02 Building up immunity of the financial system

Policy actions to address rising credit risk and preserve financial stability

As the COVID-19 crisis evolves, deterioration of credit portfolio is becoming a concern for banking supervisors and requires a holistic approach from a public policy perspective. Governments should engage in actions covering:

1. 1. Monitoring the vulnerability of economic agents: The magnitude and asymmetric impact of the COVID-19 crisis renders existing ‘model infrastructure’ impractical. Consequently, both public and private entities will have to upgrade analytical capabilities to account for higher granularity in forecasting liquidity demand of real economy.

2. 2. Assessing solvency and liquidity of financial sector: The marked recession caused by COVID-19 crisis will almost certainly leave heavy traces on bank balance sheets and profitability prospects. Severity of impact will be driven by balance sheet structure and lending portfolio, less than by its size and complexity. Hence, it is relevant for regulators to quickly obtain an overview of the health of the entire banking system, not only covering specific groups of institutions.

3. 3. Responding to bank failures: Broad impact of the recession might hamper operations of numerous banks and ultimately lead to failure. Such a scenario constitutes a systemic issue even if each bank at an individual level is far from being systemic. Traditional solutions to deal with idiosyncratic failures of small banks might not be available, requiring supervisors to have a clear view on escalation paths and a strategy to address them consistently.

4. 4. Promoting active management of Non-performing loans (NPLs): Experience shows that a large increase in volume of distressed assets requires banks to take a systematic approach to NPL management. Transparency on asset quality and volume of NPLs is crucial to enable a swift response of both financial institutions and supervisors, in particular in context of recent policy action such as moratoria, suspension of recognition rules and relaxation of buffer requirements.

5. 5. Supporting deleveraging with systemic solutions: If high NPL volumes hinder economic recovery, Systemic solutions can position as options to manage NPLs and foster front-book lending. Supervisors could consider the implications of solutions such as Asset Management Companies.

Fortunately, many banks today are in better shape than in previous crises, in part due to the regulatory reforms of recent years. The financial sector is positioned to play an important part in the solution instead of being the problem. Banking supervisors and the private sector both have a role to play to ensure financial stability is not put at stake.