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.