COVID-19: Financial Stability and Business Continuity Management – Part B

This is the second of a two-part series of our discussion on COVID-19, financial stability and business continuity management (BCM). In Part A we discussed the steps regulatory authorities can take to implement their own BCM programs, and expect from their regulated FIs, during the current pandemic.

This blog post is Part B, and is divided into two main sections: (1) the intensification of regulatory, supervisory and resolution activity the authorities can expect, while at the same time running on reduced manpower; and (2) thoughts on a new crisis management framework to put in place when the current crisis has passed and economies start to recover.

Intensified regulatory, supervisory and resolution activity: challenges of “scaling down”

During the period when COVID-19 is spreading rapidly, regulatory authorities will have to perform a kind of heroic double-duty: the authorities themselves may need to implement BCM while, at the same time, keeping an eye on the regulated FIs’ implementation of their own BCM programs (if they have them at all). Beyond that, the authorities have to keep an eye on the spillover effects from the real economy on their regulated FIs and consider running screens to determine which of them are the most exposed to the most affected sectors, such as autos, logistics, energy, transport, tourism and retail. Keeping an eye on the financial industry while the authorities’ own functions are constrained, due to a lack of manpower, will be a big challenge – intensifying the need for risk-based supervision. There has never been a greater need, and a more important role, for off-site supervision than there is today.

One of the first pillars of most BCM programs is “scaling down” activities. But in the event that the economic fallout from COVID-19 spills over into generalised weaknesses in the financial sector, then central banks and other regulatory authorities will have to make many quick decisions on many fronts. This is the opposite of “scaling down.” The regulators may have to meet for long hours, some working from remote locations, to put into effect contingency plans to shore up banks’ capital, cash supply and liquidity. Some key staff may not even be available remotely, while undergoing treatment.

Some of the urgent measures that either could or are already being taken to shore up financial stability, apart from monetary policy decisions which are not the subject of this blog post, could be: (1) for central banks, the creation of additional lines of credit or reducing collateral requirements and/or expanding the range of acceptable collateral on existing lines of credit to support specific markets (such as the broker-dealer market), certain industries or certain classes of firms such as SMEs (these measures are often collectively referred to as “eligibility easing); (2) also for central banks, the outright purchase from FIs of securities, the liquidity of whose markets has dried up; and (3) for finance ministries (but in consultation with the regulatory authorities), the purchase of shares newly issued by FIs to bolster their capital bases.

That last intervention, it should be noted, was practiced on a very wide scale in the United States at the height of the Great Financial Crisis. Policymakers realised that it was necessary to keep banks lending, which would be practically impossible in an environment where capital positions were very thin or non-existent. Over 700 banks issued shares that were bought by the US Treasury, which gradually sold the shares back to the banks when the markets and the overall economy recovered. A decade later, this intervention is still recognised as the single most effective measure taken anywhere in the world to prevent a generalized financial sector collapse.

Implementing all of these measures is very labour-intensive, at a time when senior management and staff of the regulatory authorities may be working remotely or not working at all. Regulators may also have to meet with directors and officers of FIs to discuss and agree on urgent measures. These meetings may also have to be held remotely, which is difficult in the best of times.

One subject that is attracting increasing attention is regulatory relief. Pressures on the authorities for regulatory relief, which are present even in more normal times, will intensify the longer the virus looms as a threat, requiring long and possibly contentious meetings with elected officials in many countries. Regulatory relief could take the form of allowing FIs to allow their Pillar 2 or systemic capital buffers to be drawn down, relaxing provisioning requirements on assets exposed to heightened credit risk or delaying by months or years the full implementation of Expected Credit Loss (ECL) methods of determining loan-loss allowances, encouraging or even requiring FIs to reschedule or restructure loans without immediately recognizing losses, delaying the implementation of the Net Stable Funding Ratio (NSFR, a key mandate of Basel III), and other measures that in normal times would be criticised as “forbearance.”

In fact, regulatory and borrower relief have already been implemented in Italy, Europe’s hardest-hit country. For example, Italy has declared a moratorium on mortgage payments, with the state ultimately guaranteeing these payments. How are these programs going to be implemented by understaffed regulators, and how are their impacts on financial institutions going to be assessed? What happens if shortages of staff at banks result in reduction in the supply of critical data? Many banks are now in the process of preparing their annual financial statements for 2019. Although these statements won’t reflect the effect of COVID-19 on their operations, the reports and the auditors’ opinion on these reports may be delayed for weeks, or even months, along with delays in the transmission of more current data.

Conclusion: A look into the future

If a serious global financial crisis is precipitated by the COVID-19 pandemic, and large-scale measures are taken to reduce the intensity and impact of the crisis, there will inevitably be second-guessing and cries that the regulatory authorities favoured this or that group, didn’t act quickly enough, exceeded their legislative authority or made other crucial errors. As difficult as it may be during a crisis in which many senior officials may be absent, it is essential to document the discussions and rationale for the decisions taken. Without this documentation, regulatory authorities will face crises of legitimacy long after the actual financial crisis has been abated.

In the new post-crisis world, stress testing and contingency planning will rise even further on the list of essential activities by both regulatory authorities and FIs to maintain financial stability. Pandemics will have to be added to the list of risk factors that today are mostly macrofinancial in nature. Stress tests that envision the widespread unavailability of electricity or telecommunications may have to be added to the analytical mix, as well as the failure of a major financial market infrastructure or major FI whose connectedness to the entire financial system poses a risk to every other FI.