‘Stress Tests’ for Banks as Liquidity Insurers in a Time of COVID

Viral Acharya
By Viral Acharya and Sascha Steffen
During the last few weeks, the spread of COVID-19 has rattled the global economic prospects and financial markets. Growth and employment forecasts for the global economy have been revised substantially downward to recession levels for the next two quarters; global stock prices have declined, especially for banks and other financial intermediaries; credit spreads have surged, notably for junk-rated paper in developed economies; and central banks have reacted with substantial rate cuts and/or liquidity provision and asset purchase programs.

The root of the present stress is different compared to the primary cause of the 2008-2009 global financial crisis (GFC). Importantly, the present stress did not originate in the banking system, as was the case for the GFC; pre-GFC, the banking system was over-leveraged with poor underwriting decisions in the housing sector, and the household sector was over-leveraged too. The root cause of the current stress is a pandemic. Containing the virus and the drastic steps (from social distancing to isolation) that governments need to undertake have an immediate impact on the real economy through the simultaneous occurrence of both demand and supply shocks, with attendant financial sector spillovers and side-effects such as the oil-price war.  In particular, debt repayments will come due as usual, but liquidity appears to be quickly evaporating for both small and large companies as economic activity grounds to a virtual halt. 

In spite of their better capitalisation and liquidity positions relative to pre-GFC, the banking sectors in developed economies, notably in the US, have already been under severe pressure as bank stock prices have declined about 40-50%. One important reason behind this could be the role of banks as liquidity insurers for the real economy. While non-bank financial institutions took over a large share of corporate financing over the past decade, particularly of highly leveraged firms, banks remain the main source of liquidity insurance for all firms – investment-grade, non-investment grade and also unrated firms. Indeed, as leveraged loans and bonds financed by the non-bank financial sector come due, firms may draw down on the bank lines of credit, causing credit to re-intermediate (involuntarily) to the banking system.

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Viral Acharya is the C.V. Starr Professor of Economics