How European Banks Can Support the Recovery
IMF Blog, March 26, 2021
Source details
- Canonical URL
- How European Banks Can Support the Recovery
Other formats
Bibliographic details
- Authors: Mai Chi Dao, Aiko Mineshima, Srobona Mitra, Andreas Andy Jobst
- Published: March 26, 2021
Overview
- A robust post-COVID-19 recovery will depend on banks having sufficient capital to provide credit. While most European banks entered the pandemic with strong capital levels, they are highly exposed to economic sectors hit hard by the pandemic.
- The analysis uses the IMF’s January 2021 projections as a baseline.
- The study differs from other recent studies by the European Central Bank and European Banking Authority by:
- incorporating policy support provided to banks and borrowers;
- incorporating granular estimates of corporate sector distress; and
- examining a larger number of European countries and banks.
Key findings on bank capital and resilience
- Aggregate euro area capital ratio projection:
- Declines from 14.7 percent to 13.1 percent by the end of 2021 if policy support is maintained.
- Prudential minimum:
- No bank will breach the prudential minimum capital requirement of 4.5 percent, even without policy support.
- Emerging Europe:
- Banks in Europe’s emerging economies are likely to see a higher capital erosion of 2.4 percentage points (relative to comparator groups), reflecting tighter government budgets and lower levels of support.
- Hybrid capital exposure:
- Larger banks hold about 25 percent of capital in hybrid instruments, which contain elements of both debt and equity and typically rely on interest payments.
- Recovery speed sensitivity:
- If GDP growth in 2020–21 is 1.2 percentage points below the baseline forecast, the erosion of bank capital could become more pronounced.
- Over 5 percent of all banks would risk breaching their MDA (maximum distributable amount) thresholds, even with policies in place.
- This share would double if policies do not work as projected.
Scenarios and benchmarks
- Baseline scenario:
- Uses IMF January 2021 projections, assumes policy support is maintained.
- Adverse scenarios considered:
- Weaker GDP growth (example: 1.2 percentage points below baseline for 2020–21).
- Ineffective policy support leading to greater capital erosion and higher probability of MDA breaches.
- Market-based capital thresholds:
- Market-relevant thresholds such as MDA are higher than regulatory minimums and are particularly important for larger banks that rely on hybrid capital and investor confidence.
Policy-relevant implications and risks
- Effective policies substantially reduce both the extent and variability of banks’ capital erosion and weaken the link between the macroeconomic shock and bank capital.
- Without effective policies:
- Several banks might struggle to meet MDA capital thresholds, triggering restrictions on dividend distributions and interest payments to hybrid capital and potentially spooking investors.
- Larger banks could come under funding pressure given their hybrid capital exposure.
- A protracted recovery could result in much larger credit losses and higher provisions for bad loans, increasing risks of capital strain and lending retrenchment.
Policy recommendations
- Continue pandemic support policies until the recovery is firmly established:
- Avoid premature winding down of borrower support to prevent “cliff edge effects” that could choke off credit supply.
- As recovery gains momentum, tighten and better target eligibility criteria.
- Consider some direct equity support for viable firms.
- Clarify supervisory guidance on availability and duration of capital relief:
- Supervisors should clarify the timetable for banks’ capital buffers.
- Allow banks to build back capital buffers gradually to preserve lending capacity.
- Maintain restrictions on dividend payouts and share buybacks until the recovery is well underway.
- Support balance sheet repair and strengthen bank resolution frameworks:
- Strengthen nonperforming loan management as policy measures expire and delayed loss recognition may trigger defaults.
- Use the system-wide stress test (due in July 2021) to assess the need for precautionary recapitalizations.
- Strengthen insolvency regimes by addressing administrative constraints and establishing fast-track procedures to restructure debt.
- Address structurally low bank profitability:
- Improve profitability to rebuild capital organically through retained earnings over several years.
- Enhance non-interest revenues and streamline operations to improve cost structures, including greater use of digital technologies.
- Consider consolidation to improve efficiency and facilitate better allocation of capital and liquidity within banking groups.
IMF Blog: How European Banks Can Support the Recovery (March 26, 2021)