Maintaining confidence and the smooth functioning of financial markets[i]
Since the initial publication of this blog post, this article has been further developed into a full fledged SEACEN Policy Analysis Paper, which has been published on the SEACEN Centre Website on 15 May 2020. The paper can be accessed here.
As the world shelters from COVID-19 and attends to those already ill or infected, the primary concern of central banks, stand-alone financial sector regulatory authorities, and deposit insurers (collectively, regulatory authorities or RAs) must be the health and workplace safety of their senior management, staff, and their families. Beyond that, the RAs have a public policy objective of maintaining confidence in, and the smooth running of, the financial sector, the effects on the real sector of the shutdown of which would be too much for any economy in any jurisdiction to bear.
Maintaining confidence and smooth functioning of the financial sector, in turn, requires attention to the “force multipliers” of a financial crisis:
- Correlation. The situation where the same negative factor affects most financial institutions (for example, a sharp drop in housing prices or a sharp rise in unemployment).
- Connectedness. The situation where banks lend to and borrow from one another and/or banks purchase each other’s debt and/or equity securities, causing possible linked failures.
- Contagion. The situation where events negatively affecting a few banks (usually larger ones) lead to a loss of confidence in other banks, even if these banks are not negatively affected by the same events and there is little or no connectedness.
In any given crisis, any one or all of these force multipliers may be in play.
In achieving this public policy objective of maintaining confidence and smooth functioning under extremely trying conditions, the RAs must be prepared to address a possible severe financial crisis quickly and effectively. This goal will require the RAs, together with the Finance Ministry and possibly other government leaders, to prepare and agree upon in advance measures that, if selected, could be put into place without much dissension. All of the involved organs of government should agree that stopping or at least attenuating a financial crisis, and its concomitant negative effects on the real sector, will necessitate all of the following activities:
- Allocating losses from failed financial institutions according to policies and procedures that, if not already enshrined in laws and regulations, are at least perceived as fair and do not further alarm depositors and other creditors.
- Preventing new losses by reducing connectedness and contagion.
- Bolstering surviving institutions by strengthening capital and liquidity positions, thereby making new lending and refinancing of existing lending possible.
A 2020 financial crisis, should it materialize, will be different from the 2007-2017 Great Financial Crisis (GFC) and subsequent euro-area sovereign debt crisis, because the origin will be an exogenous, real sector shock and not a buildup of vulnerabilities in the financial sector itself. Even so, the trajectory of a severe real sector shock leading to a financial crisis that reverberates back again on the real sector may necessitate the use of some of the same tools that were used to react to the GFC, but perhaps to an even stronger degree, and may also necessitate the use of new tools with which RAs may be experimenting, and which may have to be adjusted as events unfold.
The questions of transparency and communication
Two common themes of this brief that should be addressed right from the beginning are transparency and communication, which are different but intimately related. How much transparency should the RAs practice about the intrinsic condition of the financial sector? And how should these messages be communicated, giving policymakers and the general public the information they need to know, without alarming them?
The main argument in favor of transparency – which includes not delaying the phase-in of accounting and reporting standards that may worsen the reported (but not intrinsic) condition of banks and other financial institutions – is that in the absence of full disclosure and the realization by policymakers and the general public that “adjustments” have been made, they may assume that the condition of the banks is even worse than it really is intrinsically. Moreover, the effect of relaxed standards on the accounting for and reporting of problem loans, just to take one example, is not evenly distributed across the banks. The relative ranking of banks in terms of overall financial strength may well change when broad-based adjustments are made in accounting and reporting standards, even if the intrinsic ranking stays the same. The effect of these changes in relative rankings may be to distort supervisory decision-making, which would be most unfortunate in a time of crisis.
The main argument against transparency, and allowing banks to appear better capitalized and more profitable than they really are, is that policymakers and the general public could become alarmed if they find out that the majority of banks are unprofitable and heading toward capital deficiency or even insolvency. This concern, which is not to be minimized, stems partly from a confusion about what “bank capital” and “bank insolvency” really are. Ordinary people tend to confuse capital with cash, and they may interpret a bank’s declining capital position as a hemorrhaging of cash. In surveys, households often opine that loan-loss allowances are a “fund” that is “drawn down” by a bank in stressful times. They may also confuse insolvency with illiquidity.
The media often contribute to this confusion, which is why RAs in crisis preparedness mode should devote time and effort to bringing in the media every step of the way in developing or modifying its crisis management program. Journalists often confuse terms such as defaulted loans, non-performing loans, rescheduling, restructuring, charge-offs, write-offs, and other concepts which have precise and different meanings in the context of banking regulation and supervision. They may write headlines alleging that the RAs are allowing deadbeat borrowers to go scot-free. In some parts of the world, they may have become unused to reporting about bank failures or even display a lack of understanding of what it means if a bank is “failing or likely to fail.” They may question why insolvent banks are allowed to remain open. All of this confusion of course, can be amplified on social media and produce a situation of general panic.
The same tools of effective communication will have to be used if and when RAs allow reductions in capital and liquidity buffers, such as the countercyclical capital buffer and the high-quality liquid assets required by the Liquidity Coverage Ratio, as some have already done. Policymakers and the general public must be convinced that these buffers were created with the expectation that they will be used in a stressed environment, and RAs are not asleep at the wheel by allowing thee buffers to be drawn down.
Going back to first principles: how to deal with the technical insolvency of the entire banking system in the aggregate
It’s instructive to look at the worst-case situation and measures to handle it, then work back to the factors that may lead to such a situation. With economies essentially stopped or frozen, RAs may contemplate a banking system that in the aggregate is insolvent (assets less than liabilities) quite possibly in a market-value sense, and even in a book-value sense. (As RAs seldom make decisions based on the market value of institutions, this brief will assume insolvency is on a book-value basis.)
Banks, individually and in the aggregate, can continue to operate for months, or even years, in a situation of negative capital, though this condition is hardly desirable.[ii] Some of the decisions RAs will have to make over the next few weeks and months will be:
- Do we close banks with negative capital, or, even more severely, close banks when capital is still positive but below regulatory minima?
- Do we adjust accounting and/or reporting rules to make insolvent banks appear solvent?
- What kind of disclosures are required?
- Should we recapitalize insolvent banks with public money?
One possibility is for RAs to be completely transparent about the situation of industry insolvency, communicating to policymakers and the general public that this is the condition facing the entire industry, and the health of the banks in the aggregate is a concern that the RAs are monitoring closely. It is instructive that this was not the approach taken in the early 1980s in the United States, when the entire savings and loan (savings bank) industry was insolvent, and accounting rules and regulatory capital reporting were jiggled to make the industry appear solvent.
The move was not transparent, but it was transparently political to anyone paying attention; few astute industry observers were fooled. CEOs of these intrinsically-insolvent institutions also responded to these acts of grace by taking on even more risk, so that several years later, when the accounting and reporting rules were changed again in the direction of greater (though not perfect) reality, the “hole to fill” was much bigger than it would have been if the regulators had been transparent from the very beginning.
An argument can also be made for keeping a large number of intrinsically-insolvent banks open to serve community needs during the crisis and obviate additional complex decisions on which of them, and which parts of them, provide “critical services” to the real economy. To that extent, and with some adjustments (described below), an entire insolvent banking sector can be kept open and functioning almost as a public utility.
Of course, in many jurisdictions there are laws and regulations requiring RAs to intervene when a bank’s capital falls below a certain level. Situations described by terms such as “failing or likely to fail,” “point of non-viability,” “critically-undercapitalized,” etc., have mandated supervisory action such as beginning resolution procedures, revoking the banking license, placing the bank in conservatorship or receivership, or even liquidating the bank. As part of crisis preparedness, RAs may elect to approach lawmakers, or may change their own regulations autonomously, for authority to waive these mandated actions in order to keep troubled banks functioning without any kind of disruptive intervention.
Recapitalizations of individual banks with public money may also be an option. As mentioned above, a financial crisis more often than not spreads to the real economy, causing a decline in the level of economic activity. Therefore, one goal of financial crisis preparation and management is to keep banks adequately capitalized and thereby able to continue lending to the real economy. From both an asset-liability management perspective and a liquidity perspective, recapitalizing banks may help replace interest-bearing liabilities (some of which may have run off) with an interest-free (though not necessarily cost-free) source of funds, perhaps boosting bank profitability while keeping the size of the balance sheet constant and avoiding painful deleveraging.[iii]
Meeting the liquidity needs of banks
Much has already been written in the national and international media about various measures adopted by central banks, such as easing requirements for discount window borrowing and long-term refinancing, to sustain the liquidity of commercial banks, which will not be covered in this brief except to remind readers that an insolvent bank can remain open for a long period of time, while an illiquid bank must be closed (or resolved) immediately. Central banks may also elect to support entire markets for certain classes of securities, such as commercial paper or the activities of broker/dealers, to keep the liquidity of the system flowing, a practice known as “eligibility easing.”
In the broader markets, central banks should be alert to reports of unusual activity by banks to sell these certain classes of securities. Fire-sales of assets to meet immediate liquidity demands can push a bank or banks from an illiquidity position to an insolvency position, and may cause the markets for these certain classes of securities to freeze up completely.
However, in crisis preparedness steps, RAs and banks must also remember that there are two, not one, main sources of liquidity disturbance that tend to erupt at the onset of a financial crisis: panic withdrawals of deposits and drawdowns by customers of available credit under lines of credit. RAs may elect to encourage banks to “know their customers,” that is, review their credit lines and their sources of deposits and try to anticipate the drawdown and withdrawal responses of the most stressed enterprises and households. Some of these enterprises and households may be calmed by communications from the banks that their needs will be met. Deposit insurers, in particular, have a special responsibility to calm the public and gently discourage depositors from withdrawing more than the necessary amounts of funds from their accounts.
Deposit insurers, supported by government policymakers, may also elect to raise the covered amount, as was practiced by several deposit insurers at the onset of the GFC. RAs may also choose to pause any discussions that may have been started over “bailing in” uncovered depositors. It may also be necessary for deposit insurers to commit (with fiscal backing, if required) to immediate depositor payout from accounts at a closed bank if immediate payout is not yet a long-standing practice in that jurisdiction. All of these measures may help to avoid a rush to cash out of accounts or stop a rush that is already in progress.
Temporary and tailored modifications to insolvency regimes to obviate closing banks and throwing borrowers into bankruptcy
In many jurisdictions, failed banks are handled by collective insolvency proceedings which entail the partial or total divestment of a debtor (the failed bank) and the appointment of a liquidator or an administrator normally applicable to banks under national law and either specific to those institutions or generally applicable to any natural or legal person. Some jurisdictions have special provisions for banks, whether they are systemic or not. Sometimes they are self-contained and bank-specific (like in the United States). That approach is preferable, in that it keeps failed banks as much as possible out of the court system, where resolution may drag on for months or even years. Other jurisdictions use the ordinary bankruptcy or company law but with special provisions for banks, which leads to confusion in many instances.
Whichever approach is used – and there may not be time or political appetite for emergency changes to insolvency regimes – RAs may try to speed up the handling of failed banks during the COVID-19 crisis by adopting some of these modifications:
- Suspending the duty by bank directors to file for bankruptcy in those jurisdictions where corporate directors are subject to this duty. This duty seems irrelevant, and possibly could provoke alarm, if RAs have an explicit policy of allowing insolvent banks to keep operating.
- Suspending the duty, if it exists in a jurisdiction, to recapitalize or liquidate companies.
- Suspension of creditors’ rights to file an involuntary bankruptcy petition against a bank.
- Prohibiting critical third-party vendors of a bank from terminating contracts with the bank due to missed payments, when COVID-19 is the reason.
- Relaxing liability of directors and officers of banks hovering in the zone of insolvency due to COVID-19, to enable them to implement recovery plans (if they have them) without distraction or interruption.
It should be clear that in the wider commercial environment these measures may be applied to bank borrowers, as well as to the banks themselves. If enterprises that are viable but for COVID-19 interruptions are not automatically thrown into bankruptcy proceedings, the banks that have lent to them can pursue loan workout strategies with the existing management structure and asset mix, possibly speeding their recovery when economic activity begins to resume.
The impact of borrower distress, loan rescheduling and restructuring, repayment moratoria, and accounting and reporting practices on bank profitability and capital adequacy
Many jurisdictions around the world have encouraged or required their banks to reschedule loans for all or certain classes of borrowers who will find it difficult or impossible to make scheduled principal and interest payments, as a result of a generalized economic shutdown due to COVID-19. (Rescheduling is to be carefully distinguished from restructuring. The former refers to stretching out the timeline of required payments of principal and/or interest on a loan; the latter refers to actually reducing those payments, through waiving part of the principal and/or reducing the interest rate. Sometimes a loan modification combines both rescheduling and restructuring.)
In both rescheduling and restructuring, the intent of the bank should be that the borrower will be able to meet the revised schedule of principal and interest payments. For loan classification and regulatory provisioning purposes, under a pre-IFRS 9 or transition period regime, the loans could be upgraded to “performing” or “standard” status, once the borrower emerges from any “grace period” embedded in the new contract and actually begins to make payments according to the revised schedule.
Things get complicated when the transition to IFRS 9 and COVID-19 reschedulings and restructurings are occurring simultaneously. Most jurisdictions that have implemented loan repayment moratoria in response to COVID-19 have done so on a blanket basis (or at least targeting certain industries that are likely to be most affected), not individual borrowers. Moratoria have also been combined with governmental guarantees, particularly for loans to small- and medium-sized enterprises (SMEs). In general, RAs have taken a lenient attitude toward accounting and reporting for these loans, not requiring them to be considered “non-performing” and not requiring, from an IFRS 9 perspective, to be treated as having experienced “a significant increase in credit risk,” which would otherwise have necessitated a move to “Stage 2” and an increase in required loan-loss allowances.
The philosophy behind this relatively lenient attitude, especially with regard to the blanket moratoria, is that IFRS 9 could envision a “long-long” term approach to firm viability, so that the current dire situation is viewed (from a discounted net cash flow basis) as just a “blip” in a long chain of expected payments. Especially when combined with government guarantees, loans whose required repayment is stretched out over a 10-year (or longer) period in a near-zero interest-rate environment would hardly even require more loan-loss allowances.
Restructurings, on the other hand, pose a different set of challenges. When principal and/or interest payments are actually reduced, and not just stretched out over longer time periods, discounted cash flows can decrease substantially even with ultra-low interest rates. In that situation, RAs may elect to apply existing accounting and reporting rules with less or no leniency.
As time goes on, with COVID-19 looking like a long-lasting, devastating hit to the level of economic activity, some RAs may begin to advocate delaying the implementation of IFRS 9 (or other expected credit loss regimes). In the United States, for example, the Chair of the Federal Deposit Insurance Corporation (FDIC, which is a banking supervision agency, resolution agency, and deposit insurance fund all at the same time) wrote to the Financial Accounting Standards Board (FASB, the standard-setter for the accounting regime used in the United States) asking for a delay in implementing the Current Expected Credit Loss (CECL) regime, a stricter and simpler variant of IFRS 9, for banks currently subject to the transition. Her reasoning was so that banks could then “better focus on supporting lending to creditworthy households and businesses.”[iv]
There is no doubt that IFRS 9 and CECL are more complex than earlier rules for determining loan-loss allowances, and there may be some merit in the argument that banks, many of whom may soon be operating with diminished staff numbers, should focus on the provision of basic services and not on implementation of complex accounting rules. However, RAs should exercise extreme caution in advocating for a delayed transition on the grounds that it would make (reported) capital and (reported) profitability look worse (to be fair, the FDIC Chair was not making that argument), or that a delayed transition would result in more loans being originated than under the current transition.
There is a long-standing dispute in banking and bank supervision and regulation over the idea that a strict regime of loan-loss provisioning leads to less lending, and a more relaxed regime leads to more lending. The idea has a certain plausibility, but cracks in the wall of certainty appear as soon as one considers that no loan-loss provisioning regime can alter the occurrence or the magnitude of credit losses, only the timing of these losses’ recognition. Loss recognition can be upfronted, or it can be pushed forward in time; but the magnitude of the loss results only from the ability and willingness of the borrower to repay the loan on time and in full. Most loan officers will say that the provisioning regime in force has no impact on their decision to approve a loan or not, only the contours of the bank’s overall credit policy and his/her assessment of borrower ability and willingness.
Another argument against delaying the transition to IFRS 9 or CECL is that “temporary” measures to address reported (though not intrinsic) bank capital and profitability have a way of becoming permanent, long after the crisis conditions have abated. The combined efforts of international standard-setting bodies and RAs throughout the world to introduce tougher requirements to bolster the resiliency of banks and lessen the probability of another financial crisis have already required enormous adjustment, much of it successful, on the part of the banks. It would be a shame if the banks used the tragedies of the current crisis to successfully advocate for a permanent relaxation of capital, liquidity, accounting, reporting, or disclosure requirements.
Conclusion: Prepare, be transparent, and seek legislative authorization for extraordinary measures
RAs around the world are in an extremely difficult position. They are going to be required to make rapid-fire decisions, spurred on by capital and liquidity stress conditions at banks and other financial institutions, in an environment in which senior officers and staff – at both the RAs and their regulated institutions – may be absent or incapacitated. That frightful situation brings into even sharper view the necessity for RAs to prepare for crises, and get their crisis management tools ready and sharpened, for rapid deployment.
In the long run, the legitimacy of RAs will depend on how, and how well, they used their delegated authorities from their constitutionally-enacted legislative frameworks. Extraordinary measures, such as allowing banks to remain open with negative capital, should have legislative authorization, so that post-crisis inquiry commissions (What did the RAs know? When did they know it? Did they take appropriate and timely action, given their authority?) do not result in constraints on these RAs’ future abilities to respond to crises nimbly and effectively.
And finally, transparency does matter. Policymakers and the general public have the right to know the true condition of individual banks and the banking sector as a whole. Perverse as it may sound, one of the benefits of the waves of financial crises that have washed over the world in the last 50 years is that the public may be less sensitive to negative news coming out of the financial sector, and more accepting of the reassurances given by RAs and governments. But they will not be fooled by accounting and reporting manipulation that has fooled them too often in the past.
[i] This brief is intended to lay out issues and options for regulatory authorities. It is not intended to provide technical advice or advocate for the adoption of laws, regulations, and policies. The phrase “may” is to be construed in the subjunctive sense and not the permissive sense. The situations described are hypothetical and should not be construed as predictions.
[ii] Drawbacks of leaving an insolvent bank open are well-known: first, the incentive for bank directors and officers to take on much higher credit, market, and liquidity risk in order to “win the bet” and return to solvency; second, the difficulties faced by an insolvent bank in staying profitable with far fewer interest-earning assets than interest-bearing liabilities, perhaps increasing the “size of the hole” to fill; third, the possible loss of confidence of bank depositors and other creditors as the insolvency drags on; and others.
[iii] An encouraging example of bank recapitalization came from the United States, where at the height of the GFC the Treasury bought shares in 707 banks between March and December 2009, spending $205 billion. Eventually, as the markets recovered, the vast majority of those shares were repurchased by the banks, returning over $220 billion to the Treasury. The program, called the “Capital Purchase Program,” was not a complete success: 32 banks that had received capital injections still failed.
[iv] Letter from Jelena McWilliams, FDIC Chair, to Shayne Kuhaneck, Acting Technical Director, FASB, “Request for Delay in Transitions to and Exclusions from Certain Accounting Rules,” 19 March 2020.