## CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES

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### Chapter at a Glance
- The coronavirus disease (COVID-19) crisis may pose challenges to the capital of banks, even though they entered the crisis with higher capital ratios than before the global financial crisis and despite the large policy interventions aimed at containing the economic fallout from the current crisis.
- Forward-looking simulations based on a new global stress test tool show that in a baseline scenario consistent with the October 2020 World Economic Outlook (WEO) bank capital falls sharply but recovers quickly, while an adverse scenario suggests sustained damage to average capital ratios.
- In the adverse scenario, a weak tail of banks, corresponding to 8.3 percent of banking system assets, would fail to meet minimum regulatory requirements, and the capital shortfall relative to broad statutory regulatory thresholds reaches $220 billion.
- In absence of the bank-specific mitigation policies already implemented, the weak tail of banks would reach 14 percent of banking system assets, and the global capital shortfall would be $420 billion.
- Bank-specific mitigation policies would help reduce financial stability risks if the crisis recedes promptly but may pose risks to banks’ capital adequacy if the crisis proves to be longer lasting.

### Initial impact on the global banking industry
- Banks entered the COVID-19 crisis with stronger capital and liquidity buffers relative to pre-global financial crisis levels, but profitability was already challenged amid prolonged low interest rates and low term spreads.
- Initial contractionary shock produced a scramble for liquidity:
  - In the United States, corporate borrowers drew on committed credit lines, increasing loans and driving down bank capital ratios.
  - Risk weights for undrawn credit lines are in the range of 20–50 percent, whereas those for drawn credit lines are 100 percent.
- The transition to “expected credit loss” accounting standards in the United States (effective January 1, 2020) led many US banks to book large provisions; example: Citi took a $4.2 billion current expected credit losses transitional charge.
- Bank lending standards tightened sharply—with US loan officers reporting the tightest credit standards since 2005—and loan loss provisioning rose substantially across systems.
- Following initial liquidity stresses, bank credit growth slowed or reversed for most banks, relieving pressure on risk-weighted assets; some major banks reported capital-market-driven gains in Q2 2020.

### Bank-specific policy categories and channels
- Three bank-specific policy categories quantified:
  - Borrower support (new loans, loan guarantees, repayment relief).
  - Loss recognition (IFRS/CECL relaxation, recognition deferral).
  - Capital adequacy (lower buffers, lower RWA and leverage exposures, lower capital deductions).
- Policies operate through three channels within the risk-based capital framework:
  - Increasing capital levels (restrictions on distributions such as dividends and share buybacks; many with end dates typically not later than the end of 2020). Government loan guarantees can also lower loss given default.
  - Lowering risk-weighted assets or “leverage exposure” (regulators have typically waived risk-asset weights for loans covered by government guarantees; reductions in risk weights for targeted borrowers; exemptions of central bank reserves and government bond holdings from leverage exposure in some countries).
  - Releasing some capital buffers (releases of the countercyclical capital buffer; informal guidance encouraging use of the capital conservation buffer of 2.5 percent of total capital).

### Stress test framework and scenarios
- Global stress test features:
  - Uses publicly available financial statement data on about 350 banks in 29 major banking systems—accounting for 73 percent of global banking sector assets—to estimate how banks’ financial statements react to macroeconomic variables.
  - Conducts forward-looking simulations under two scenarios: a baseline scenario consistent with the October 2020 WEO and an adverse scenario outlined in the October 2020 WEO.
- Macro scenarios implicitly incorporate broad macroeconomic and monetary policy interventions (interest rate cuts, unconventional monetary policies, fiscal measures, social safety nets).
- Analysis assumes that the accounting impact of bank-specific policies on bank balance sheets is not fully captured in macro trajectories.
- Limitations: reliance on publicly available data reduces granularity relative to supervisory stress tests, narrows types of analyzable policies, and requires several mapping assumptions.

### Consequences for CET1 before bank-specific mitigation
- Aggregate CET1 minimum levels:
  - Baseline scenario: 9.6 percent (minimum).
  - Adverse scenario: 9.3 percent (minimum).
- Declines relative to 2019 CET1:
  - Baseline: drop of 3.6 percentage points below 2019.
  - Adverse: drop of 3.9 percentage points below 2019.
- Recovery trajectory by 2022:
  - Baseline: CET1 still 0.7 percentage points below its initial level at the end of the simulation in 2022.
  - Adverse: CET1 levels remain 2.4 percentage points below their initial levels by 2022.

### Drivers of changes in CET1
- Main driver: increase in loan loss provisions.
  - Baseline scenario: higher loan loss provision expenses contribute to a 5 percentage point decline in CET1.
  - Adverse scenario: provision expenses contribute 6 percentage points to the CET1 decline.
- Risk-weighted assets: play only a minor role in driving changes in CET1.
- Geographic differences in provision impacts:
  - Advanced economies experience a larger maximum decline in CET1 in the baseline scenario.
  - In the adverse scenario:
    - Advanced economies see a maximum decline in CET1 of about 4.0 percentage points.
    - Emerging markets see a maximum decline in CET1 of about 4.9 percentage points.

### Heterogeneity across banks and the weak tail
- At trough in the adverse scenario:
  - More than half of banks in the sample (by assets) have CET1 ratios above 10 percent.
  - Banks accounting for 13 percent of assets fall below 4.5 percent CET1.
  - An additional 3 percent of assets are below 6 percent CET1.
- Weak tail measures:
  - Weak tail (CET1 below 4.5 percent plus GSIB buffer) amounts to 14 percent by assets in the adverse scenario without mitigation.
  - Weak tail in baseline scenario: 5 percent.
- Differences by bank type and region (adverse scenario):
  - Global systemically important banks (GSIBs): 8 percent of these banks’ assets end the simulation with capital ratios below 4.5 percent.
  - Non–global systemically important banks: 16 percent of bank assets fail to maintain a 4.5 percent CET1 ratio.
  - Emerging market banks: almost 40 percent of total banking assets end the simulation with CET1 ratios below 4.5 percent.
  - Advanced economy banks: 12 percent of banks’ assets below 4.5 percent by 2022.
- Distinguishing characteristics of banks that fall below minimums:
  - Initial CET1 levels about 0.8 percentage point below those that maintain ratios above regulatory minimums.
  - Banks that fall below minimums generate meaningfully lower returns than peers that maintain adequate capital.

### Capital shortfalls (benchmarks and magnitudes)
- Two benchmarks:
  - Barebones: regulatory minimum CET1 = 4.5 percent plus bank-specific GSIB surcharge.
  - Broad: includes statutory buffers (capital conservation buffer and countercyclical buffer as of June 2020).
- Adverse scenario shortfalls (no policy mitigation):
  - Global barebones capital shortfall: about $200 billion.
  - Global broad capital shortfall: about $420 billion (0.6 percent of sample banking assets).
  - Broad shortfall as percent of GDP:
    - 0.8 percent of the GDP of countries where at least one bank has a capital shortfall.
    - Average broad shortfall across those countries: 1.1 percent of GDP.

### Effect of bank-specific policies on capital ratios (adverse scenario)
- Policy mix considered: government loan guarantees and capital adequacy policies (including dividend cancellations, release of capital buffers, changes to RWA calculations).
- Quantification assumptions:
  - Government guarantees reduce loss given default and are applied to all banks in a country proportionally to the ratio of government guarantees to total corporate loans.
  - Assumes full uptake of announced guarantees (full uptake). Lower uptake leads to proportionally less mitigation.
  - Capital adequacy policy effects quantified from announced measures and integrated into bank balance sheets over the simulation horizon; policies assumed maintained over three years unless an explicit expiration date was announced.
- Impact on CET1:
  - CET1 ratio for advanced economies is about 110 basis points higher at the end of the simulation when both government loan guarantees and capital adequacy policies are considered.
  - Improvement largely driven by decline in provision expenses because of government loan guarantees.
  - Capital adequacy policies explain about a third of the overall improvement in CET1 at the end of the simulation period in advanced economies.
  - Sensitivity: an ultimate uptake of half the announced guarantee amount would reduce the mitigating effect of the policy roughly by half.
- Changes in distribution of assets by CET1 after mitigation (adverse scenario):
  - Share of bank assets with CET1 below 4.5 percent declines from 13 percent (no mitigation) to 8 percent (with mitigation).
  - GSIBs: share with CET1 below 4.5 percent declines from 8 percent to 3 percent.
  - Non-GSIBs: declines from 16 percent to 12 percent.
  - Advanced economies: segment below 4.5 percent shrinks from 12 percent to 6 percent.
  - Emerging markets: policies have only a small effect on the troubled tail.
  - Overall weak tail (CET1 below 4.5 percent plus GSIB buffers) declines from 14 percent to 8.3 percent of bank assets.
- Capital shortfalls after mitigation (adverse scenario):
  - Broad capital shortfall: about $220 billion, with roughly half corresponding to the barebones shortfall.
  - Broad shortfall represents about 0.4 percent of combined GDP in economies where banks with shortfalls are headquartered.
  - Average shortfall across countries: about 0.7 percent of GDP.
- Note on initial CET1 of banks with shortfalls: "In the adverse scenario the global shortfall reaches 6.5 percent and the average is 7.7 percent."

### Maximum broad capital shortfall under adverse scenario — key findings
- Policy support would reduce the weak tail of banks by 5 percent.
- Policy mitigations would cushion some of the capital depletion, especially provision policies, and the capital shortfall by over $200 billion.
- Relative to a minimum capital standard that treats all guidance statements as reducing capital buffers the shortfall is lower—about $110 billion, or about 0.2 percent of global GDP.
- Banks analyzed had a median CET1 ratio of 11.9 in 2007, compared with 16.2 percent in 2019.

### Quantitative results and timing
- Simulated increase in loan loss provision ratios peaks during the first half of 2021.
  - At its peak, the increase in the loan loss provision ratio is about 1 percentage point in advanced economies.
  - At its peak, the increase in the loan loss provision ratio is about 0.4 percentage point in emerging market economies.
- The increase in loan loss provision expenses in response to the macroeconomic scenario is the main driver of the simulated decline in capital ratios, even after accounting for bank-specific mitigation policies.
- Some measures—such as changes in reclassification criteria and freezing classifications—spare loans from increased risk-asset weighting, but the stress test model cannot capture the RWA savings because the quantity of loans that would have been reclassified cannot be quantified in advance and is generally not reported.
- Aggregate solvency result reflects buffers accumulated after the global financial crisis; aggregate capital ratios remain above regulatory minimums, yet a weak tail of banks could see solvency challenged in an adverse scenario.

### Risks, trade-offs, and caveats
- Delaying provision expenses can prevent liquidity shocks from becoming insolvency and support banks’ profitability and solvency in the short term, but:
  - If the pandemic and containment measures last longer and borrower solvency deteriorates, banks will need larger future provisions and will have lower buffers against future shocks.
  - Maintenance of generous guarantee programs over an extended period could jeopardize fiscal solvency if defaults materialize and could lead to further bank losses related to sovereign exposures.
- Relaxing loan classification and provisioning rules undermines transparency and data reliability, risking loss of confidence in the banking system and adverse implications for stability.
- A severely adverse scenario with stronger consequences for the banking sector cannot be ruled out given uncertainty about the depth and duration of the COVID-19 recession.
- The stress test uses aggregate data; regulator- or supervisor-conducted assessments with more granular data would provide additional richness.

### Policy discussion and recommendations
- Act now to strengthen the financial safety net, including deposit guarantee programs, resolution regimes, and central bank liquidity facilities.
- Capital preservation measures can help, including temporarily limiting distribution of dividends.
- For countries that allowed banks to draw down capital buffers, stress test results can guide timing and pace of unwinding these exceptional measures.
- Supervisors should reassess forward-looking capital plans and take measures aimed at preserving and supporting plans to rebuild capital gradually for the most vulnerable entities to ensure confidence, avoid procyclicality, and preserve financial stability.
- Prepare contingency plans detailing how authorities will respond to possible future pressures to support effective policy responses if the adverse scenario materializes.
- Phase out exceptional measures carefully:
  - Phasing out government support, including guarantees, too quickly would lead to lasting damage to the economy.
  - Phasing out support too late could risk damaging public finances or unduly keeping insolvent borrowers afloat.
- In any scenario, banks must promptly recognize losses for borrowers that become insolvent as evidence of impairment becomes available.

### Box: The role of corporate and consumer risk in provisioning
- A satellite model decomposes loan loss provisions into components related to household risk and corporate risk using local projections.
- Most of the increase in provisions is due to heightened corporate risk, although households play a significant role in advanced economies because of their larger share on advanced economy banks’ portfolios.
- The level and composition of total provisions depends on the mix of bank loan portfolios and on the relative size of the shocks to firms and households.
- These insights inform assessment of policies that target specific sectors (for example, government loan guarantees that tend to focus on corporate loans).

*Source: International Monetary Fund, CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES (October 2020).*

### Introduction

### Introduction

### Chapter at a Glance
- The coronavirus disease (COVID-19) crisis may pose challenges to the capital of banks, even though they entered the crisis with higher capital ratios than before the global financial crisis and despite the large policy interventions aimed at containing the economic fallout from the current crisis.
- Forward-looking simulations based on a new global stress test tool show that in a baseline scenario consistent with the October 2020 World Economic Outlook (WEO) bank capital falls sharply but recovers quickly, while an adverse scenario suggests sustained damage to average capital ratios.
- In the adverse scenario, a weak tail of banks, corresponding to 8.3 percent of banking system assets, would fail to meet minimum regulatory requirements, and the capital shortfall relative to broad statutory regulatory thresholds reaches $220 billion.
- In absence of the bank-specific mitigation policies already implemented, the weak tail of banks would reach 14 percent of banking system assets, and the global capital shortfall would be $420 billion.
- Bank-specific mitigation policies would help reduce financial stability risks if the crisis recedes promptly but may pose risks to banks’ capital adequacy if the crisis proves to be longer lasting.

### Initial Impact of COVID-19 on the Global Banking Industry
- Banks entered the COVID-19 crisis with stronger capital and liquidity buffers relative to pre-global financial crisis levels, but profitability was already challenged amid prolonged low interest rates and low term spreads.
- The initial contractionary shock produced a scramble for liquidity:
  - In the United States, corporate borrowers drew on committed credit lines, increasing loans and driving down bank capital ratios.
  - Risk weights for undrawn credit lines are in the range of 20–50 percent, whereas those for drawn credit lines are 100 percent.
- The transition to “expected credit loss” accounting standards in the United States (effective January 1, 2020) led many US banks to book large provisions; example cited: Citi took a $4.2 billion current expected credit losses transitional charge.
- Bank lending standards tightened sharply—with US loan officers reporting the tightest credit standards since 2005—and loan loss provisioning rose substantially across systems.
- Following initial liquidity stresses, bank credit growth slowed or reversed for most banks, relieving pressure on risk-weighted assets; some major banks reported capital-market-driven gains in Q2 2020.

### Reactions of Financial Sector Authorities to the COVID-19 Crisis
- Governments implemented policies of unprecedented scope to support the real economy, prevent permanent balance sheet damage, and maintain credit flow.
- The chapter focuses on three bank-specific policy categories that can be directly quantified:
  - Borrower support (new loans, loan guarantees, repayment relief).
  - Loss recognition (IFRS/CECL relaxation, recognition deferral).
  - Capital adequacy (lower buffers, lower RWA and leverage exposures, lower capital deductions).
- These policies can operate through three channels within the risk-based capital framework:
  - Increasing capital levels (restrictions on distributions such as dividends and share buybacks; many with end dates typically not later than the end of 2020). Government loan guarantees can also lower loss given default.
  - Lowering risk-weighted assets or “leverage exposure” (regulators have typically waived risk-asset weights for loans covered by government guarantees; reductions in risk weights for targeted borrowers; exemptions of central bank reserves and government bond holdings from leverage exposure in some countries).
  - Releasing some capital buffers (releases of the countercyclical capital buffer; informal guidance encouraging use of the capital conservation buffer of 2.5 percent of total capital).

### Magnitude and Effects of Announced Mitigation Policies
- Policies combined are estimated to have improved reported common equity Tier 1 (CET1) ratios and expanded capital space between current positions and broad regulatory capital levels.
- A few jurisdictions (Japan, Switzerland, United States) eased constraints on leverage ratios by excluding certain low-risk assets from the leverage exposure denominator.

### Bank Capital Ratios, Stress Test, and Scenarios
- The chapter uses a recently developed global stress test that:
  - Uses publicly available financial statement data on about 350 banks in 29 major banking systems—accounting for 73 percent of global banking sector assets—to estimate how banks’ financial statements react to macroeconomic variables.
  - Conducts forward-looking simulations under two scenarios: a baseline scenario consistent with the October 2020 WEO and an adverse scenario outlined in the October 2020 WEO.
- Macro scenarios implicitly incorporate broad macroeconomic and monetary policy interventions (interest rate cuts, unconventional monetary policies, fiscal measures, social safety nets).
- The analysis assumes that the accounting impact of bank-specific policies on bank balance sheets is not fully captured in macro trajectories.
- Limitations: reliance on publicly available data reduces granularity relative to supervisory stress tests, narrows types of analyzable policies, and requires several mapping assumptions.

### Central Questions Addressed
- How prepared are banks to withstand continued challenging economic conditions in the coming years?
- How much would bank-specific regulatory policies recently implemented help them face these scenarios?
- The chapter discusses policy options and highlights an intertemporal trade-off from encouraging banks to use regulatory flexibility to sustain credit: such targeted policies can reduce near-term financial stability risks if the crisis recedes promptly but may impair banks’ capital adequacy if the crisis is longer lasting.

*Source: International Monetary Fund, Chapter 4 — Introduction, October 2020.*

### CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES

### CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES

### Consequences of COVID-19 for Bank Capital before Bank-Specific Mitigation
- Aggregate CET1 minimum levels across the global banking system:
  - Baseline scenario: 9.6 percent (minimum).
  - Adverse scenario: 9.3 percent (minimum).
- Declines relative to 2019 CET1:
  - Baseline: drop of 3.6 percentage points below 2019.
  - Adverse: drop of 3.9 percentage points below 2019.
- Recovery trajectory by 2022:
  - Baseline: CET1 still 0.7 percentage points below its initial level at the end of the simulation in 2022.
  - Adverse: CET1 levels remain 2.4 percentage points below their initial levels by 2022.

### Drivers of Changes in CET1
- Main driver: increase in loan loss provisions.
  - Baseline scenario: higher loan loss provision expenses contribute to a 5 percentage point decline in CET1.
  - Adverse scenario: provision expenses contribute 6 percentage points to the CET1 decline.
- Risk-weighted assets: play only a minor role in driving changes in CET1.
- Geographic differences in provision impacts:
  - Advanced economies experience a larger maximum decline in CET1 in the baseline scenario.
  - In the adverse scenario:
    - Advanced economies see a maximum decline in CET1 of about 4.0 percentage points.
    - Emerging markets see a maximum decline in CET1 of about 4.9 percentage points.

### Heterogeneity across Banks and the Weak Tail
- Even at trough in the adverse scenario:
  - More than half of banks in the sample (by assets) have CET1 ratios above 10 percent.
  - Banks accounting for 13 percent of assets fall below 4.5 percent CET1.
  - An additional 3 percent of assets are below 6 percent CET1.
- Weak tail definition and magnitudes:
  - Weak tail (CET1 below 4.5 percent plus GSIB buffer) amounts to 14 percent by assets in the adverse scenario.
  - Weak tail in baseline scenario: 5 percent.
- Differences by bank type and region (adverse scenario):
  - Global systemically important banks (GSIBs): 8 percent of these banks’ assets end the simulation with capital ratios below 4.5 percent.
  - Non–global systemically important banks: 16 percent of bank assets fail to maintain a 4.5 percent CET1 ratio.
  - Emerging market banks: almost 40 percent of total banking assets end the simulation with CET1 ratios below 4.5 percent.
  - Advanced economy banks: 12 percent of banks’ assets below 4.5 percent by 2022.
- Distinguishing characteristics of banks that fall below minimums:
  - Initial CET1 levels about 0.8 percentage point below those that maintain ratios above regulatory minimums.
  - Banks that fall below minimums generate meaningfully lower returns than peers that maintain adequate capital.

### Capital Shortfalls (Measured against two benchmarks)
- Two benchmarks:
  - Barebones: regulatory minimum CET1 = 4.5 percent plus bank-specific GSIB surcharge.
  - Broad: includes statutory buffers (capital conservation buffer and countercyclical buffer as of June 2020).
- Adverse scenario shortfalls (no policy mitigation):
  - Global barebones capital shortfall: about $200 billion.
  - Global broad capital shortfall: about $420 billion (0.6 percent of sample banking assets).
  - Broad shortfall as percent of GDP:
    - 0.8 percent of the GDP of countries where at least one bank has a capital shortfall.
    - Average broad shortfall across those countries: 1.1 percent of GDP.

### Effect of Bank-Specific Policies on Capital Ratios
- Policies considered: government loan guarantees and capital adequacy policies (including dividend cancellations, release of capital buffers, changes to RWA calculations).
- Quantification assumptions:
  - Government guarantees reduce loss given default and are applied to all banks in a country proportionally to the ratio of government guarantees to total corporate loans.
  - Assumes full uptake of announced guarantees (full uptake). Lower uptake leads to proportionally less mitigation.
  - Capital adequacy policy effects quantified from announced measures and integrated into bank balance sheets over the simulation horizon; policies assumed maintained over three years unless an explicit expiration date was announced.
- Impact of policies (adverse scenario):
  - CET1 ratio for advanced economies is about 110 basis points higher at the end of the simulation when both government loan guarantees and capital adequacy policies are considered.
  - Contribution to CET1 improvement:
    - Largely driven by decline in provision expenses because of government loan guarantees.
    - Capital adequacy policies explain about a third of the overall improvement in CET1 at the end of the simulation period in advanced economies.
  - Sensitivity to uptake: an ultimate uptake of half the announced guarantee amount would reduce the mitigating effect of the policy roughly by half.
- Changes in distribution of assets by CET1 (adverse scenario) after mitigation:
  - Share of bank assets with CET1 below 4.5 percent declines from 13 percent (no mitigation) to 8 percent (with mitigation).
  - GSIBs: share with CET1 below 4.5 percent declines from 8 percent to 3 percent.
  - Non-GSIBs: declines from 16 percent to 12 percent.
  - Advanced economies: segment below 4.5 percent shrinks from 12 percent to 6 percent.
  - Emerging markets: policies have only a small effect on the troubled tail.
  - Overall weak tail (CET1 below 4.5 percent plus GSIB buffers) declines from 14 percent to 8.3 percent of bank assets.
- Capital shortfalls after mitigation (adverse scenario):
  - Broad capital shortfall: about $220 billion, with roughly half corresponding to the barebones shortfall.
  - Broad shortfall represents about 0.4 percent of combined GDP in economies where banks with shortfalls are headquartered.
  - Average shortfall across countries: about 0.7 percent of GDP.
- Initial CET1 of banks that experience a shortfall:
  - "In the adverse scenario the global shortfall reaches 6.5 percent and the average is 7.7 percent." (exact phrasing preserved)

*Source: CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES (IMF, October 2020).*

### 4. Maximum Broad Capital Shortfall under Adverse Scenario

### 4. Maximum Broad Capital Shortfall under Adverse Scenario

### Key findings
- Policy support would reduce the weak tail of banks by 5 percent.
- Policy mitigations would cushion some of the capital depletion, especially provision policies, and the capital shortfall by over $200 billion.
- Relative to a minimum capital standard that treats all guidance statements as reducing capital buffers the shortfall is lower—about $110 billion, or about 0.2 percent of global GDP.
- Banks analyzed had a median CET1 ratio of 11.9 in 2007, compared with 16.2 percent in 2019.

### Quantitative results and drivers
- The simulated increase in loan loss provision ratios peaks during the first half of 2021.
  - At its peak, the increase in the loan loss provision ratio is about 1 percentage point in advanced economies.
  - At its peak, the increase in the loan loss provision ratio is about 0.4 percentage point in emerging market economies.
- The increase in loan loss provision expenses in response to the macroeconomic scenario is the main driver of the simulated decline in capital ratios, even after accounting for bank-specific mitigation policies.
- Some measures—such as changes in reclassification criteria and freezing classifications—spare loans from increased risk-asset weighting, but the stress test model cannot capture the RWA savings because the quantity of loans that would have been reclassified cannot be quantified in advance and is generally not reported.
- The aggregate solvency result reflects buffers accumulated after the global financial crisis; aggregate capital ratios remain above regulatory minimums, yet a weak tail of banks could see solvency challenged in an adverse scenario.

### Policy mitigations analyzed
- Provision mitigation policies include guarantees only.
- Broad policy packages implemented by authorities primarily support banks by improving macroeconomic conditions (through direct support to borrowers, liquidity provision, and loan guarantees) rather than only through bank-specific interventions.
- Capital adequacy policies and regulatory flexibility (clarifying usability of buffers, encouraging buffer use, restricting capital distributions) provided a second line of defense easing pressures on bank capital ratios.
- Some regulatory easing lowered minimum requirements below Basel framework levels in several cases.

### Risks, trade-offs, and caveats
- Delaying provision expenses can prevent liquidity shocks from becoming insolvency and support banks’ profitability and solvency in the short term, but:
  - If the pandemic and containment measures last longer and borrower solvency deteriorates, banks will need larger future provisions and will have lower buffers against future shocks.
  - Maintenance of generous guarantee programs over an extended period could jeopardize fiscal solvency if defaults materialize and could lead to further bank losses related to sovereign exposures.
- Relaxing loan classification and provisioning rules undermines transparency and data reliability, risking loss of confidence in the banking system and adverse implications for stability.
- A severely adverse scenario with stronger consequences for the banking sector cannot be ruled out given uncertainty about the depth and duration of the COVID-19 recession.
- The stress test uses aggregate data; regulator- or supervisor-conducted assessments with more granular data would provide additional richness.

### Policy discussion and recommendations
- Act now to strengthen the financial safety net, including deposit guarantee programs, resolution regimes, and central bank liquidity facilities.
- Capital preservation measures can help, including temporarily limiting distribution of dividends.
- For countries that allowed banks to draw down capital buffers, stress test results can guide timing and pace of unwinding these exceptional measures.
- Supervisors should reassess forward-looking capital plans and take measures aimed at preserving and supporting plans to rebuild capital gradually for the most vulnerable entities to ensure confidence, avoid procyclicality, and preserve financial stability.
- Prepare contingency plans detailing how authorities will respond to possible future pressures to support effective policy responses if the adverse scenario materializes.
- Phase out exceptional measures carefully:
  - Phasing out government support, including guarantees, too quickly would lead to lasting damage to the economy.
  - Phasing out support too late could risk damaging public finances or unduly keeping insolvent borrowers afloat.
- In any scenario, banks must promptly recognize losses for borrowers that become insolvent as evidence of impairment becomes available.

### Box: The role of corporate and consumer risk in provisioning
- A satellite model decomposes loan loss provisions into components related to household risk and corporate risk using local projections.
- Most of the increase in provisions is due to heightened corporate risk, although households play a significant role in advanced economies because of their larger share on advanced economy banks’ portfolios.
- The level and composition of total provisions depends on the mix of bank loan portfolios and on the relative size of the shocks to firms and households.
- These insights inform assessment of policies that target specific sectors (for example, government loan guarantees that tend to focus on corporate loans).

*Source: Haver Analytics.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/october/english/ch4.pdf_