European Bank Crash “Highly Likely” if Covid Crisis Continues into 2021

If the global Covid-19 crisis continues into 2021, it is “highly likely” that major European banks would not be able to withstand the financial shocks, according to research from EconPol Europe.

And, while the current framework for bank resolution – put in place following the global crash of 2008 – has made European banks stronger than they were during that crisis, it would take only 21% of loans not being repaid to exhaust the funds of the banks completely.

The research, by Jézabel Couppey-Soubeyran (EconPol Europe, University Paris 1 Panthéon-Sorbonne, CEPII), Erica Perego (EconPol Europe, CEPII) and Fabien Tripier (EconPol Europe, Université Paris-Saclay (Univ. Evry), CEPII), analyzes the problems that the Covid-19 crisis poses to banks, the proposals currently under discussion and the decisions taken to date by the monetary and prudential authorities.

It highlights, say authors, the fragility of the current prudential framework and the inadequacy of the resolution mechanism.

“The Covid-19 crisis is a serious test of the reforms undertaken in the wake of the 2007-2008 financial crisis,” they say. “That led to reforms that were intended to prevent a systemic financial crisis or, failing that, to mitigate its consequences. The reality of systemic risk was one of the major lessons of the financial crisis. But we are now faced with the reality of a health risk that has been previously underestimated.

“On the scale of disasters, this health crisis is even more serious than a systemic financial crisis because of the way in which it simultaneously affects all economic activities at the global level.”

Given the scale of the looming recession, if the support offered by banks - such as loan rescheduling, repayment moratoria, liquidity facilities, and zero or negative interest rate loans - were to last for long periods of time, capital reserves will become depleted and the Banking Union resolution mechanism agreed in 2012 may be insufficient to provide a lifeline.

“If losses accumulate in the economy and financial markets, the erosion of banks' capital will increase their insolvency risk,” continue the authors. “It will then be necessary to activate the resolution mechanism (SRM). After mobilization of the creditors of the banking groups concerned for at least 8% of the losses, the SRF could then be mobilized for approximately 40 billion (its current allocation equal to 80% of 55 billion). This, however, represents barely 2% of the capital of euro area banks. This amount would not be sufficient if several banking groups had to be recapitalized at the same time.”

According to the European Systemic Risk Board (ESRB), the risk of bank failure has increased sharply since the start of the Covid-19 crisis. The probability of at least two major European banks defaulting exceeded the 5% mark in March 2020. And, while we are still a long way from the record levels of over 15% observed during the sovereign debt crisis, the speed at which this indicator is rising and the gloomy economic outlook for the coming year suggest a substantial risk of contagion from the current crisis to the banking sector.

“Following the recommendations of the Basel 3 agreement signed in 2010 and finalized in 2017, capital requirements have been strengthened, liquidity requirements introduced and a new, simpler capital ratio, not dependent on risk-weighted assets, added. All these provisions have undoubtedly made European banks stronger than they were on the eve of the 2007 financial crisis.

“But the current prudential framework is fragile,” conclude the authors of the research. “It was not designed to deal with a crisis of this nature and the resolution mechanism will require additional resources if the banking crisis cannot be avoided.”

Read the full paper: https://www.econpol.eu/publications/policy_brief_30