvency.
Since the pandemic outbreak, governments have depended on expansionary monetary and fiscal policies to counteract the sharp drops in economic activity caused by widespread shutdowns and social discrimination. Wealthier nations have had a distinct edge in their ability to respond; however, a rise in funding by international organizations has also aided emerging and developing economies in financing their response to the health crisis.
Banks have backed macroeconomic stimulus through a range of temporary lending moratoria, unlike in the 2007-09 crisis (or most prior crises), as the International Monetary Fund has recorded in its Policy Tracker. These measures have offered some relief to people experiencing job losses and income losses, as well as companies battling to keep their operations running during lockdowns and other interruptions (tourism-linked sectors stand out starkly in this regard).
Financial institutions around the country have extended grace periods for existing loans, and many have re-contracted loans with reduced interest rates and improved conditions. Just as the health crisis is transitory, the reasoning has been that so is financial suffering among businesses and individuals. However, because of the pandemic’s persistence, many nations have decided to continue these measures until 2021.
Several nations have eased their banks’ restrictions on bad-loan provisioning and NPLs’ categorization along with the interim moratoriums. As a result of these developments, the size of NPLs may now be underestimated, especially in many nations. Financial institutions may be unprepared to deal with the impact on their balance sheet in many situations. Meanwhile, the less regulated non-bank financial sector is much more vulnerable to danger (compounded by weaker disclosure).
In addition to these private-sector events, sovereign credit rating downgrades hit a new high in 2020. Although wealthy nations are not immune, the repercussions for banks are more severe in emerging and developing economies, where government credit ratings are at or near the trash. Banks will suffer losses on their government securities holdings in more catastrophic situations of sovereign collapse or restructuring – and such crises are on the rise as well.
Even if one or more successful vaccinations quickly resolve the epidemic, the COVID-19 catastrophe has wreaked havoc on the global economy and financial institutions’ bank sheets. Beyond the traditional boundaries of fiscal and monetary policy, forbearance policies have been helpful stimulus tools. Grace periods, on the other hand, will cease in 2021.
Policy weariness or political restrictions imply that future US fiscal and monetary stimulus will not approach the size seen in early 2020, according to the US Federal Reserve’s November 2020 Financial Stability Report. Many emerging economies and developing nations have reached or are approaching their monetary policy ceilings. As the year 2021 progresses, it will become evident if many businesses and families face insolvency rather than a lack of liquidity.
Firms’ excessive leverage will exacerbate the banking sector’s balance sheet issues on the eve of the pandemic. The world’s two largest economies, the United States and China, are heavily indebted, with numerous high-risk borrowers. The European Central Bank has expressed worry about the growing percentage of NPLs’ in the eurozone. In contrast, the International Monetary Fund has regularly voiced alarm about the sharp rise in dollar-denominated corporate debt in several emerging economies. In many regions globally, exposure to commercial real estate and the hotel sector is a cause of worry.
It takes time to restore balance-sheet harm. As financial institutions grow more cautious in their lending policies, the previous borrowing frequently leads to a protracted period of deleveraging. This stumbling-through period, which is often linking with a slow recovery, might last for years. As bailouts convert pre-crisis private debt into public-sector liabilities, these financial crises can sometimes turn into sovereign debt crises.
Recognize the breadth and scale of the problem before restructuring and writing down bad debts as quickly as possible. Putting resources into zombie loans, on the other hand, is a prescription for a slow recovery. Given the pandemic’s already enormous economic and human consequences, governments everywhere must make averting that situation a key priority.