The COVID-19 crisis was a major shock to the global economy, with far-reaching consequences for many companies and large government interventions as a result. An important question is to what extent such an economic crisis could result in a financial crisis in which the banking sector gets into trouble, with a potential further round of economic damage as banks may reduce the availability of credit for companies. However, assessing the gravity of this threat is challenging, since banks’ accounting-based loan-loss provisions are sluggish. In this project, we are developing a new method to infer expected banks’ expected losses due to the crisis based on the stock market losses in response to the crisis as well as a formal model (Merton model) to translate these stock market losses into an estimate of the potential impact of the crisis on banks’ portfolios as a whole (including bank loans). We use this new method to provide a real-time, market valuation-based assessment of the impact of COVID-19 on euro area banks’ corporate loan portfolios. The method can also be applied in other situations where a sudden economic shock arises in which a timely assessment of the potential threat to financial stability is warranted.
In the second half of 2020, we completed a first analysis of this research question based on the stock market response for 1,981 publicly listed firms in the euro area as of April 2020 and four different scenarios reflecting the uncertainty around the structural change in stock market volatility as a result of the COVID-19 crisis as well as around the fraction of defaulted loans that are recovered by the bank. Our results indicate that the market value losses in the corporate debt portfolio of euro area banks range from 4 to 25% of the book value of the loans (or up to more than €1 trillion in absolute numbers), depending on the scenario. In the second stage of the project, we will update and refine these analyses in three directions: (1) we will re-estimate our model using the latest stock market developments, and (2) we will make an explicit distinction between the different driving forces of stock market fluctuations (in particular, expected corporate profitability and expected stock market returns), since stock markets have recovered over the course of 2020, but this recovery may have been in part driven by investors lowering their return expectations – thus still leaving considerable scope for economic losses for companies and thus banks’ loan portfolios. Furthermore, we will investigate in-depth which economic industries were affected most by the COVID-19 crisis.
Primary research question: “Is COVID-19 a threat to banks and financial stability in Europe?”
Secondary research question: “Which economic sectors are hit hardest by the COVID-19 crisis?”
The COVID-19 pandemic will have a severe but uncertain economic impact. The IMF projects the global economy to shrink by 3% in 2020, which is even more than during the 2008-2009 “Great Recession”. How long-lasting and severe the COVID-19 recession will be, will to an important extent be determined by its impact on the banking sector. If banks are hit hard and financial stability is undermined, the economic damage will be much greater, given the central role of banks in the economy. However, assessing the impact of COVID-19 on banks’ loan portfolios is a major challenge, since such assessments are usually based on slow-moving accounting data. We urgently need a timely assessment of expected loan losses (based on market valuations rather than accounting numbers) to evaluate which policy measures are needed now to safeguard banking sector stability.
Our hypothesis is that banks’ current loan loss provisions based on accounting rules severely underestimate the actual expected losses in their loan portfolios. Using real-time market valuations, will provide a much more up-to-date assessment of actual expected loan losses. We expect our research outcomes to be of immediate interest to financial regulators and supervisors, which will need to act quickly if financial sector stability is at stake.
PLAN VAN AANPAK
Our key innovation is that we will use the option valuation approach of Nobel laureate Robert Merton to assess expected loan losses for banks in Europe based on real-time stock market data. We will estimate increases in default probabilities due to the COVID-19 crisis for 1,981 publicly listed firms in 19 economic sectors in the euro area, and subsequently evaluate the potential impact on the balance sheets of euro area banks under different scenarios.