Banking, Regulation and Covid-19: (Stress) Testing Times By Jonathan Cardwell, Product Consultant

They say all good things must come to an end eventually. After more than 10 years of sustained economic growth and steadily rising GDP across Europe and the rest of the world, that end has come in a dramatic way this year. To say I would have been shocked if anyone had of predicted that in 2020 we would see a third of the global population on lockdown, the largest declines in trade and GDP since 2008, as well as unprecedented rates of unemployment, is a vast understatement. Therefore, from the confines of my London apartment, I will be producing a short series of blogs over the coming months to try and analyse and understand what this means for the banking industry, for regulators and regulation, for governments and their responses and what the future holds for us and our industries alike.

There is no doubt that heading into 2020 banks were in a much stronger position (albeit some more than others) than they were heading into the 2008 financial crisis. In the aftermath of 2008, European regulators were determined to avoid another catastrophe like the one they had just witnessed. The regulators took steps to stabilise the banking sector by strengthening the regulatory framework and the supervision of banks. Banks were told to strengthen their books, to improve the quality of the assets on their balance sheet, to maintain large liquidity buffers and to reduce their operational risk.

In January of this year, the European Banking Authority once again launched its annual stress test, aiming to ‘assess the resilience of financial institutions to adverse market developments, as well as to contribute to the overall assessment of systemic risk in the EU financial system.’

This year’s test was stated as being the harshest and most extreme scenario yet, with the EBA describing the scenario as following a ‘lower for longer narrative, a recession coupled with low or negative interest rates for a prolonged period’ for the first time. Firms capital positions and liquidity buffers were to be tested to the maximum. In the scenario, real GDP of the EU would decline by 4.3% by 2022; unemployment would rise by 3.5%, equity prices would fall by 25% and real estate would slump by 16%.

Fast forward three months, current WTO estimates indicate that trade could suffer as much as 32%, world GDP could decrease up to 8.8% and up to staggering 11.8% in the EU. While an upturn is expected by 2021, the numbers are substantially more devasting that the scenario posed by the EBA stress test. Not surprisingly, this year’s stress test has been superseded by reality, resulting in a delay until 2021, allowing banks to focus on and ensure continuity of their core operations, including support for their customers.

While other industries have clearly been hit harder than the banking sector (aviation and the oil and gas industry come to mind), the outlook for banks largely depends on two factors:

  1. How long the coronavirus pandemic will last – something nobody knows at present
  2. The scale and swiftness of government responses for each jurisdiction

With most of the fear and anxiety coming from the lack of government exit plans, key questions still remain (which will be covered in future blogs). How are the regulators responding to such an unprecedented crisis? Have governments been slow to react and what impact has this had? How will this affect individual bank’s and country’s credit ratings?

With this year’s official stress test delayed until 2021, it is clear the current economic crisis caused by Covid-19 is a perfect example of the type of economic downturn the regulator has been trying to prepare for. The question to be answered is have the regulators and banks done enough since the 2008 financial crash to adequately survive this real-world scenario?