COVID-19: How Will European Banks Fare?
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

This paper evaluates the impact of the crisis on European banks’ capital under a range of macroeconomic scenarios, using granular data on the size and riskiness of sectoral exposures. The analysis incorporates the important role of pandemic-related policy support, including not only regulatory relief for banks, but also policies to support businesses and households, which act to shield the financial sector from the real economic shock.

Abstract

This paper evaluates the impact of the crisis on European banks’ capital under a range of macroeconomic scenarios, using granular data on the size and riskiness of sectoral exposures. The analysis incorporates the important role of pandemic-related policy support, including not only regulatory relief for banks, but also policies to support businesses and households, which act to shield the financial sector from the real economic shock.

Executive Summary

The COVID-19 pandemic is exacting a severe social and economic toll on Europe. While European banks have substantially raised their capital buffers over the years, many suffer from chronically low profitability due to inefficient cost structures, compressed net interest margins, and the drag of legacy assets from the Global Financial Crisis (GFC) and the European sovereign debt crisis. They now stand heavily exposed to economic sectors that have been hard hit by the pandemic.

This paper evaluates the impact of the crisis on European banks’ capital under a range of macroeconomic scenarios, using granular data on the size and riskiness of sectoral exposures. The analysis incorporates the important role of pandemic-related policy support, including not only regulatory relief for banks, but also policies to support businesses and households, which act to shield the financial sector from the real economic shock. Compared to previous studies conducted by the European Central Bank (ECB) and European Banking Authority (EBA) in 2020, the analysis covers a wider range of policies and a broader set of banks—including smaller banks—within the euro area, while extending the sample to cover most European countries outside the euro area.

The baseline results suggest that despite a significant fall in capital ratios, banks remain broadly resilient to the shock. While there is no aggregate capital shortfall relative to the minimum prudential requirement, a number of the larger euro area banks may struggle to meet their threshold for the maximum distributable amount (MDA), which could create funding pressures, especially with respect to hybrid capital. The data reveal considerable cross-country variation, with the change in bank capital being sensitive both to the size of the macroeconomic shock and the initial condition of bank balance sheets and profitability. Policy is extremely important in reducing both the extent and variability of capital erosion; in particular, good policies can substantially weaken the link between the macroeconomic shock and bank capital.

In an adverse scenario with a slower recovery in 2021, the erosion of bank capital would become more pronounced, especially if a premature phase-out of support measures increases default risk. The number of banks potentially breaching their MDA threshold would double, greatly increasing the risk of higher capital costs and funding difficulties.

Based on these results, the paper recommends a multi-pronged policy strategy:

  • Keep in place borrower support measures, such as debt repayment relief or “moratoria”, credit guarantees, and direct support for firms, until the recovery is firmly established. As the recovery gains momentum, eligibility criteria should be tightened to better target illiquid but viable firms and the most vulnerable households while preventing loan misclassification, credit misallocation and the rise of “zombie” firms.

  • Clarify supervisory guidance on the availability and duration of capital relief and conservation measures. Banks should be allowed to build back capital buffers gradually, so new lending does not need to be cut back. Restrictions on dividend payouts and share buybacks, should be maintained until the recovery is well underway.

  • Support balance sheet repair by strengthening non-performing loan (NPL) management and the bank resolution framework. As policy measures such as insolvency moratoria expire, a wave of bankruptcies and loan defaults are likely to follow. The EU authorities should use the current system-wide stress test, expected to be completed in July 2021, to assess the need for precautionary recapitalizations. Insolvency regimes should be strengthened, focusing particularly on fast-track procedures to restructure debt.

  • Address structurally low bank profitability. Rising impairments and provisions will exacerbate the pre-existing challenge of very low rates of return on assets, limiting the ability of banks to restore capital buffers organically. Banks should therefore enhance non-interest revenues and improve their cost structures. Although many banks have appropriately started investing in digital technologies to streamline operations, this is likely to increase expenses over the short term. Further domestic and cross-border consolidation could improve banks’ efficiency, while also faciliating a better allocation of capital and liquidity within banking groups.

Chapter 1 Introduction

The combined health and economic crises triggered by the COVID-19 pandemic and related adverse confidence effects pose a potential threat to financial stability. Euro area real GDP declined sharply last year, and the recovery is likely to be protracted. Uncertainty remains elevated, with risks to growth tilted to the downside in the face of new waves of infections and vaccine-rollout delays. A prolonged health crisis and slower recovery could depress demand and further weaken private and public sector balance sheets, with adverse effects on the banking sector.

Banks are likely to face rising capital and liquidity pressures due to shrinking profits and deteriorating asset quality. The crisis has intensified profitability challenges. Before the pandemic, most banks’ business models were already under pressure because of compressed net interest margins and inefficient cost structures amid legacy assets from the last crisis. The pandemic has amplified these pre-existing conditions as banks are likely to: raise provisions for higher loan losses due to lower average borrower quality; write of a rising share of NPLs to insolvent borrowers with diminishing prospects for collateral recovery; and face lower income from non-lending activities.

Balance sheet pressures in turn could hinder banks’ ability to support credit growth for the recovery. With capital markets continuing to function smoothly, helped by central bank support, the challenge will likely be concentrated in companies that lack access to capital markets. European non-financial firms exhibit greater dependence on loans than companies in other advanced economies (Figure 1), so any constraints to bank credit supply would create correspondingly larger challenges for the economic recovery.

Figure 1.
Figure 1.

Liabilities of Nonfinancial Corporations, 20191

(Percent of GDP)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: Haver Analytics; and IMF staff calculations.1 Liabilities exclude “other equity,” “insurance and pension reserves,” “financial derivatives and employee stock options,” and “other accounts payable.”2 Include loans from other nonbank financials and other nonfinancial companies.

Various national and European-level policy measures adopted in 2020 have helped cushion the adverse economic impact of the crisis. In response to the first wave of COVID-19 infections during the spring of 2020, several European governments introduced a range of exceptional mitigation measures to alleviate the liquidity stresses of firms and households, while the ECB-Banking Supervision and EBA announced capital relief and conservation measures (supplemented by the reduction of macroprudential capital buffers by competent national authorities). Tanks to these measures, to date, the impact on bank capital has been relatively limited. As a result, corporate credit growth increased substantially during the initial phase of the pandemic, especially to highly affected sectors with higher liquidity needs (Figure 2). The net issuance of debt also increased against the backdrop of favorable financing conditions. While some relief measures have been extended in response to surging infections towards the end of 2020, some of them could be phased out this year.

Figure 2.
Figure 2.

Stock of Lending to Nonfinancial Corporations and Households

(Percent, year-over-year; EUR billion)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: European Central Bank.

This paper aims to quantify the impact of both the pandemic and policy support on bank capital. We investigate the implications of our baseline and adverse GDP growth and unemployment paths—as published in the IMF’s January 2021 World Economic Outlook (WEO) Update—on bank capital at the end of 2021. To better understand the role of policy, we also attempt to assess a counterfactual: what would have been the bank capital level without support measures, such as repayment moratoria, loan guarantees, insolvency moratoria, as well as borrower measures?

The paper builds on previous analyses by the European authorities with a wider sample. Both the EBA (2020e) and the ECB (2020a) have already completed preliminary vulnerability analyses. We widen the analysis beyond larger banks to reach a coverage of at least 80 percent of domestic banking sector assets in the euro area, and also include banks in some non-euro area European countries that are not covered by the EBA sample.1

The analysis incorporates sector-specific shocks to the real economy and a more comprehensive range of country-specific borrower support measures. Different sectors of the economy have been differentially affected by the pandemic. Aside from assessing the general effect of the COVID-19 shock on banks’ credit exposures to households and firms, we also incorporate granular data on bank-specific corporate exposures and map them to the projected loss rate for each sector in each country. At the same time, the paper assesses how banks are directly affected by borrower support measures, including debt moratoria, credit guarantees and deferred bankruptcy proceedings, complementing public information with IMF desk surveys.

Although the impact of the crisis on banks has been limited so far, our analysis suggests that capital pressures will rise during the protracted recovery. Banks have been able to slowly absorb rising impairments without a significant change in their capital ratios given continued borrower-support and effective capital conservation measures.2 However, vulnerabilities might emerge as policy support measures expire, resulting in a rise of impairments and a surge of bankruptcies due to the declining debt service capacity of nonfinancial corporations and households. A more sluggish recovery than projected in the baseline could lead to potentially larger bank credit losses, especially if a premature phaseout of supportive policy measures creates “clif effects” and amplifies deleveraging pressures on weaker banks and those most exposed to vulnerable sectors. Indeed, as the EBA’s Risk Assessment Report (2020) has recently warned, traces of asset quality deterioration have already emerged despite support measures.

The paper is structured as follows. We discuss the financial soundness of European banks before the COVID-19 pandemic in Chapter 2. Chapter 3 provides stylized facts on European banks’ vulnerability to the pandemic-related shock. Chapter 4 summarizes key policy measures that have a direct or indirect impact on banks. Chapter 5 describes the analytical framework of our exercise, followed by results in Chapter 6. Chapter 7 extends the analysis to a wider set of European banks, and Chapter 8 concludes with policy implications.

Chapter 2 Pre-Pandemic Bank Health

European banks entered the COVID-19 pandemic with higher capital compared to 2007—the eve of the global financial crisis (GFC). Banks held nearly 15 percent of Common Equity Tier 1 (CET1) capital in percent of risk-weighted assets (RWA) (Table 1 and Figure 3, panel 2) in 2019 (EC/ECB/SRB 2020).1 The ratio nearly doubled from about 7 percent in 2007 and was well above the prudential minimum of 4.5 percent (plus the bank-specific Pillar 2 requirement). Likewise, the non-risk weighted leverage ratio (that is, Tier 1 capital in percent of total assets) has also doubled since 2007 and stood at around 6 percent on average, about twice the minimum threshold of 3 percent that will be binding from June 2021. After peaking at 7½ percent of gross loans after the GFC in 2013, NPLs have continuously declined to about 3 percent of gross loans (Aiyar and others 2015), supported by lower unemployment, higher GDP growth, and efforts by banks along with enhanced supervision (Figure 3, panel 1).

Table 1.

European Banks: Selected Financial Soundness Indicators

(Percent, asset-weighted mean)

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Sources: FitchConnect; and IMF staff estimates.Note: The number of banks with available 2019 data in FitchConnect in each subsample are 107 (EBA), 593 (EU-non EBA), 66 (SSM), 501 (EA-non SSM), 291 (CESEE), and 443 (Non-EU). CESEE = Central, Eastern, and Southeastern European economies; CET1 = common equity Tier 1; EBA = European Banking Authority; EU = European Union; NPL = nonperforming loan; ROA = return on assets; ROE = return on equity; SSM = Single Supervisory Mechanism.
Figure 3.
Figure 3.

Euro Area—Macroeconomic Conditions and Bank Health

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: FitchConnect; Haver Analytics; and IMF staff estimates.Note: Euro area SSM-bank sample; asset-weighted ratios of bank indicators. SSM = Single Supervisory Mechanism.

Despite higher capital buffers, European banks have been suffering from chronic low profitability. The return on assets (ROA) of many European banks has declined since the GFC (Table 1 and Figure 3, right panel), with euro-area banks’ ROA below those in other advanced economies in 2019 (Figure 4, panel 1). Even before the pandemic, analysts did not expect ROA and return on equity (ROE) to rise above levels that investors would find attractive. The limited ability of European banks to build up CET1 capital from retained earnings has been driving down price-to-book ratios of bank equities, especially in the euro area where a quarter of banking system assets were trading with price-to-book ratios below 0.4 in 2019, a share that has increased further in 2020 (Figure 4, panel 2).

Figure 4.
Figure 4.

Bank Profitability and Price-to-Book Ratios

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

The health of the banking system in aggregate masks wide variation among countries. CET1 capital ratios and profitability (ROA) vary greatly among European countries (Figure 5, Panel 1). In general, euro area banks underperform their peers outside the bloc, especially in the largest economies. Banks also differ considerably in asset quality. Even though NPLs have significantly declined since the GFC, some more vulnerable euro area economies (for example, Cyprus and Greece) continue to carry a large stock of NPLs (shown as the share of Stage 3 loans in Figure 5, panel 2). In addition, in these countries, the high share of Stage 2 loans indicates that a significant amount of loans were on the cusp of becoming NPLs. While the transition of loans into Stage 2 prior to the pandemic was limited (ECB 2019, 2020d), the disproportionately high share of these loans covered by debt moratoria suggests latent asset quality pressures.

Figure 5.
Figure 5.

Cross-Country Variation of Profitability, Capitalization, and Loan Classification, 2019

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority 2020 Transparency Exercise; and IMF staff calculations.Note: CET1 = common equity Tier 1; EBA = European Banking Authority; ROA = return on assets. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Chapter 3 Banks’ Vulnerability to the Pandemic

The pandemic forced governments to lock down contact-intensive businesses, with the stringency of containment measures varying among countries (Figure 6). Furthermore, the demand for services requiring personal contact plummeted. Firms in these sectors, especially those with pre-pandemic liquidity and solvency concerns, could face bankruptcy if they are unable to tide over their liquidity needs with new bank loans.

Figure 6.
Figure 6.

Stringency of Containment Measures and GDP Growth

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: IMF, World Economic Outlook database; Oxford Coronavirus Government Response Tracker (OxCGRT); and IMF staff calculations.Note: Data labels use International Organization for Standardization (ISO) country codes.1 The index is based on eight policy indicators that aim to measure the strictness of “lockdown style” policies (for example, school closures and restrictions in movement). These indicators simply record the number and strictness of government policies and should not be interpreted as “scoring” the appropriateness or effectiveness of a country’s response.

European banks are heavily exposed to economic sectors hit hard by the pandemic. More than 60 percent of banks’ corporate exposures are to sectors that have been highly affected by the pandemic, especially accommodation and food services, real estate and retail trade, and to a lesser extent, construction and transportation. Bank lending to firms in these sectors is about 200 percent of Tier 1 capital on average and exceeds 250 percent in some countries, such as Finland, Germany, Greece, and Italy (Figure 7). Among the sub-sectors, there is substantial exposure to specific real estate activities, such as commercial real estate (CRE) businesses that faced the closure of shopping malls and offices. In addition, more than half of bank lending is to households, especially in the form of mortgages, which are increasingly affected by adverse income and employment prospects. These exposures are putting pressure on banks’ profit and capital positions and will continue to do so as the crisis evolves.

Figure 7.
Figure 7.

Large European Banks’ Exposure to Highly Affected Sectors

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Firms in Europe face an unprecedented synchronized shock to liquidity and solvency, although the decisive policy response of governments has effectively staved of the increase in insolvencies so far (EC 2021b). Chapter 3 of the IMF Regional Economic Outlook (REO) for Europe in October 2020 (IMF 2020c) uses detailed balance sheet and income statement data for millions of European companies to show that 30 to 40 percent of firms in advanced Europe and up to 50 percent in emerging Europe would face liquidity gaps in 2020 absent supportive policies, with such gaps being most concentrated among small and medium enterprises (SMEs) whose access to external finance would be more curtailed.1 The share of insolvent firms, that is, firms with negative net worth, could rise to 20 to 30 percent in the median advanced and emerging European economy, respectively.2 However, policy support from European authorities is expected to play a vital mitigating role—as discussed in the next chapter—reducing the number of illiquid firms in Europe by about two-thirds, and, by design, reducing the number of insolvent firms by a lesser amount.3

Chapter 4 Policy Measures to Support Banks, Firms, and Households

Regulators provided substantial capital and liquidity relief for banks to strengthen their capacity to absorb losses while continuing to lend. Banks were allowed to use their combined capital buffers and were temporarily allowed to operate below the level of capital required under Pillar 2 guidance (Figure 8) and the liquidity coverage ratio. Prudential authorities also temporarily granted flexibility in the classification and greater clarity on the provisioning of loans backed by public support measures (EBA 2020e).1 These temporary measures, which have been enhanced by lower countercyclical capital buffers set by national macroprudential authorities, have provided substantial capital relief. Together with capital conservation measures, such as restrictions on dividend distribution and share buy backs, this has supported bank lending.

Figure 8.
Figure 8.

Stylized Stacking of Capital Elements

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: Basel Committee on Banking Supervision; European Banking Authority; and authors.Note: CET1 = common equity Tier 1; CRD = Capital Requirements Directive; GSII = global systematically important institutions; O-SII = other systematically important institutions; SRB = systemic risk buffer.

Many European countries have implemented policy measures to support the real economy and reduce bank credit risk. A range of policy measures aim to support firms and households. On the labor side, several economies have substantially expanded short-time work schemes to protect jobs and household incomes (IMF 2020a). These schemes encourage firms to retain their workforce by using public funds to supplement up to 70–80 percent of employees’ pay for the hours not worked. Several countries have also provided direct liquidity support to firms and households in the form of cash grants, as well as tax deferrals and expanded direct lending to firms. Meanwhile, governments have introduced a range of loan guarantee programs for firms, especially SMEs. Debt service moratoria or repayment holidays for households and firms were also introduced by governments or as private-sector initiatives by the banking sector.

Loan guarantees have been one of the main instruments employed by European countries. According to a survey of IMF “desk economists” for 44 European countries, 39 countries offer pandemic-related guarantee programs, although the actual take-up of guarantee programs varies among countries. Guarantees are channeled either through existing development agencies or through newly established guarantee funds. The size of the overall envelope for guaranteed loans varies markedly among countries, with seven countries offering an envelope well in excess of 10 percent of GDP (Figure 9). Public guarantee programs are often targeted at SMEs; for example, guarantee programs in Norway, Portugal, and Serbia are exclusively for SMEs, while more than 90 percent of the total guarantee envelope in Slovenia, Switzerland, and the United Kingdom is for SMEs. Guarantees tend to have a coverage ratio of 70 to 90 percent, which is expected to be high enough to incentivize banks to extend loans while mitigating the risks of moral hazard by leaving some credit risk with banks. For EU member countries, 100 percent government guarantees are allowed only for loans up to €800,000 according to the State Aid rules.2

Figure 9.
Figure 9.

Total Envelope of COVID-19 Pandemic-Related Public Guarantee Program

(Percent of projected 2020 GDP)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: IMF staff.Note: KfW = Kreditanstalt für Wiederaufbau; SME = small and medium enterprise; WSF = Wirtschaftsstablisierungsfonds. Data labels in the figure use International Organization for Standardization (ISO) country codes. Data as of the end of September 2020.1 Include (1) KfW’s “Quick loan,” (2) KfW’s standing guarantee programs that were expanded during the COVID-19 pandemic, and (3) Economic Stabilization Fund (“WSF”).

Government guarantees on new loans helped firms obtain bank loans to tide over liquidity and working capital needs. Indeed, euro area bank lending growth increased from 5 percent (year over year) at the beginning of 2020 to nearly 9 percent (yoy) in May amid very strong precautionary cash demand (see Figure 2). Even though new lending growth to firms fell to about 6½ percent (year over year) by October, the rate is double of that observed on average over the last few years. Government guarantees do not carry high capital costs for banks as the risk-weights on such loans are lower.

Debt service moratoria have also been widely introduced to mitigate the liquidity concerns of households and firms. Our survey indicates that 38 European countries have introduced debt service moratoria. Such moratoria can be based either on the applicable national law (legislative moratoria) or on the private initiatives of the banking industry (non-legislative moratoria). In most countries, moratoria were provided for both households (mortgage and consumer loans) and businesses (Figure 10). The duration of moratoria originally ranged from three to six months, and was extended in some countries into 2021 (Figure 11). Temporary debt service moratoria can alleviate liquidity concerns for households and businesses and help them tide over difficult times while minimizing the loss of private consumption.

Figure 10.
Figure 10.

Key Beneficiaries of Debt Service Moratoria

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Systemic Risk Board; national authorities; and IMF country survey.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.
Figure 11.
Figure 11.

Duration of Pandemic-Related Debt Service Moratoria

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Systemic Risk Board; national authorities; and IMF country survey.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Debt service moratoria entail a mixed impact on bank profitability. On the one hand, such moratoria entail a loss of interest income for banks.3 On the other hand, prudential authorities were quick to emphasize flexibility in the classification of loans eligible for debt repayment relief.4 EBA, tasked with ensuring consistent application of the EU banking rules, published temporary guidelines in April 2020 advising banks and supervisors to (1) “look through” the transitory systemic shock as they assessed risks, (2) suspend days-past-due automaticity in classifying loans as forborne or defaulted, and (3) focus on identifying borrowers that might face longer-term financial difficulties. In mid-September, EBA announced that its temporary guidelines emphasizing flexible provisioning would lapse at the end of the month, but then reinstated the guidelines in December while emphasizing that banks need to recognize credit risk in a timely way.

Deferred bankruptcy proceedings are likely to delay loan write-offs due to corporate default. Most countries adopted insolvency mor-atoria for about half a year from the end of March 2020 onward (Figure 12). Thus, a potential deterioration of asset quality due to higher borrower default risk resulted first and foremost in higher loan loss provisions without significant loss recognition through write-offs. Banks did not reach the point of being forced to write of bad loans of insolvent companies if consensual debt resolution and/or workout fail. However, once the insolvency moratoria fully expire, there could be cliff-edge risks of suddenly rising bankruptcies, adversely impacting bank capital.5

Figure 12.
Figure 12.

Duration of COVID-19 Pandemic-Related Insolvency Moratoria

(Number of months)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: National authorities; and IMF staff calculations.Note: EA = euro area; EEA = European Economic Area; EU = European Union. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Chapter 5 Analytical Framework

We adopt a standard top-down stress testing approach, using publicly available data to assess banks’ capital buffers in the face of the pandemic shock. Over the past decade, bank stress testing has rapidly evolved to become a key aspect of the IMF’s Financial Sector Assessment Program (FSAP) (Ong and Jobst 2020).1 Stress testing has also grown in importance for many IMF member countries as a forward-looking technique for supervisors and macro-prudential authorities to identify vulnerabilities to a deteriorating operational and market environment affecting banks’ overall risk profile. In this paper’s context, we focus on the implications of the COVID-19 shock on bank capital as a critical determinant of the banking sector’s ability to lend and support the economic recovery.

The exercise uses a variety of data sources.

  • First, detailed data from EBA’s 2020 Transparency Exercise (EBA 2020d) for 117 large European banks are used for the main exercise, although the results focus on 90 euro area banks from this “EBA sample.” The dataset includes each bank’s exposures to firms, including granular information on sectors as well as detailed information on risk weights, impairments, loan loss coverage, and asset recovery rates.

  • Second, these data are combined with bank-specific time-series data over 2008–19 on key performance variables from FitchConnect, such as categories of assets, capital levels, profitability (ROA), NPLs, and lending growth. These data feed into empirical models linking macroeconomic performance to ROA, ROA-components, loan growth and NPLs. For this purpose, macroeconomic data, including baseline projections for GDP growth and unemployment rate are taken from the IMF World Economic Outlook database.

  • Third, beyond the core sample of large banks in the EBA Transparency Exercise, we use data from S&P Global Market Intelligence to expand our coverage to smaller euro area banks as well as banks in advanced and emerging market economies in Europe outside the euro area. The sample coverage of the various datasets is shown in Figure 13.

Figure 13.
Figure 13.

Sample Coverage

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: IMF staff.Note: (x/x) indicates the number of banks covered in the “EBA coverage” and “extended coverage.” “EBA coverage” = 117 EU/EEA banks, of which 90 are the largest euro area banks (~SSM); “Extended coverage” = 467 European banks (covering all European IMF member countries, except Andorra, Israel, Kosovo, Moldova, and North Macedonia), of which 138 are euro area banks; includes the “EBA coverage.” EBA = European Banking Authority; CESEE = Central, Eastern, and Southeastern European economies; SSM = Single Supervisory Mechanism.1 Fourteen advanced economy euro area countries (85/181): Austria (6/19), Belgium (6/15), Cyprus (2/9), Finland (4/10), France (8/10), Germany (15/26), Italy (11/16), Ireland (3/9), Greece (4/8), Luxembourg (3/13), Malta (2/9), Portugal (5/11), Netherlands (5/12), Spain (11/13).

The impact on bank capital derives from three channels—profitability, assets, and risk weights—each of which interacts with policy measures (Figure 14). In response to the worsened macroeconomic conditions and heightened probability of default, banks are likely to (1) raise provisions for higher loan losses across all asset types (mortgage, consumer and corporate lending), and face lower income from nonlending activities; (2) write of a rising share of nonperforming loans to insolvent borrowers and bankrupt firms with rapidly diminishing prospects for effective collateral recovery; and (3) face higher credit risk weights. Starting with the 2019 CET1 capital ratio, the projected profitability (that is, ROA) for subsequent years is added to it. This is because retained earnings from net profits—after accounting for dividend payouts and taxes—organically increase banks’ CET1. The extraordinary shock arising from corporate sector bankruptcies is deducted from both assets and capital, and risk-weights on existing and new assets are adjusted up. However, policies help cushion some of these effects. Different complementary approaches are used to estimate the propagation of the macroeconomic impact through each of the channels. In what follows, each of these channels, their estimation, and the effect of policies, is described in greater detail (also see Annex 2).

Figure 14.
Figure 14.

Capital Impact through Three Channels

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: IMF staff.

The profitability channel comprises the impact of macroeconomic conditions and bank-specific variables on net operating income and its components. Following Elekdag, Malik, and Mitra (2020) as well as Jobst and Weber (2016), the empirical “satellite model” uses bank-by-bank panel data for 41 European countries over 2008–2019 at a consolidated level. The linear specification of the model tends to generate a conservative estimate of the change in banks’ profitability across the entire loan portfolio, covering both household and corporate lending.2

The results of the satellite model show that ROA is mainly influenced by real GDP growth and the unemployment rate, along with the past ratio of NPLs to gross loans. Every 1 percentage point decline in real GDP growth reduces the ROA of large euro area (SSM) banks by 27 basis points, while a 1 percentage point increase in the unemployment rate reduces their ROA by 21 basis points, and a 1 percentage point increase in the last period’s NPL ratio reduces ROA by 15 basis points (Table 2). There is some variation in the sensitivity to these variables across different sub-samples, with smaller banks facing a somewhat smaller impact from macroeconomic conditions but a larger impact from past NPLs. However, the differences are relatively small, particularly given the large variation in bank performance in the sample and their underlying balance sheet exposures. The effects on ROA can be further disaggregated by its components—net interest income/ assets, noninterest income/assets, loan-loss provisions/assets, and operational cost/assets. Quantitatively, the most important of these components is the increase in loan loss provisions (see Annex 2). The corresponding satellite model for loan loss provisions is in turn used to estimate the expected provisions in the absence of policies and applied further to derive the change in credit risk weights (see below and Annex 2).

Table 2.

Factors Impacting Profitability

article image
Source: IMF staff.Note: EA = euro area; EA, ex. SSM = euro area non-SSM banks; EBA = European Banking Authority; NPL = nonperforming loan; ROA = return on assets; SSM = sample of large euro area banks that are supervised by the Single Supervisory Mechanism. ***p < 0.01, **p < 0.05, *p < 0.1.

The asset channel comprises two components, the first of which is the write-of component. The pandemic is expected to lead to a surge in bankruptcies and associated loan losses above historical averages. These loans will need to be written of after accounting for existing loan loss reserves.3 The amount of impaired corporate loans is derived from the analysis in Chapter 3 of the October 2020 Regional Economic Outlook: Europe. In particular, the share of firms in each sector in each country projected to become both illiquid and insolvent is mapped into banks’ sectoral exposures to corporates to derive the share of credit defaults and related loan write-offs (Box 1).4

The second component of the asset channel is the pace of loan growth. We assume that supply factors are the binding constraints on loan growth in the current crisis. This is because corporate credit demand has been very strong during the pandemic, in part to fund working capital needs. This experience differs from that of the GFC when credit demand fell significantly (Figure 15). In our empirical model, we link changes in lending to initial bank capital ratios—a 1 percentage point lower CET1 ratio is associated with a 0.6 percentage point decline in credit growth (Annex Table 2.4). In turn, lower credit growth directly reduces asset growth in the next period, mechanically generating an increase in the capital ratio.

Figure 15.
Figure 15.

Selected Euro Area Countries: Changes in Credit Demand

(Net percentage change; +/= increase)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Central Bank; Haver Analytics; and IMF staff calculations.Note: GFC = global financial crisis; NFC = non-financial corporations. Data labels in the figure use International Organization for Standardization (ISO) country codes. Changes in credit demand during the respective quarter(s) based on net percentages calculated as the difference between banks seeing increasing versus decreasing demand. Contributing factors do not add up to the overall assessment of demand conditions. For the global financial crisis and COVID-19 crisis periods, the quarterly values are averaged.

Because the asset channel comprises two conceptually distinct components, the impact of an economic shock through this channel depends empirically on the balance between the components. A negative shock that simultaneously causes an increase in write-offs and a reduction in new lending will generally have an ambiguous effect on capital ratios, which will tend to fall due to higher write-offs but rise due to lower lending.

Finally, changes to credit risk weights of bank assets also affect the capital ratio. We adjust the riskiness of corporate, consumer and mortgage exposures by updating their model-implied probability of default (PD) consistent with changes in loan loss provisions.5 We extract the one-year PD from credit risk weights (as reported in the EBA Transparency Exercise 2020 on a bank-by-bank basis) using the internal ratings-based approach (IRB) formula for credit risk in the Basel framework. The increase in loan loss provisions, in turn, is estimated from sub-components of the ROA satellite model described above.6 In our calculations, we apply uniform but asset class-specific recovery rates and maturities for each country based on EBA’s latest quarterly risk parameters (EBA 2021b) and its recent report on the effectiveness of national insolvency frameworks (EBA 2020c).

Several policy measures, both on the demand and supply sides, affect each of the three channels. On the demand side, grants, tax deferrals / exemptions, and wage subsidies to firms reduce their default probability and thus reduce write-offs to banks’ loan exposures (“asset” channel). Credit guarantees reduce expected losses from borrowers and debt moratoria reduce the default risk of borrowers, slowing the rise in banks’ provisions (“profitability channel”) and risk weights (“risk channel”). But moratoria also weigh on bank profitability through deferred or lost interest income, and from caps on the interest rate of some guaranteed loans (Figure 16). On the supply side, banks benefit from a wide range of prudential measures, especially significant relief from various capital buffer requirements (such as the countercyclical capital buffer and systemic risk buffer) and delayed provisions in the absence of an automatic reclassification of impaired loans under moratoria.7 These supply side measures act through all three channels by delaying loss recognition and dampening the rise in provisions and risk weights. For the latter, we assume a sluggish adjustment of provisioning for loans subject to debt moratoria relative to expectations (based on satellite model estimations; see Annex 2).

Figure 16.
Figure 16.

Policy Measures and Model Treatment

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: Authors.Note: LGD = loss-given-default; PD = probability of default; RW = risk weight; RWA = risk-weighted assets; SME = small and medium enterprises.

The stress test covers two macroeconomic scenarios, using publicly available data on bank performance. The first scenario is calibrated to the baseline growth and unemployment forecast of the January 2021 World Economic Outlook (WEO) Update, which shows a sharp and unprecedented recession in 2020, followed by a partial recovery in 2021 (Figure 17).8 An illustrative adverse scenario modeled in the January 2021 WEO Update sees a slower recovery in 2021. Such an adverse scenario is projected to materialize if vaccinations proceed slower than expected and more stringent or longer-lasting containment measures lead to deeper economic scarring.

Figure 17.
Figure 17.

Specifications of Macro Scenario: Real GDP Growth

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Central Bank; and IMF staff calculations.1 January 2020 World Economic Outlook Update. 2 January 2021 World Economic Outlook Update.

Assumptions about the duration of the policy measures and the evolution of their take-up guide the distribution of bank losses over a two-year horizon until end-2021. We calibrate the duration of each bank and borrower-level policy measure—most notably public loan guarantees, debt moratoria and deferred insolvency proceedings—to the announced length of each measure in each country. This granular approach allows us to account for the policy impact in a more precise and flexible manner. For example, the legal requirement to file bankruptcy in Germany was suspended from May until the end of September 2020 for firms which are illiquid (and until the end of April 2021 for liquid but insolvent firms receiving grants under the November– December aid programs). We thus assume that only 15 percent of the total estimated bankruptcies would materialize in banks’ balance sheet write-offs in 2020, with the remainder materializing in 2021.

Determining the Corporate Default Risk Shock

We specify the deterioration of corporate risk as a single-factor shock by combining bank-specific exposure data with expected loss rates across all sectors. While the general impact of changes in macroeconomic conditions on bank profitability already includes higher provisioning expenses and impairment charges, the extraordinary economic contraction during the COVID-19 crisis (with potentially significant scarring effects) is likely to result in a more profound impact on corporate default risk beyond the level suggested by historical inference. Corporate exposure data are extracted from the detailed composition of sectoral corporate exposures of sample banks covered by the EBA’s annual Transparency Exercise (EBA 2020f). The loss rates for each sector (at the NACE2 level) are based on the findings of Chapter 3 of the October 2020 REO: Europe (IMF 2020c), which determine the “financial status” of all sample firms in each country and sector after accounting for the impact of the crisis on their assets and liabilities, as well as on revenues and profitability. This can be summarized in a 2x2 matrix of solvency and liquidity conditions (Box Figure 1.1).

Box Figure 1.1.
Box Figure 1.1.

Corporate Risk Matrix

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: Authors.

We first update the Regional Economic Outlook results with the January 2021 World Economic Outlook Update macroeconomic forecasts (IMF 2021a). This update uses historical growth elasticities (Box Figure 1.2). These estimates are then used to derive, for each sector and country, the change in each firm’s “financial status,” which is aggregated to the share of firms that are likely to default in 2020–21—with and without the risk mitigating impact of policy measures.

Box Figure 1.2.
Box Figure 1.2.

Euro Area: Elasticity of Estimated Firm Bankruptcies (Illiquid and Insolvent)

(Average percentage point change to 1 pp decrease of GDP growth)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: IMF staff estimates.1 Debt repayment relief (moratoria) for businesses and households, corporate credit guarantees, delayed insolvency proceedings, and dividend restrictions (only in 2020).

The exercise follows a two-step process:

  • First, we determine the within-sector, debt-weighted share of firms that are likely to become illiquid and insolvent (Box Figure 1.3, panel 1), which define the sector-specific default rates—with and without policy measures—in each country. The share of firm debt in major European advanced economies that is estimated to be at risk of default ranges from 2 percent in Germany to 7 percent in Italy, reflecting the structure of the economy (for example, tourism dependence), as well as initial financial conditions in the corporate sector. For illustrative purposes, the sectoral exposures have been grouped into “highly affected” and “other” sectors in each country.

  • Second, we map these default rates to each bank’s actual corporate exposure to each sector (Box Figure 1.3, panel 2) to determine the additional corporate default losses for each bank (Box Figure 1.3, panel 3). These losses feed into our model as an additional corporate shock in addition to the general deterioration of bank profitability and asset quality across all credit types.1 We translate these estimated loan losses to bank-level loan write-offs, after accounting for existing loan loss coverage (including the flow of new provisions in 2020) and the average recovery value of collateral (proxied by public information on so-called “loss-given-default” for corporate exposures in each country).

Box Figure 1.3.
Box Figure 1.3.

Mapping Corporate Vulnerability to Banks’ Corporate Loan Default Risk

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; and IMF staff estimates.Note: The grey shaded area of the boxplots shows the interquartile range (25th to 75th percentile), with whiskers at the 5th and 95th percentile of the distribution. Data labels in the figure use International Organization for Standardization (ISO) country codes.1 Debt repayment relief (moratoria) for businesses and households, corporate credit guarantees, delayed insolvency proceedings, and dividend restrictions (only in 2020).2 Highly affected sectors include construction, wholesale/retail trade, transport and storage, accommodation and food services, real estate activities,

We find that policies can significantly mitigate the impact of the crisis on corporate risk and therefore on bank expectations of corporate loan defaults over the stress test horizon. There is also large variation across countries in the magnitude of the policy impact. For example, policies reduce loan losses by half in Germany and by two-thirds in France. Since we cover two time periods, 2020 and 2021, we control for the effect of deferred insolvency proceedings in many countries, which delays the materialization of corporate defaults (and the extent to which banks incur write-offs). On average, only 15 percent of the calculated corporate shock occurs in 2020, and the remainder spills over into the next year.

We further use other elements of the corporate risk matrix (Box Figure 1.1) to adjust the changes in profitability and risk weights related to banks’ corporate exposures. For instance, the estimated increase of the share of liquid but insolvent firms (top right quadrant in Box Figure 1.1) raises specific provisions and informs the degree of potential under-provisioning of corporate loans subject to debt moratoria, applying the EBA transition probabilities between credit risk stages (“IFRS 9 staging”), as detailed in Annex 2.

1 See Mojon, Rees, and Schmieder (2021) for a similar analysis using corporate exposures of banks in G-7 countries, Australia and China.

Chapter 6 Results

Overall, the results suggest that banks are likely to remain resilient under the baseline scenario albeit with a sizeable narrowing of buffers. Under the baseline scenario, and accounting for granular borrower support measures, we find that the aggregate CET1 capital ratio for large euro area banks declines from 14.7 to 13.0 percent by the end of 2021 (Figure 18, panel 1). The capital erosion decreases by about one-third if banks continue to refrain from dividend distributions in 2021 (Figure 19).

Figure 18.
Figure 18.

Euro Area Banks: Solvency Stress Test—Baseline Scenario (EBA Coverage)

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; European Systemic Risk Board; FitchConnect; S&P Global Market Intelligence; and IMF staff estimates.Note: CCB = capital conservation buffer; CESEE = Central, Eastern, and Southeastern European economies; CET1 = common equity Tier 1; EA = euro area; EU = European Union; MDA = maximum distributable amount (weighted average). Data labels in the figure use International Organization for Standardization (ISO) country codes. The grey shaded area of the boxplots shows the interquartile range (25th to 75th percentile), with whiskers at the 5th and 95th percentile of the distribution. The analysis covers all three channels affecting the capital adequacy ratio under stress—profitability (net interest income and provisions), nominal assets (net lending and charge-offs after reserves), and risk exposure (changes in credit risk weights).1 Due to corporate write-offs and net lending—corporate write-offs of new debt-at-risk due to a higher share of illiquid and insolvent firms (weighted by outstanding debt and mapped to the sector-by-sector corporate exposure of sample banks).2 Debt repayment relief (moratoria) for businesses and households, corporate credit guarantees, delayed insolvency proceedings, and dividend restrictions (only in 2020).3 The Slovak Republic is not included in the EBA Transparency Exercise.4 Net profitability impact of policy measures (lower provisions for guaranteed loans to solvent corporates, some loss forbearance on eligible loans under moratoria, and decline in interest income due to duration of debt moratoria (households and businesses)) and change in net operating income after general provisions (including non-interest income and impairment charges for non-corporate exposures) due to lower GDP growth and higher unemployment rate.5 Increase of credit risk weights due to higher unexpected losses (derived from the increase of default risk implied by the projected increase of general provisions and specific provisions for additional corporate loan losses) and lower credit risk weights for guaranteed portion of corporate loans.
Figure 19.
Figure 19.

Euro Area Banks: Change of CET1 Capital Ratio under Different Assumptions

(Percentage points, end-2021 relative to end-2019)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; FitchConnect; S&P Global Market Intelligence; and IMF staff estimates.Note: CET1 = common equity Tier 1.1 Debt repayment relief (moratoria) for businesses and households, public credit

Supportive policies significantly mitigate the impact on bank capital. Without supportive policies, capital erosion would be 1.7 percentage points larger, or roughly double the scale of capital depletion (Figure 18, panels 1 and 2). With supportive policies, the profitability channel is estimated to reduce the CET1 capital ratio by 0.7 percentage points, slightly larger than the impact from the asset and risk weight channels of 0.5 percentage points respectively (Figure 18, panels 3 and 4). Meanwhile, without policy measures, lower profitability explains most of the capital depletion, together with an increased contribution from higher credit risk weights. However, the asset channel now acts to slightly increase the capital ratio, with the reduction in lending (which mechanically lowers the denominator of the capital-asset ratio) dominating the impact of capital depletion from higher write-offs.

CET1 capital ratios are sensitive to both macroeconomic conditions and the initial health of the bank balance sheets. The pandemic shock to macroeconomic conditions (that is, GDP growth and unemployment rates) exerts its impact on banks’ CET1 capital ratio through all the three channels discussed above (profitability, assets, and risk weights). In general, about half of the CET1 capital decline before policy support can be attributed to the macro-economic shock. However, various initial conditions also influence the outcome. As expected, banks with better pre-stress asset quality (and to a smaller extent, those with higher profitability at the beginning of the crisis) are likely to experience smaller declines in their CET1 ratios (Figure 20). This illustrates that banks that have aggressively reduced their stocks of legacy NPLs and adopted measures to strengthen operational efficiency before the crisis seem to now benefit from greater resilience in times of stress.

Figure 20.
Figure 20.

European Banks (EBA Sample): Capital Impact and Pre-Stress Bank Asset Quality

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; FitchConnect; and IMF staff estimates.Note: Excludes outlier banks with pre-stress NPL ratios of more than 10 percent as well as banks with a post-stress change in the CET1 capital ratio of more than 5 percentage points. CET1 = common equity Tier 1; NPL = nonperforming loan.

There is no capital shortfall relative to the minimum capital requirement in our baseline results. No bank breaches the regulatory minimum of 4.5 percent even without policy support. However, several banks would breach a hurdle rate comprising both the regulatory minimum and capital conservation buffer (7 percent) without policy support. Policy support is expected to improve bank solvency, lifting the aggregate CET1 ratio to above the 7 percent threshold in all countries (see Figure 25).

Figure 21.
Figure 21.

Euro Area Banks: Changes in Capital and Growth

(Baseline scenario [percent], EBA coverage)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; FitchConnect; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. CET1 = common equity Tier 1; EBA = European Banking Authority.1 Debt repayment relief (moratoria) for businesses and households, public credit guarantees, deferred insolvency proceedings, and dividend restrictions (only in 2020).
Figure 22.
Figure 22.

Euro Area Banks: Dispersion of Change in Risk Weights

(Baseline scenario [percent], EBA coverage)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; FitchConnect; and IMF staff estimates.Note: EBA = European Banking Authority. The grey shaded area of the boxplots shows the interquartile range (25th to 75th percentile), with whiskers at the 5th and 95th percentile of the distribution.1 Debt repayment relief (moratoria) for businesses and households, corporate credit guarantees, delayed insolvency proceedings, and dividend restrictions (only in 2020).
Figure 23.
Figure 23.

Selected Euro Area Countries: Change in NFC Credit Standards

(Net percentage change; +/= tightening)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Central Bank; Haver Analytics; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. GFC = global financial crisis; NFC = nonfinancial corporations. Changes in credit standards during the respective quarter(s) based on net percentages calculated as the difference between banks with tightening versus easing credit standards. Contributing factors do not add up to the overall assessment of credit standards. For the global financial crisis and COVID-19 crisis periods, the quarterly values are averaged.
Figure 24.
Figure 24.

Euro Area Banks: Solvency Stress Test—Adverse Scenario (EBA Coverage)

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; European Systemic Risk Board; FitchConnect; S&P Global Market Intelligence; and IMF staff estimates.Note: CCB = capital conservation buffer; CESEE = Central, Eastern, and Southeastern European economies; CET1 = common equity Tier 1; EA = euro area; MDA = maximum distributable amount (weighted average). Data labels in the figure use International Organization for Standardization (ISO) country codes. The grey shaded area of the boxplots shows the interquartile range (25th to 75th percentile), with whiskers at the 5th and 95th percentile of the distribution. The analysis covers all three channels affecting the capital adequacy ratio under stress—profitability (net interest income and provisions), nominal assets (net lending and write-offs after reserves), and risk exposure (changes in credit risk weights).1 Due to corporate write-offs and net lending—corporate write-offs are due to the rise of illiquid and insolvent firms (weighted by outstanding debt and mapped to the sector-by-sector corporate exposure of sample banks).2 Debt repayment relief (moratoria) for businesses and households, corporate credit guarantees, delayed insolvency proceedings, and dividend restrictions (only in 2020).3 The Slovak Republic is not included in the EBA Transparency Exercise.4 Net profitability impact of policy measures (lower provisions for guaranteed loans to solvent firms, loss forbearance on eligible loans under moratoria, and decline in interest income due to duration of debt moratoria (households and businesses)) and change in net operating income after general provisions and losses on other noninterest income due to lower GDP growth and higher unemployment rate, including impairment charges for noncorporate exposures.5 Increase of credit risk weights due to higher unexpected losses (derived from the increase of default risk implied by the projected increase of general provisions) and additional specific provisions for additional corporate loan losses.
Figure 25.
Figure 25.

Euro Area Banks—Potential Capital Need and Number of Banks below Thresholds (EBA Coverage)

(EUR billion/count)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: Authors’ calculations.Note: EBA = European Banking Authority. The thresholds of 4.5 and 9.1 percent represent the regulatory minimum for the common equity Tier 1 capital ratio (assuming the current capital relief) and the average threshold for the maximum distributable amount for euro area banks, respectively. Sample of 90 banks covered by the EBA Transparency Exercise (“EBA Coverage”).

Some banks are likely to fall below their threshold for the Maximum Distributable Amount (MDA) if policies do not operate as expected. About 14 percent of the largest (90) euro area banks are likely to breach their MDA threshold, which varies by bank but averages about 9 percent of risk-weighted assets; this would require €25 billion of new capital (or 1.7 percent of reported CET1 capital at the end of 2019). However, with supportive policies, only a few smaller euro area banks would struggle to clear the MDA hurdle rate. Importantly, banks that cannot meet their MDA would be forced to stop dividends, and then suspend coupon payments to hybrid capital, which could result in a significant funding shock and lower market valuations, while also triggering negative credit rating actions. For many large banks, hybrid capital— which is senior to and hence cheaper than equity capital—is likely to be an important element of a strategy to replenish aggregate capital levels at a time when many banks face a high cost of capital.1

Policy support also helps limit greater dispersion in capital levels across larger banks. With large variation in the macroeconomic impact of the pandemic across countries, and widely different initial liquidity/solvency conditions of firms, the shock to bank capital varies greatly across countries absent any mitigating policies, leading to a higher dispersion in CET1 ratios among banks in the bottom half of the distribution (Figure 18, panels 1 and 2). With policies, the hit to capital ratios is smaller, as is the dispersion in capital ratios within the lower half of the CET1 distribution. In fact, policy measures considerably weaken the link between the severity of the macro shock and the change in bank capital ratios (Figure 21). The role of policies in reducing dispersion operates mostly through dampening the increase in risk weights (Figure 22). With policies, average risk weights among euro area banks increase by an average of about 1.7 percent; without policies risk weights increase by more than 4 percent and exhibit slightly larger upside dispersion.

Our assessment of capital under baseline conditions with policy measures seems consistent with current developments. Banks’ credit standards have not tightened commensurately with the outsized shock of the pandemic and compared to the GFC (Figure 23). But while regulatory flexibility and credit guarantees have cushioned the immediate impact of potential impairments, they have not altered the underlying increase in credit risk. Despite the still favorable credit standards, European banks’ willingness to lend over the near term remains subdued across the board, particularly for consumer, corporate, and commercial real estate lending (EBA 2020f). Indeed, banks in vulnerable countries have increased their loan loss provisions on precautionary grounds, and already report a net tightening impact of higher NPL ratios as the effect of the initial pandemic-related containment measures on borrowers becomes increasingly apparent. Although NPL ratios have continued to decline recently, other asset quality metrics already show signs of weakening; notably, forborne exposures and loans classified as “Stage 2” under IFRS-9 have both increased markedly.

While the capital impact in the baseline appears manageable, the materialization of downside risks would significantly increase capital pressures. In an illustrative adverse scenario, we assume a slower pace of economic reopening across countries, with cumulative GDP growth over 2020–21 being 1.2 percentage points below the baseline forecast. This could increase the debt over-hang and lead to liquidity pressures for firms, especially in vulnerable sectors, resulting in larger credit losses for banks. The CET1 capital ratio would decline by an additional 1 percentage point by the end of 2021—even with current policy measures in place (Figure 24). There would still be no aggregate capital shortfall relative to the prudential minimum of 4.5 percent; however, more than five percent of the large euro area banks (6 banks), would see their CET1 capital ratio drop below the MDA threshold, and, thus, come under additional capital market pressure (Figure 25). These banks are concentrated in Italy, Portugal, and Spain (Figure 23, panel 2). Without policies, more than a quarter of larger euro area banks (25 banks) would breach the MDA threshold, generating a capital need of nearly €47 billion relative to that threshold (or 3.1 percent of reported CET1 capital at the end of 2019). Careful communication of buffer usability and capital relief policies are therefore even more crucial in dampening the hit to bank capital under the adverse scenario (Figure 26). Finally, we should note that the WEO adverse scenario is relatively mild. Increasing the severity of the adverse scenario (similar to the one the ECB examined in its Vulnerability Analysis [Box 2]) would triple the additional output loss over the stress test horizon to about 3 percent, one bank would fall below the prudential minimum of 4.5 percent and a quarter of the banks would be at or below the MDA threshold—even with effective policy measures in place (Figure 27).

Figure 26.
Figure 26.

Euro Area Banks—Changes in Capital and GDP Growth, Adverse Scenario

(EBA sample)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; FitchConnect; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. EBA = European Banking Authority.
Figure 27.
Figure 27.

Euro Area Banks: Sensitivity of Projected CET1 Capital Ratio to the Severity of the Adverse Scenario

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Source: IMF staff estimates.Note: CET1 = common equity Tier 1; EBA = European Banking Authority.

Absent a material rise in profitability, replenishing bank capital buffers in an organic manner will take time. Assuming that banks revert to their long-term pre-crisis profitability of about 0.4 percent (without changing their leverage) and resume dividend payouts after this year, it would take them more than 2½ years on average to replenish their capital buffers by 1.6 percentage points (which corresponds to the expected capital depletion to a CET1 capital ratio of 13.1 percent at the end of this year) (Figure 28). However, if earnings capacity during the recovery phase were to be subdued, at about half the historical average, this would lengthen the duration of the capital replenishment path to more than five years. Alternatively, banks would need to nearly triple their long-term profitability to restore their pre-crisis CET1 capital ratio of 14.7 percent by the end of 2022.2

Figure 28.
Figure 28.

Euro Area Banks: Time to Restore Precrisis Capitalization (CET1 = 14.7%) through Profits after end-20211

(Years)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Central Bank; FitchConnect; and IMF staff calculations.Note: CET1 = common equity Tier 1; RoA = return on assets.1 Long-term average until end-2019.2 Assumptions: average asset risk weight = 40 percent, taxes = 20 percent, dividend payout ratio = 15 percent.

Comparison of Stress Test Results with the ECB Vulnerability Analysis

In July 2020, ECB Banking Supervision completed a Vulnerability Analysis (ECB, 2020a) of the largest euro area banks to the impact of the COVID-19 outbreak. The analysis focused on the early-stage impact of the crisis on the capital position of 86 banks directly supervised by the ECB and aimed to identify potential vulnerabilities over a three-year time horizon. The baseline scenario of this exercise (“central scenario”) projected a decline of economic activity by 8.7 percent in 2020, followed by a dynamic recovery in the subsequent years, with real growth of 5.2 and 3.3 percent in 2021 and 2022, respectively (Box Figure 2.1). Relative to the pre-crisis baseline forecast in December 2019, the “central scenario” assumes a cumulative output loss of 6.0 percent during 2020–21, which is similar to the 5.8 percent-decline under the baseline exercise—and more severe than the adverse scenarios of system-wide stress tests the ECB completed as part of EBA’s biannual exercise (Box Figure 2.2).1

Box Figure 2.1.
Box Figure 2.1.

GDP Growth

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Central Bank (ECB); and IMF staff calculations.1 January 2020 World Economic Outlook Update.2 January 2021 World Economic Outlook Update.3 ECB macroeconomic projections in December 2019.4 ECB macroeconomic projections in December 2020.5 ECB macroeconomic projections (baseline and adverse) in June 2020.
Box Figure 2.2.
Box Figure 2.2.

Comparison of Baseline Growth Shock in IMF and ECB Exercises Compared to Adverse Scenarios in EBA Stress Tests

(Percentage point deviation from [precrisis] baseline)1

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; European Systemic Risk Board; and IMF staff calculations.Note: EBA = European Banking Authority; ECB = European Central Bank; ST = stress test.1 Two-year cumulative deviation of real growth rate (for the ECB and EBA exercises, which cover three years, the first two years were chosen).2 Baseline projections based on IMF World Economic Outlook forecast in January 2021 for 2020 and 2021 (relative to precrisis forecast in January 2020).3 Based on ECB June 2020 baseline (“central”) forecast for 2020 and 2021 (relative to ECB precrisis baseline forecast in December 2019).4 Based on deviation of growth rate in adverse scenario relative to baseline forecast for euro area in EBA system-wide stress tests in 2014, 2016, and 2018.

The results from ECB’s analysis are consistent with those from our exercise and provide an important source of cross-validation. The ECB found that banks can withstand pandemic-induced stress under baseline conditions but that under the adverse scenario, depletion of bank capital would be material and several banks would need to take action to maintain compliance with their minimum capital requirements. More specifically, the CET1 capital ratio of banks declines by 1.9 percentage points in the baseline scenario over a three-year time horizon (Box Figure 2.3). This is similar to the result from our exercise, which identifies a 1.7 percentage point capital impact over a two-year period (after considering all relevant policy measures). Some of the difference might be explained by our more comprehensive coverage of supervisory and fiscal relief measures taken in response to the coronavirus crisis, including borrower support in the form of debt repayment relief and deferred bankruptcy proceedings, which were excluded from the ECB’s Vulnerability Analysis. We also find that the increase in the risk-weighting of credit sensitive assets would be considerably smaller than that projected by the ECB (assuming that the policy measures are effective) (Box Figure 2.4).

Box Figure 2.3.
Box Figure 2.3.

Euro Area Banks: Projected Change of CET1 Capital Ratio

(Percentage points, end-2021 relative to end-2019)1

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; S&P Global Market Intelligence; and IMF staff calculations.Note: CET1 = common equity Tier 1; ECB = European Central Bank.1 Based on EBA coverage of 90 euro area banks (“EBA sample”).
Box Figure 2.4.
Box Figure 2.4.

Euro Area Banks: Comparison of Average Change in Asset Risk Weights with ECB Vulnerability Analysis (Baseline Scenario)

(Percent)1

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; FitchConnect; S&P Global Market Intelligence; and IMF staff estimates.Note: ECB = European Central Bank.1 Averages weighted by assets.2 Debt repayment relief (moratoria) for businesses and households, corporate credit guarantees, delayed
1 The ECB analysis also included an adverse scenario incorporating a cumulative output loss of –9.3 percent (over the first two years of the stress test time horizon); this is considerably more severe than our adverse scenario and hence the results for capital ratios are not readily comparable with our exercise.

Chapter 7 Expanding the Analysis Beyond Euro Area Banks

Expanding the empirical coverage of the analysis to a broader set of banks provides additional insights into the Europe-wide capital impact of the COVID-19 crisis. We supplement the coverage of 90 euro area banks included in the EBA Transparency Exercise (EBA 2020f) (“EBA coverage”) with publicly available financial statement data from FitchConnect and S&P Market Intelligence. Increasing the original sample to 468 banks in 40 countries (Figure 13) provides for a more representative sample of banks and allows us to apply our methodology also to smaller euro area banks and European banks outside the euro area (that is, banks in non-euro area advanced economies and Central, Eastern and Southern European (CESEE) countries). The lack of information on granular bank-level sectoral exposure for banks that are not included in the EBA Transparency Exercise requires some approximations; for example, the sectoral exposure of smaller banks that are not included in the EBA Transparency Exercise is assumed to be same as the average sectoral exposure of banks included in the EBA Transparency Exercise in the same country.1 However, the sensitivity of profitability and its components, NPLs, and loan growth to macroeconomic variables and bank-level characteristics are estimated with subsample-specific coefficients from the satellite model to account for this more heterogenous set of banks (Annex 2).

The findings from the extended sample are similar to those in our main exercise (Figure 29).

Figure 29.
Figure 29.

Solvency Stress Test—Dispersion of CET1 Capital Ratio (Baseline Scenario/Extended Coverage)

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; European Central Bank; European Systemic Risk Board; FitchConnect; S&P Global Market Intelligence; and IMF staff calculations.Note: The grey shaded area of the boxplots shows the interquartile range (25th to 75th percentile), with whiskers at the 5th and 95th percentile of the distribution. CCB = capital conservation buffer; CESEE = Central, Eastern, and Southeastern European economies; CET1 = common equity Tier 1; MDA = maximum distributable amount (weighted average). The analysis covers all three channels affecting the capital adequacy ratio under stress—profitability (net interest income and provisions), nominal assets (net lending and write-offs after reserves), and risk exposure (changes in credit risk weights). The crisis-specific risk drivers of these channels are (1) write-offs due to the projected insolvency of illiquid and insolvent firms (weighted by outstanding debt and mapped to the sector-by-sector corporate exposure of sample banks); (2) the profitability impact of policy measures (lower provisions for guaranteed loans to solvent firms, loss forbearance on eligible loans under moratoria, and decline in interest income due to duration of debt moratoria); and (3) the increase in risk weights to the general increase of the default risk of mortgages and firms. In addition, there is a general change in net operating income after general provisions and losses on other noninterest income due to lower GDP growth and higher unemployment rate, including impairment charges for noncorporate exposures.1 Only larger banks covered by the EBA Transparency Exercise.2 Debt repayment relief (moratoria) for businesses and households, corporate credit guarantees, delayed insolvency proceedings, and dividend restrictions (only in 2020).
  • All euro area banks. The impact on bank solvency for all euro area banks, with and without policy measures, is slightly higher than for larger euro area banks included in the EBA Transparency Exercise. However, given their slightly higher CET1 capital ratio at the end of 2019 (14.9 percent, compared to 14.7 percent), the projected CET1 capital ratio under stress is about the same (Annex Figures 1.3 and 1.5). Euro area banks in the expanded sample are likely to absorb the capital impact without breaching regulatory capital requirements under both adverse and baseline scenarios. However, even under baseline conditions, about 9 percent of all euro area banks covered in the expanded sample are likely to breach their MDA threshold if policies do not operate as expected; this would require €26 billion of new capital (or 1.7 percent of reported CET1 capital at the end of 2019) to avert capital market pressure. With supportive policies, only about 3 percent of all euro area banks in our extended sample would struggle to clear the MDA hurdle rate, generating a capital shortfall of €0.6 billion. In the adverse scenario, the number of banks that are likely to fall below their threshold for the MDA doubles relative to the baseline results, with and without policies (Annex Figures 1.10 and 1.11).

  • Non-EU CESEE banks. Non-EU CESEE banks have a much lower CET1 capital ratio at end-2019 and are expected to suffer somewhat higher capital erosion than euro area banks, resulting in a projected CET1 capital ratio of 10.8 and 10.5 percent under the baseline and adverse scenarios, respectively (Annex Figures 1.12 and 1.13). Reflecting smaller policy space and associated less-generous support measures for borrowers and banks among non-EU CESEE countries, the cushioning effect of mitigation policies is estimated to be smaller than for euro area banks; mitigating policies lift CET1 capital ratios in non-EU CESEE banks by merely 0.4 percentage point, compared to around 1.3 percentage points among euro area banks covered by the EBA Transparency Exercise.2

Annex Figures 1.6 and 1.8 show that, similar to the largest banks in the EBA Transparency Exercise, banks in the expanded sample in the euro area and the EU would experience roughly balanced contributions from the three channels of transmission (profitability, assets, and risk weights) under the baseline policy scenario. Absent policies, the capital erosion among euro area and EU banks stemming from the profitability channel would become about three times larger, and twice as large from the risk weight channel in the baseline macro scenario. The relative importance of the profitability channel for the overall impact and policy responsiveness is preserved in the illustrative adverse scenario for the expanded euro area and EU banks sample, though absolute magnitudes of capital erosion are larger. In contrast, for non-EU CESEE banks covered in the expanded sample, the risk weight channel explains most of the decline in CET1 capital ratios (Annex Figures 1.10 and 1.11). The dominance of the risk weight channel reflects the low asset quality among many banks in the CESEE region, as a result of the rapid buildup of NPLs over recent years (Table 1), which exposes these banks to a disproportionate increase in unexpected losses and associated risk weights.

Chapter 8 Summary and Policy Implications

In summary, we find that European banks are likely to remain broadly resilient to the pandemic shock, but with considerable cross-country variation due to different macroeconomic paths, initial capital buffers, and levels of policy support. Most banks entered the pandemic with sizeable capital buffers, which helped cushion the direct effects of the crisis on asset quality. While bank capitalization remains appropriately high, a deterioration of asset quality is likely to adversely affect banks’ already low profitability, especially for those with significant credit exposures to firms operating in vulnerable sectors. During the first lockdown and subsequent reopening, fiscal support limited the rise in unemployment rates and firm bankruptcies. Banks were able to slowly absorb rising impairments without a significant change in their capital ratios given continued borrower support and effective capital conservation measures. However, we find a larger capital impact on banks in countries that have been hit especially hard by the pandemic, and for banks with higher initial NPLs and large exposures to highly affected sectors.

Credit supply constraints might arise as capital buffers are depleted. Even though both profitability and capital improve during the recovery phase in 2021, there is likely to be considerable drag from higher NPLs (Aiyar and others 2015). An erosion of capital buffers, if left unaddressed, could reduce loan growth going forward. The longer the crisis lasts, the higher the risk that banks will experience a significant deterioration in asset quality in their loan portfolios. Subdued economic activity owing to a delayed reopening would exacerbate the liquidity problems of borrowers and increase debt overhang, especially in vulnerable sectors. This would result in potentially much higher loan loss provisions and larger credit losses. In turn, banks’ diminishing capacity to lend would likely weigh on financing for consumption and investment at precisely the time when it is most needed. Lower capital buffers under the baseline scenario would force some banks to cut back lending to conserve capital. Estimates under the baseline scenario suggest that capital constraints could reduce lending growth by about 1.6 percentage points next year. However, if policy measures do not fully operate as expected, credit growth could slow by about 3 percentage points—corresponding to the average credit growth of large euro area banks in 2019.

Under the adverse scenario, the erosion of bank capital becomes much larger, especially after support measures expire and default risk increases. While potential capital shortfalls remain small, more banks would be likely to de-leverage to preserve sufficient capital to prevent market pressures as their CET1 capital ratios approach the MDA threshold.

These results suggest a multi-pronged strategy, focusing on the following areas.

Borrower Support

In the near term, bankruptcies could start rising as insolvency moratoria phase out while the expiry of other borrower support measures could increase credit risk and cause lending conditions to tighten (Figure 30). Governments should ensure a smooth transition by continuing some direct support for firms, targeting those whose operations have been temporarily impaired by health risks or social distancing restrictions and firms that are crucial for the economy to function, while facilitating the exit of unviable ones. Implementing such triage is inherently difficult, given the uncertainty surrounding the post-pandemic landscape. At this stage policymakers should err on the side of caution, recognizing that it is better to preserve some firms that will ultimately prove to be unviable than to allow the wholesale closure of viable firms. As the recovery gains momentum, eligibility criteria should be tightened to better target illiquid but viable firms in the most affected sectors and the most vulnerable households, while preventing credit misallocation and the rise of “zombie” firms. The following considerations should influence the trade-offs related to the scale and duration of borrower support measures:

  • Debt repayment relief. Under normal circumstances, the best form of debt-service relief is a tailored package offered by banks to a stressed but potentially viable borrower. Such operations should remain a core element of banks’ toolkits—to pre-empt missed payments or, failing that, to restore loans to performing status if current arrears are temporary and regular payments are expected to resume over a reasonable time horizon. The crisis has demonstrated that broadly available lifelines, such as general debt moratoria, can be effective in preventing widespread insolvencies of otherwise viable (but temporarily illiquid) borrowers. However, moratoria are not sustainable over a longer time horizon, since they defer banks’ accrued interest income, putting pressure on net operating income and potentially distorting asset valuations through inappropriate loan classification and loan loss provisions. Blanket moratoria also operate indiscriminately, raising questions of fairness and compensation for bank claimants, and potentially weakening the repayment culture. As the recovery takes hold, better targeting illiquid but viable firms and the most vulnerable households would make moratoria more effective and efficient. Available moratoria should be extended only if they do not risk distorting classification and provisioning requirements, while banks should be encouraged to restructure the debts of illiquid but likely viable borrowers.

  • Credit guarantees. As a tool for targeted support, public sector credit guarantees may be preferable to a mandatory blanket moratorium (Bhatia and others, forthcoming). The design of guarantees should ensure that banks’ incentives to select and service borrowers are aligned with the public sector interest of limiting losses beyond what is required to address any market failure (“skin in the game”). The realization of contingent liabilities could result in additional public debt and potentially increase the sovereign-bank nexus, especially in fiscally more vulnerable countries and less capitalized banking sectors (Lozano Guerrero, Metzler, and Scopelliti 2020).1

Figure 30.
Figure 30.

European Banks: COVID-19 Pandemic-Related Repayment Relief—Usage Rate and Share of Nonperforming Loans

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: European Banking Authority; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. EA = euro area; EEA = European Economic Area; HH = households; NFC = nonfinancial corporations; NPL = nonperforming loans.1 The usage rate refers to the share of the outstanding stock of loans that have been reported as being subject to debt repayment relief via legislated or non-legislated moratoria (based on as of the end of June 2020 values).2 Under IFRS 9 classification.

Capital Relief and Conservation Measures

  • Clarify the effective availability of capital buffers. Many banks have been reluctant to dip into capital buffers (ECB 2020b) since effective hurdle rates, such as the MDA, are much higher than the current prudential minimum.2 Supervisors encouraged banks to use their capital buffers (Figure 8; ECB 2021c). However, any breach of the combined buffer requirement, which forms a significant part of the MDA, will lead to restrictions on dividend distributions and coupon payments on hybrid capital.3 Since there is considerable overlap between the MDA and capital that in principle could be used to withstand stress, supervisors need to clearly convey to banks and investors the extent to which capital buffers can be used to avert market pressures.4 Beyond the specific concern about the MDA, there is a more general question as to whether the current “stacking” of banks’ capital provides sufficient flexibility to create releasable capital buffers during times of stress (Schmitz and others 2021).

  • Adopt a realistic timetable for replenishing capital buffers. Supportive financial sector measures, including restrictions on dividend payouts and share buybacks, should be maintained until the recovery is well underway.5 This would allow the gradual rebuilding of capital and liquidity buffers without impairing the capacity to lend. Current supervisory guidance states that capital buffers can be used through the end of 2021, and that the capital add-on under Pillar 2 Guidance does not need to be replenished until after 2022 (ECB 2021b). However, it is not clear when banks are expected to start restoring their capital buffers, and which ones should be restored. Banks may be cautious about using their capital buffers because they can take a long time to replenish (Figure 28). The starting point and desired speed of the replenishment path of capital should be state dependent, seeking to preserve lending capacity subject to evolving macroeconomic conditions. A strategy overly focused on quick and early replenishment could discourage buffer use and slow the recovery (Borsuk, Budnik, and Volk 2020).

NPL Management and Bank Resolution Frameworks

  • NPL management. As the recovery takes hold, prudential standards should be normalized—and clearly communicated—to incentivize timely recognition of problem assets through greater balance sheet transparency and upgraded reporting. Supervisors should enhance NPL monitoring to ensure that banks have the capacity to adequately provision for impaired loans.6 Keeping banks’ balance sheets transparent and implementing credible NPL reduction strategies will help avoid cliff effects once supportive policies are phased out. Fostering the development of secondary markets for distressed assets would also facilitate the disposal of NPLs, particularly for smaller banks. In some countries and for some types of loans, asset management companies (AMCs) could help offload NPLs. But this would need to proceed with care and be subject to appropriate safeguards, since NPL sales during times of stress are likely to entail losses that need to be borne by either the banks’ shareholders (potentially amplifying capital pressures) or governments, if public support is required to attract private investors (Aiyar and others 2015).7

  • Insolvency proceedings. The deferral of insolvency proceedings in many countries has delayed defaults (Figure 31, panel 1) but also created a legacy risk of pent-up creditor claims and reduced asset recovery prospects. Historically, bankruptcy proceedings have taken about one to three years, but with substantial heterogeneity among countries (Figure 31, panel 2). There is an urgent need to provide EU-level benchmarks for upgrading insolvency regimes in Member States to reduce the the time and cost of insolvency proceedings (Bhatia and others 2019, EBA 2020a). Such improvements would not only facilitate economic restructuring in the years ahead but also reduce fragmentation and strengthen the euro area’s resilience to future shocks (Aiyar and others 2019). Countries should address potential administrative constraints and fast-track court procedures to support debt restructuring. They should also put in place efficient out-of-court workouts with separate tracks for firms, SMEs and households, which have often proved to be quicker and less costly than court-led procedures.

  • Bank capital planning and resolution. To the extent that banks experience a significant depletion of capital buffers and conditions are unfavorable to raise fresh capital from markets, taxpayer-funded capital injections might become necessary. The EU authorities should use the current system-wide stress test (EBA 2020e, 2021a), expected to be completed in July 2021, to assess banks’ potential recapitalization needs under a realistic adverse scenario. Precautionary recapitalizations could then occur using the flexibility provided by the Temporary State Aid Framework (EC, 2020) for public financial support to vulnerable banks. The results from such an exercise could also help supervisors challenge banks’ capital projections in the supervisory review and evaluation process (SREP), foster consistency in the assessment of risks, and promote prudent provisioning policies (ECB 2020a, EC 2021a). The current flexibility in providing public support could also provide impetus to strengthening the EU’s crisis resolution framework (IMF 2018, EC 2021a).

Figure 31.
Figure 31.

Selected Euro Area Countries: Bankruptcy Build-up and Precrisis Length of Insolvencies

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: CEIC; European Banking Authority; Eurostat; Haver Analytics; KPMG; Linklaters; Organisation for Economic Co-operation and Development; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. The historical duration of bankruptcy proceedings for the EU-27 is a simple average across all member states. The time to recovery is defined as the duration in years of the recovery period (as part of the recovery rate process, from the start of the formal enforcement status to the date of ultimate recovery from the formal enforcement procedures). The recovery rates represent a simple average of the EBA-reported values for corporate and SME loans. For Belgium and Lithuania, the time to recovery applies to SMEs only. For Germany, the time to recovery for corporates is proxied by commercial real estate loans. EBA = European Banking Authority; SME = small and medium enterprise.
Figure 32.
Figure 32.

European Bank Performance Metrics

(Percent)

Citation: Departmental Papers 2021, 008; 10.5089/9781513572772.087.A001

Sources: Bloomberg Finance L.P.; and IMF staff calculations.Note: 2022 consensus EPS forecasts are used for the market-implied cost of equity, with consensus expectations used for return on equity.

Tackling Chronic Low Profitability

Over the medium term, addressing banks’ structurally low profitability will be essential to permit “self-healing” once the recovery has gained traction. Earnings capacity is likely to remain subdued over the medium term, limiting the ability of banks to restore capital buffers organically. In addition to new pressures from rising impairments and provisions, legacy cost structures weigh on profitability. An increasing number of banks are now reporting earnings below their cost of capital (Figure 32; IMF 2021b).8 While many banks have started investing in digital technologies to reduce structural margin and cost pressures, this adds to short-term expenses. Further consolidation of banking groups through domestic and cross-border mergers and acquisitions could improve banks’ efficiency and improve cross-border risk sharing, as reflected in the ECB’s increasing supervisory focus on business model sustainability (ECB 2021a). In this context, the recent ECB guidance on the use of supervisory tools to facilitate sustainable consolidation is timely and helpful (ECB 2021b). Any remaining prudential and legal obstacles to cross-border integration of banking activities should be eliminated.

COVID-19: How Will European Banks Fare?
Author: Mr. Shekhar Aiyar, Mai Chi Dao, Mr. Andreas A. Jobst, Ms. Aiko Mineshima, Ms. Srobona Mitra, and Mahmood Pradhan
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    Liabilities of Nonfinancial Corporations, 20191

    (Percent of GDP)

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    Stock of Lending to Nonfinancial Corporations and Households

    (Percent, year-over-year; EUR billion)

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    Euro Area—Macroeconomic Conditions and Bank Health

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    Bank Profitability and Price-to-Book Ratios

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    Cross-Country Variation of Profitability, Capitalization, and Loan Classification, 2019

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    Stringency of Containment Measures and GDP Growth

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    Large European Banks’ Exposure to Highly Affected Sectors

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    Stylized Stacking of Capital Elements

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    Total Envelope of COVID-19 Pandemic-Related Public Guarantee Program

    (Percent of projected 2020 GDP)

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    Key Beneficiaries of Debt Service Moratoria

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    Duration of Pandemic-Related Debt Service Moratoria

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    Duration of COVID-19 Pandemic-Related Insolvency Moratoria

    (Number of months)

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    Sample Coverage

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    Capital Impact through Three Channels

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    Selected Euro Area Countries: Changes in Credit Demand

    (Net percentage change; +/= increase)

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    Policy Measures and Model Treatment

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    Specifications of Macro Scenario: Real GDP Growth

    (Percent)

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    Corporate Risk Matrix

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    Euro Area: Elasticity of Estimated Firm Bankruptcies (Illiquid and Insolvent)

    (Average percentage point change to 1 pp decrease of GDP growth)

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    Mapping Corporate Vulnerability to Banks’ Corporate Loan Default Risk

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    Euro Area Banks: Solvency Stress Test—Baseline Scenario (EBA Coverage)

    (Percent)

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    Euro Area Banks: Change of CET1 Capital Ratio under Different Assumptions

    (Percentage points, end-2021 relative to end-2019)

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    European Banks (EBA Sample): Capital Impact and Pre-Stress Bank Asset Quality

    (Percent)

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    Euro Area Banks: Changes in Capital and Growth

    (Baseline scenario [percent], EBA coverage)

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    Euro Area Banks: Dispersion of Change in Risk Weights

    (Baseline scenario [percent], EBA coverage)

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    Selected Euro Area Countries: Change in NFC Credit Standards

    (Net percentage change; +/= tightening)

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    Euro Area Banks: Solvency Stress Test—Adverse Scenario (EBA Coverage)

    (Percent)

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    Euro Area Banks—Potential Capital Need and Number of Banks below Thresholds (EBA Coverage)

    (EUR billion/count)

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    Euro Area Banks—Changes in Capital and GDP Growth, Adverse Scenario

    (EBA sample)

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    Euro Area Banks: Sensitivity of Projected CET1 Capital Ratio to the Severity of the Adverse Scenario

    (Percent)

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    Euro Area Banks: Time to Restore Precrisis Capitalization (CET1 = 14.7%) through Profits after end-20211

    (Years)

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    GDP Growth

    (Percent)

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    Comparison of Baseline Growth Shock in IMF and ECB Exercises Compared to Adverse Scenarios in EBA Stress Tests

    (Percentage point deviation from [precrisis] baseline)1

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    Euro Area Banks: Projected Change of CET1 Capital Ratio

    (Percentage points, end-2021 relative to end-2019)1

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    Euro Area Banks: Comparison of Average Change in Asset Risk Weights with ECB Vulnerability Analysis (Baseline Scenario)

    (Percent)1

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    Solvency Stress Test—Dispersion of CET1 Capital Ratio (Baseline Scenario/Extended Coverage)

    (Percent)

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    European Banks: COVID-19 Pandemic-Related Repayment Relief—Usage Rate and Share of Nonperforming Loans

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    Selected Euro Area Countries: Bankruptcy Build-up and Precrisis Length of Insolvencies

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    European Bank Performance Metrics

    (Percent)