We are in the midst of an unprecedented pandemic. Apart from the tragic loss of life, the economic implications will be felt for years. This will not only be in terms of the businesses that have been closed down, many of which will never re-open, but also through effects on employment and career development, and the massive levels of debt that governments are incurring in order to support their economies.

Scientists have for long sounded alarm about the likely outbreak of a pandemic like COVID-19. But despite such warnings, governments around the world actively cut the budgets of their health services, including those aimed at dealing with pandemics. In the UK, a cross-government pandemic influenza outbreak drill took place in October 2016. Exercise Cygnus, as it was called, identified that the UK’s National Health Service would need thousands more intensive care beds in a pandemic crisis, that doctors would have to start triaging patients and only help those with a better chance of survival, and that there would be a shortage of masks and other protective equipment available to frontline staff. The required investments in equipment and facilities were never made and tragically the predictions of the exercise have now become a reality, as the UK now has the highest number of COVID-19 deaths across Europe. Similarly, in the USA the administration over the last three years cut the funding and workforce of the Centers for Disease Control and Prevention, and the USA now suffers from the highest COVID-19 deaths in the world, numbering more than 85,000 at the time of writing.

A parallel can be drawn to scientists’ warnings of a climate catastrophe. The world is facing the growing threat of abrupt and irreversible climate change. Scientists recently revealed that a large part of the Arctic Ocean has already warmed by more than 4°C above pre-industrial conditions. We have been witnessing an increasing number of climate-related incidents such as hurricanes, earthquakes and bush fires, leading to a loss of life, jobs and habitation. The harrowing scenes of the recent Californian or Australian fires that led to such devastating loss of human and animal life and habitation may be a harbinger of a “new normal”. Are we going to be equally slow to heed such calls for action, until a global climate emergency forces us to act?

One of the major sectors of the economy that needs to act in this regard is the financial sector. It is financial institutions that fund the activities of the companies contributing to global warming and environmental destruction. Going forward, it is crucial that the financial system starts to fully consider the cost of economic activities that cause environmental destruction, pollution and biodiversity loss when making decisions on loans and investments. Furthermore, it is crucial that the financial sector is better prepared to deal with systemic risks, including climate and other environmental risks.

In this regard, it is positive to see that central banks have been showing greater awareness of sustainability risks and acknowledging the need for them to act in helping to align the financial system with sustainable development. Launched at the Paris One Planet Summit in December 2017 by eight institutions, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) has grown to 65 members and 12 international observers. NGFS members have acknowledged that climate change represents a systemic risk to financial stability and have started to develop approaches to integrate climate-related financial risks into prudential supervision frameworks. A recent survey by the Basel Committee on Banking Supervision revealed that the majority of its membership considers it “appropriate to address climate-related financial risks within their existing regulatory and supervisory frameworks.”

Many countries have been considering to introduce disclosure requirements for climate-related financial risks, as suggested by the Task Force on Climate-Related Financial Disclosures, as well as micro- and macro-prudential instruments to mitigate these risks. A number of central banks – including the Bank of England, the Nederlandsche Bank and the Banque de France – have already started developing climate stress tests for their financial systems.

But calls have emerged from the financial industry to delay prudential measures aimed at addressing climate risks. Without doubt, this is a period of great stress for our economies and the financial sector, and pragmatism and flexibility are needed to manage a difficult crisis situation where so much is at stake. But we need to be clear that the current crisis must not be used as an excuse to undermine efforts by central bankers and financial supervisors to climate-proof financial systems. If anything, the COVID-19 crisis should strengthen the resolve of central banks and supervisors to speed up efforts to integrate environmental and climate risks in financial decision making to prevent the next big crisis to occur.

The central policy challenge facing both pandemics and climate crises is the same – we must make rapid progress in mitigating risks in the face of deep uncertainty and make our societies and economies more resilient. The financial sector will have to play a key role in this.

_____________________________

An abridged version of this article was first published by OMFIF on 14 May 2020 and can be accessed here.

Aziz Durrani is Senior Financial Sector Specialist at the South East Asian Central Banks (SEACEN) Research and Training Centre.

Ulrich Volz is Director of the SOAS Centre for Sustainable Finance and Reader in Economics at SOAS, University of London.

The ongoing COVID-19 pandemic, which began in January 2020, has led to unprecedented global responses with the aim of slowing down the virus transmission. Policy responses involving contact tracing, early detection to through testing, social distancing and public health information are integral measures intended to slow down the rate of infection.  But given the voracity of the virus, due mainly to the lack of complete information on the new virus including its methods of transmissions as well as available vaccine and treatment, tougher measures are needed to reduce the rate of human-to-human transmission and local community outbreaks.  Subsequently, governments have imposed travel bans, quarantines, city-wide lock downs and movement controls. These tougher measures are intended to flatten the curve of infection so as not to overwhelm and paralyse the health care system.  These measures will also buy time until more is known about the virus, specifically about its transmission and treatment.

These tougher measures in controlling the virus have their downside consequences.  Specifically, nation-, region- and city-wide lock downs translate into significant output contractions due to demand and supply-side effects. On the demand-side, consumer demand for goods and most services are substantially curtailed. This translates into loss of revenues and income from businesses and service providers. For instance, the travel ban and quarantines led to almost all passenger airlines operating below 10 per cent of their capacity (although cargo services remain strong).  On the supply-side, the manufacturing sector is the hardest hit given tougher measures to combat the spread of the virus. Primary indicators such as electricity load, unemployment benefit claims, purchasing manager indices and even atmospheric concentrations of nitrogen oxide have all pointed to sharp dips or spikes since the start of containment measures.  Consequently, the head of the International Monetary Fund has said that the global economy may undergo a recession, while the Asian Development Bank expects regional growth to slow sharply to 2.2 per cent in 2020. 

With the ongoing uncertainty on the how the COVID-19 pandemic will affect output, perhaps past episodes of pandemics may shed light on the magnitude of output drops and growth slowdowns the present pandemic may impart on the global economy.  Potter (2001) discussed various influenza pandemic episodes from the 18^th to the 20^th centuries.[1]  But to have insights on how output behaves before, during and after pandemics, focusing on pandemics from 1820’s onwards is more insightful for two reasons. First, the industrial revolution took off between 1820 to 1840. Hence, both the agricultural and manufacturing sectors were relatively developed in some economies around that time. Second, the Maddison Historical Statistics have available estimated data for economic output for more economies after 1820.[2]  As such, we can estimate global output around pandemic episodes. For these reasons, we consider the dynamics of global output growth before, during and after the pandemics of 1831-33, 1898-1900, 1918-19, 1957-58 and 1968-69.[3]

Figure 1 presents average global growth rates before, during and after the five identified influenza pandemic episodes. Several observations are in order. First, in most cases, average global output growth slowed during pandemics relative to before them, as in the case of 1889-90, 1918-19 and 1957-58. Based on these episodes, global output growth dropped by 1.1 per cent. The severity of the slowdowns corresponds to the number of reported and estimated deaths like in the case of the Spanish flu pandemic of 1918-19. Second, global growth after pandemics appears lower compared to before the pandemic, as in the case of the 1889-90, 1918-19 and 1957-58 pandemics. Specifically, global growth was 0.2 per cent lower in the post-pandemic periods compared to before.  These stylised facts, however, must consider that the underlying data are estimated, and that the sample contains economies with varying starting dates. For the 1831-33 pandemic, the sample includes 11 economies such as France, the United Kingdom and the United States. In contrast, for 1918-19, the sample includes 36 economies. China is included only in the 1957-58 and 1968-69 pandemics.[4] Moreover, there are other factors driving growth dynamics around and during pandemics. In 1918-19, World War I was in its final stages, while the 1957-58 pandemic coincided with the US recession. Though there are shortcomings, these stylised facts highlight two important points. First, global output growth slows during pandemics; and second, global output growth tends to be slower during post-pandemic years.

Notes: Growth rates (year-on-year, percent) refer to the weighted average growth of individual economies with available estimated Maddison GDP data. Pre- and post-pandemic global growth rates are computed as the average global growth rates two (or three) years before and after a pandemic episode. For instance, pre-pandemic growth rates in 1918-19 are those for 1916-17, while post-pandemic growth rate are those for 1920-21.
Source: Author’s estimates.

But this time, it is different. The world has significantly changed from the late 20^th up to the 21^st century. Globalisation has taken hold. The movement of people is now faster and, hence, pathogen transmissions are wider and faster. The production of goods and services as well as finance have become global. These facts imply that economic spillovers and disruptions in global value chains may make the economic fallout more severe. Yet advances in science, technology and medicine enabled early information-sharing and made detection possible. Treatment has improved by using ventilators, and vaccines may come sooner than later. Information and communication technology enable people to work remotely. On balance, in this current pandemic, there are growth-supporting factors that may mitigate severe economic fallout. Even under a prolonged pandemic scenario, globalisation and advances in science and technology may, in fact, facilitate a swift transition into new modes of production, delivery and labour market mechanisms.

Nonetheless, output drops and a slower recovery must be avoided, but public health must remain the top priority. An early lifting of restrictions and quarantines, coupled with lax testing, social distancing and contact tracing following the lifting of restrictions, may run the risk of protracted transmission, which may enable the virus to mutate and cause a second wave of pandemic as in the case of the 1918-19 pandemic. To cushion the economic fallout, fiscal policy must play a dominant role. This may take the form of loan guarantees, equity stakes and wider and enhanced social safety nets focusing on small to medium enterprises, lower income groups and the unemployed. Given that half of the world economies (including emerging and developing economies) have general government debt of less than 55 per cent of GDP; as well as the pandemic nature of the economic slowdown, there is scope for these economies to use targeted and effective fiscal policy measures to cushion the economic impact of the pandemic and rump-up the capacity of their respective health care system in dealing with future epidemics and pandemics. Now is not the time for fiscal restraint and debt considerations.

[1] The focus on this blog article is influenza pandemics, which is the same as the current COVID-19 pandemic (Potter (2001)).

[2] Refer to Maddison Historical Statistics of Groningen Growth and Development Centre of the University of Groningen.

[3] Global output based on Maddison Historical Statistics were computed as the weighted average of estimated real GDP, using population as weights. These episodes are considered severe cases conditional on an estimated number of deaths of at least 1 million people.

[4] Based on the five pandemic episodes, excluding China, average annual global growth during pandemics drops by 0.6 per cent from the pre-pandemic average growth rate, while the post-pandemic growth rate slows by 0.1 per cent compared to the pre-pandemic growth rate.

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.

References

[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. 

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.

The coronavirus (COVID-19) outbreak could cause global foreign direct investment (FDI) to shrink by 5%-15%, according to an UNCTAD report published on 8 March. The UN trade body had earlier projected a stable level of global FDI inflows in 2020-2021 with a potential increase of 5%. Now it warns that flows may hit their lowest levels since the 2008-2009 financial crisis, should the epidemic continue throughout the year. COVID-19’s negative impact on investment will be felt the strongest in the automotive, airlines and energy industries, the report says.

According to the Center for Strategic and International Studies (CSIS), at the sectoral level, tourism and travel-related industries will be among the hardest hit as authorities encourage “social distancing” and consumers stay indoors. The International Air Transport Association warns that COVID-19 could cost global air carriers between $63 billion and $113 billion in revenue in 2020, and the international film market could lose over $5 billion in lower box office sales. Similarly, shares of major hotel companies have plummeted in the last few weeks, and entertainment giants like Disney expect a significant blow to revenues. Restaurants, sporting events and other services will also face significant disruption. Industries less reliant on high social interaction, such as agriculture, will be comparatively less vulnerable but will still face challenges as demand wavers.

Since our blog post on 5 March 2020, we noted that central banks, governments and international agencies such as the International Monetary Fund (IMF) have taken a much more decisive and coordinated approach in their efforts to mitigate the impact of COVID-19 on the global economy. In response to this crisis, governments and central banks all over the world have enacted fiscal and monetary stimulus measures to counteract the disruption caused by the coronavirus. The IMF announced $50 billion of support for countries hit by the coronavirus. Since this announcement, Iran said it has asked the IMF for $5 billion of emergency funding to help it fight the social and economic impact of coronavirus.

The US announced another significant rate cut and are discussing an economic stimulus package. A number of other central banks such as the Bank of England and the Reserve Bank of Australia also cut interest rates. In addition, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank (ECB), the Federal Reserve and the Swiss National Bank are today announcing a coordinated action to enhance the provision of liquidity via the standing US dollar liquidity swap line arrangements. The ECB also announced a range of operational measures that it is taking as a precaution to protect its staff from risks associated with the spread of COVID-19.

Despite central bank and government actions, there has been a dislocation in financial markets and a crash in oil prices. Stock markets suffered significant declines as the threat of a coronavirus-fuelled oil war and ongoing panic about the spreading disease grew and triggered a rare automatic halt to trading early in the session. Russia’s refusal to meet OPEC’s push for production cuts unleashed a 10% fall in the price of crude oil and threatens to revive an energy war as the coronavirus’ global spread inflicts mounting damage on commodity and equity markets. Italian government bonds suffered their biggest one-day fall inalmost a decade after the ECB’s president, Ms. Christine Lagarde, said it was not the role of the ECB to “close the spread” in sovereign debt markets — referring to the spread between Italian and German bond yields that is a key risk indicator for Italy.

A question being asked is whether the IMF should inject liquidity through special drawing rights (SDRs) to alleviate the impact in most emerging and low-income countries, given that they are in a much weaker position compared with the global financial crisis of 2008-09. The fiscal space has all but disappeared. In 2007, 40 emerging market and middle-income countries had a combined central government fiscal surplus equal to 0.3% of gross domestic product (GDP), according to the IMF. Last year, they posted a fiscal deficit of 4.9% of GDP. The deterioration is not new — they have been posting deficits of this magnitude since 2015. The deficit of EMs in Asia went from 0.7% of GDP in 2007 to 5.8% in 2019; in Latin America, it rose from 1.2% of GDP to 4.9%; and European EMs went from a surplus of 1.9% of GDP to a deficit of 1%. Only in the Middle East has the situation barely changed, but countries there had large deficits in both periods, hardly a source of relief.

Consequently, the ability of EMs to implement countercyclical fiscal policies will be limited this time around. Their capacity for expansionary monetary policies is also significantly more constrained. For once, policy interest rates are already quite low in many EMs and their currencies are weakening fast against the US dollar. On top of this, the level of EM corporate hard currency debt is significantly higher now than in 2008. According to the IMF’s October 2019 Financial Stability Report, the median external debt of emerging market and middle-income countries increased from 100% of GDP in 2008 to 160% of GDP in 2019.

COVID-19 has already taken lives and caused suffering in many countries around the world. The human tragedy should always be first in our minds as financial sector regulators, as we discuss ways to maintain financial stability, of which business continuity management (BCM) of central banks, stand-alone financial sector regulatory authorities, deposit insurance agencies (collectively, regulatory authorities), and financial institutions (FIs) themselves plays a central role.

The threat of the virus has put everyone on alert as governments, regulatory agencies and health professionals provide guidance and possible restrictions on movement and gatherings to prevent the spread of the virus. Central banks and policymakers have also taken sizable and coordinated monetary policy and economic measures to mitigate the impact of COVID-19 on the global economy.

Regulatory authorities globally continue to monitor and assess the impact COVID-19 will have on FIs. Recently, it was reported that US financial regulators were preparing contingency arrangements, including travel restrictions and home-working, to ensure they can effectively oversee the financial markets as the virus closes in on the US capital. Many have instituted rules and regulations as well as relevant guidance to assist FIs in implementing or augmenting their BCM programs to minimise the potential adverse effects of a pandemic, including COVID-19.

This blog post consists of three (3) main sections and is published in two (2) parts: Part A and Part B. Part A is the first section, and presents a discussion of the steps regulatory authorities can take to implement their own BCM programs, and what they can expect from their regulated FIs, during the current pandemic. Part B consist of two (2) 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.

Business continuity management during a pandemic: a new twist on a very old practice

If there is one important, critical function of the regulatory authorities in the face of widespread possible disruption in financial services, it must be to maintain the confidence of individuals, households, businesses and investors in the financial system. If suppliers of funds to FIs lose confidence, massive asset sales and deposit withdrawals could result, a kind of forced deleveraging that would require extremely large injections of liquidity by central banks to revive moribund financial markets and preserve the smooth functioning of payment systems, without which declines in the level of economic activity will be exacerbated.

Maintaining confidence, of course, requires also that deposit insurance agencies set up programs to immediately pay out depositors of failed FIs. In an acute, long-lasting crisis, the desired currency-to-deposit ratio might rise sharply as households and firms hoard cash, necessitating a rapid upscaling of banknote printing and distribution.

It’s a good thing that many of the critical banking functions have been automated over the last few decades, requiring less human involvement. But human involvement is still necessary to screen and flag reports, turn equipment on and off, maintain equipment, control access to key infrastructure and so forth. FI staff or third-party vendor staff will still be necessary to keep ATMs functioning, for example.

As a possible downside of increased automation, requiring intensified vigilance by FI senior management and staff (and not only in the server room), cyber criminals and fraudsters may take advantage of a chaotic situation at one or more FIs to strike, believing that management is distracted by issues related to the virus. The current stressful period is no time to scrimp on resources devoted to ITC risk management, of which cyber risk management is an integral part. Beyond pure cyber risk, FIs may face power outages and interruptions to telephone and internet service if unavailability of manpower begins to affect key utility providers.

Post-2008 financial regulatory reforms emphasised the importance of FIs and identified critical business functions and operations in their crisis management, resolution and recovery planning. A strategic analysis of the firm’s essential and systemically important functions is necessary for resolution planning and for assessing resolvability. It should help ensure that the resolution strategy and operational plan include appropriate actions that help maintain continuity of these functions while avoiding unnecessary destruction of value and minimising, where possible, the costs of resolution to home and host authorities and losses to creditors.

Given the particular features of a pandemic, however, including a potentially longer duration than envisioned in many traditional crisis management scenarios, the critical business functions identified in the traditional BCM program may not always provide sufficient guidance for conducting operations in a pandemic scenario. Explicit identification of the highest priority critical business functions and operations will help to ensure they receive appropriate resources. These functions and operations could be defined as activities which, if not performed or maintained for more than a very short period, would cause the FI to be in default on its obligations or otherwise threaten its financial soundness.

For example, FIs may consider it appropriate to focus on servicing existing customers and completing transactions already in progress, and closing or minimising risk positions. They may choose to defer or suspend activities such as new business development, opening new accounts, undertaking special or new projects or any internal non-essential systems changes within the organisation. These activities may be progressively scaled back based on the phase of the pandemic or available resources.

The most commonly cited critical business functions of regulated FIs, which would also be consistent with governmental priorities for public confidence, generally include (but are not limited to):
• Core risk management functions — particularly market, operational, credit and liquidity risk monitoring;
• General ledger/finance capabilities to allow monitoring of the overall financial (including capital) position of the FI;
• Call centres handling customer transactions and enquiries (excluding, for example, outbound or sales calls); and
• Data centres, recovery sites and critical third-party suppliers supporting critical functions.
• Cash supply and currency distribution, including operation of automated teller machines (ATMs);
• Retail payments and banking systems that provide existing customers with access to funds, including EFTPOS, bill payments, credit cards, telephone banking and Internet banking;
• Automated direct entry payment processing for existing customers, including government payments and payroll processing for corporate customers, as well as payments to suppliers and staff;
• Credit functions, in particular those processing functions necessary for managing retail, corporate and institutional access to credit, particularly for pandemic-affected borrowers;
• For larger FIs, wholesale payments clearing and settlement activities, including interbank settlements, securities settlements and custody, particularly where these functions are provided to other FIs; and
• Limited trading functions for FIs active in markets operated by exchanges as well as over-the-counter — in particular, those functions necessary for completing transactions for existing customers and managing liquidity of the FI.

It should be noted that FIs are already taking action. In light of these acute challenges, FIs in the United Kingdom and United States are sending hundreds of staff to their UK and US disaster recovery sites, installing big screens in traders’ homes and pushing regulators for a reprieve on trading rules so they can keep their businesses running through a COVID-19 outbreak.

The efforts by big global banks including Goldman Sachs, JPMorgan Chase, Morgan Stanley and Barclays are an escalation of BCM program implementation that has already prompted them to segregate staff in Asian cities at the initial epicentre of the COVID-19 outbreak.

Of course, the real difficulty with the current situation is that even working from remote sites will not be possible as they too are open to becoming contaminated. So, the clearest way forward will be to allow all critical staff to be able to work from home remotely. In fact, these moves are being forced upon many banks, including central banks, given the lockdowns being implemented in various countries across Asia (such as the Philippines and Malaysia). The recent moves to cloud technology can help, as we note that even whilst in the office, many staff are logging onto remote servers containing all their files and data. The move to work from home for extended periods should therefore be something that is quite easily achievable.

Even once this is all in place, the real challenge will come when some of the more senior members of staff contract COVID-19. The virus does not discriminate, and we have already seen a number of celebrities and politicians contract it. So how will the market cope if/when a central bank governor, a bank CEO or the Prime Minister or President of a country, or their senior staff, start to contract the virus? Central banks, regulators, governments, and private organisations should also have a clear back-up plan for their chain of command so that they can reassure the markets that there are other experienced staff available to continue running the show and prevent further panic and instability, should the worst occur to their leadership teams.

In the past week or so, Covid-19 has become more threatening outside China as the virus is now rapidly spreading in countries such as Italy, South Korea, the US and Iran, just to name a few. Concurrently, in recent days, attention has turned to the likely damage to global output and to the possible reaction of macroeconomic policymakers.

Covid-19 is hitting the global economy when growth is soft, and inflation is relatively subdued, but many countries are grossly overleveraged. In case of the euro-area, for example, Covid-19 is hitting at a time when interest rates are already at a record low level of minus 0.5 per cent. Below we provide a chronicle of central banks and policymakers’ responses to Covid-19.

It appears the heightened attention that is being given to the likely impact of the virus on the global economy was kickstarted by a blog post by the International Monetary Fund’s (IMF’s) Managing Director, Kristalina Georgieva, on 19 February 2020 that was published on the IMF’s website. She noted that the new coronavirus, or COVID-19, outbreak was the “most pressing uncertainty” facing the world economy right now. She also highlighted that the international health emergency that “we did not anticipate in January” now threatened to derail global economic growth that was already under pressure from a global trade war and Brexit.

a few days later, speaking at the G20 summit in Saudi Arabia, the International Monetary Fund’s managing director also warned that the coronavirus had disrupted economic activity across the globe and called on countries to prepare for a weaker global growth outlook in the face of the virus. She noted her concerns that a quick recovery from the incident was not guaranteed. Even in the case of rapid containment of the virus, growth in China and the rest of the world would be impacted. She highlighted that we all hoped for a V-shaped rapid recovery but given the uncertainty, it would be prudent to prepare for more adverse scenarios.

In our chronicling of central banks and policymakers’ responses to Covid-19 we noted that in the very early days (late January/early February) of the spread of the virus, Bank Indonesia, the People’s Bank of China and the Bank of Thailand were amongst the first central banks to verbalise policies and intervention actions to mitigate risks to their economies. At that time the spread of the virus was largely concentrated in China, the epicentre of the virus.

We also noted that since Friday, 28 February 2020, the official responses of macro policymakers in the advanced economies (AEs) have shifted from a seemingly nonchalant approach to a more aggressive and coordinated one. Since then, a number of central banks have cut interest rates including the US Federal Reserve, the Reserve Bank of Australia, the Bank of Canada and Bank Negara Malaysia.

We note the that while central banks around the world are easing monetary policy and governments are offering fiscal stimulus to limit the impact on economic activities, Covid-19 is not a conventional economic threat. As noted by Kenneth Rogoff, unlike the two previous global recessions this century, the new coronavirus, Covid-19, implies a supply shock as well as a demand shock. Supply shocks are slightly more challenging to manage by central bankers and policymakers than anxiety-induced frugality among consumers, firms and investors. On the one hand, when people stop spending, growth slows and inflation falls. On the other hand, when supply is constrained, as in the case of Covid-19, shutting down factories and disrupting global supply chains, prices can accelerate concurrently with rising unemployment.

Based on our chronicling of central banks and policymakers’ responses, we believe that the fiscal and economic stimulus that we have seen to buttress health systems and affected economic sectors such as travel, tourism and manufacturing are warranted. With global inflation relatively subdued, fiscal and economic stimulus can be pursued without exacerbating an ongoing inflation problem. Massive public sector spending, however, might be challenging for governments that have not saved for a rainy day or those that are already running massive deficits. On the monetary policy side, some central bank may be constrained by the fact that they lack room for monetary policy. This is particularly concerning for countries that are already at very low or even negative interest rates. In those cases, there may be concerns about the side-effects of negative interest rates and a fear that cutting them further may do little to address the impact of Covid-19 on the economy.