Banking as a force for good in the COVID-driven credit crisis – World Economic Forum

The COVID-19 pandemic has sent shockwaves rippling through the global economy, threatening the progress that the Banking & Capital Markets Industry (BCM) had made in regaining consumer trust and improving society’s perception of the industry after the Global Financial Crisis and subsequent Great Recession. But the world’s stewards of capital should not be discouraged. They still have a unique opportunity to make a positive impact as economies, industries, and society at large struggle to deal with the fallout from COVID-19.

There is one catch. That opportunity is difficult for financial institutions to see, because they are heads down in crisis mode. Many institutions are struggling to keep all the plates spinning as they support their customers, deal with their own operational challenges, such as forced branch closures, and upgrade their systems to support distanced banking. All the while, they are re-examining their operating models, investment priorities, and talent management.

But from the outside, the opportunity is plain to see. BCM firms need to find solid ground in this crisis. They should turn themselves into highly effective vehicles for fiscal policy transmission and then provide the capital and liquidity support that can help build an economic bridge to the other side of this crisis.

The circling shark in this crisis is the economy’s fundamental lack of liquidity. Central banks dealt with the immediate threat through unprecedented bond buying programmes, international swap lines, and other interventions. But these actions just staved off a crisis. The central concern now is a double whammy of business closures and sustained unemployment from a collapse in aggregate demand, which could lead to a long, slow economic recovery.

To prevent that from happening, the economy needs sustained liquidity and capital. This can happen in three distinct phases.

First, there’s the sovereign phase where the banking industry is primarily a transmission mechanism for public policy decisions. Here, the public sector balance sheet, rather than the banks, shoulders the risk. Second is the debt phase, where the burden for providing capital and liquidity will fall principally on the banks and fixed income investors. Finally, as it becomes clear that businesses of all sizes may be unable to repay outstanding debt, we will enter phase three. This is the equity phase, which will require restructuring and changes in ownership. It is important to note that these three phases are not sequential; they are already happening in parallel. Banking and capital markets players will need to find ways to navigate these three phases while balancing the needs of customers, shareholders, and the broader public good.

Regulators and consumers need banks to be good actors

Firms need to remember the 3 Rs: reset, reprioritize, and reconfigure their business strategies to adapt to the current and near-term situation. They will need a firm grip on fiscal policy to identify where they can fill the breach as good actors. At the same time, they have to be prepared to roll with a few punches along the way, because recoveries are rarely smooth, upwards motions. In other words, firms must start thinking about risk management as a part of, rather than distinct from, their overall strategic objectives.

Facing new risks and challenges

The industry’s initial response to the crisis has been generally viewed as positive, but there will be several chapters as this is going to be a sustained and multi-phase health and economic crisis. As it unfolds, financial institutions will need to effectively manage a series of risks.

1. Increasing uncertainty: With economies reopening and then closing again, there are currently more unknowns than knowns, and firms will need to get used to flying blind just like the rest of us. They don’t know what the next waves of public sector support will look like, and hence have no idea of the public sector’s future demands on their capacity. Again, keeping close tabs on public health and fiscal policy will be key to anticipating these waves. While initial cooperation has been good, the goals and objectives of the public sector and financial institutions must stay in lockstep throughout all three phases of the credit cycle.

2. Rising default rates: Massive public stimulus is masking the true magnitude of the gathering storm. In fact, provisions being taken by major financial institutions indicate they believe that loss rates will exceed those from the Great Recession. While the industry is better able to absorb those losses given higher capital levels, there is a still an urgent need to rebuild institutional muscle around workouts and recoveries. BCM firms need to take full advantage of modern analytical tools to employ a surgical approach to dealing with non-performing loans. If banks are too lenient in their approach, they could risk their own solvency. If they are too aggressive, they risk amplifying the macroeconomic cascade effect, deepening the recession and risking their own reputation.

3. Equitable lending/transmission: As they navigate these uncertain times, financial institutions must also act responsibly and fairly. Undifferentiated credit management approaches that take no account of future viability will be counterproductive. We have already seen increased scrutiny around how public sector support has been channeled to SMEs with alleged bias both for and against specific groups of businesses. Being a good actor also means being a fair actor who can justify with full transparency, decisions made around the extension of new credit and the management of existing books.

Finding opportunities

⦁ New credit extension: In the initial wake of the outbreak, banks quickly stepped up to collaborate closely with the public sector to become effective transmission channels for fiscal policy. At the same time, we’ve seen historically low borrowing costs facilitate a spike in new public debt issuance. However, there is a risk that as public sector support tapers, balance sheet lenders will look at escalating credit provisions and limit new lending just when some sectors of the economy may need it the most. While there will be a temptation to hunker down and preserve capital, BCM firms need to keep the focus on mitigating economic stress rather than amplifying it. Smart, targeted new credit extensions must be just as much of a priority in the coming months as effective credit management of existing debt.

⦁ Product innovation/flexibility: As the need for credit increases, firms should take a holistic approach to understanding both personal and corporate balance sheets and find creative ways to help clients of all types make the best use of their assets. That could entail creative use of the banks own balance sheet in sale and leaseback type arrangements or the intermediation of credit from other sources like supply chain partners with a vested interest in seeing customers survive the pandemic. There will also be a need for creative credit term modification to help viable businesses avoid triggering covenants and extend their credit arrangements out to a point where an economic recovery will support debt servicing.

⦁ Customer centric: Putting customers front and centre will give banks an opportunity to rethink their advisory services to act as critical, trusted advisers for consumers and SMEs as they struggle to stay afloat and look for support. Banks should understand that long-term customer value and a stronger economic rebound is more important than maximizing short-term profits. Helping clients better run their businesses can reduce the impact of the crisis as companies improve cashflow management and keep away from liquidity crisis.

⦁ ESG (environmental, social, governance) agenda: Through the extension of new credit and the management of existing books, this crisis offers the potential to target capital investment at sectors where there is clear societal good, not only in the E but also the S element of ESG goals. A few countries have already linked subsidies to positive environmental developments. The World Economic Forum is supporting a dialogue on the role of banking and capital markets in Financing the Transition to a Net Zero Future.

The path forward

The COVID-driven credit crisis will likely be a two to three-year cycle depending on how the public health crisis shapes the macroeconomics. Given this prediction, the banking and capital markets industries need to continue to look for ways to be shock absorbers rather than shock amplifiers and to work collaboratively to help build stronger, more resilient communities. In phases two and three, the meaning of being “good” will likely change and we must pivot accordingly, while still collaborating with governments, multilateral development banks and other capital providers. Financial institutions have the opportunity to reset for good – it is up to us to use this moment, to show that we can be good actors.