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COVID-19 to shake up banking stress tests as concerns over pandemics grow


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COVID-19 to shake up banking stress tests as concerns over pandemics grow

The shock of the coronavirus may shake up the way supervisors conduct bank stress tests and lead them to include pandemics when they test future risk, according to experts.

The pandemic will provide key data on how a sudden shutdown affects economies, allowing regulators and market participants to better gauge financial institutions' resistance to future health crises.

COVID-19 has claimed more than half a million lives globally and wreaked economic havoc. The EU expects the eurozone economy to contract by 8.7% in 2020, and the IMF predicts that U.S. GDP will decline by 8.0%. U.S. banks could see earnings drop by more than 50% this year, while the European Banking Authority said Europe's banks could see bad loans accumulate on a scale matching that seen during the eurozone's sovereign debt crisis.

Since the global financial crisis, regulators have used stress tests to assess how financial institutions can withstand adverse economic shocks, and now some central banks are fine-tuning testing around climate-related exposure. The next step is specific pandemic stress testing, experts say.

A tool for regulators

In addition to its annual stress tests released June 25, the U.S. Federal Reserve assessed how recession-proof the U.S. banking sector was in the wake of the coronavirus and concluded that several banks would approach minimum capital levels if a second wave of the virus led to another severe drop in economic activity.

The French central bank will publish its first climate stress tests in April 2021. These include a pandemic risk for insurers because climate change is expected to lead to an increase in illnesses and pandemics, leading to rising health costs for the insurance sector, the French financial regulator Autorité de Contrôle Prudentiel et de Résolution, or ACPR, said in a consultation paper on the tests.

Sylvie Goulard, deputy governor of the Bank of France, told reporters June 23 that the stress tests would provide data and metrics on the potential impact of pandemics on financial institutions, and also that the current crisis could give regulators valuable information. Its economic consequences as well as the different approaches taken by national governments will serve as lessons for the future, she noted.

"We can learn lessons from this and see what is the best way to tackle a pandemic ... to avoid economic damage, poverty and unemployment," she said.

Other risks

Bankers, too, believe supervisors will do more to create frameworks designed to help protect the banking sector against risk.

Antoni Ballabriga, global head of responsible business at Spain's Banco Bilbao Vizcaya Argentaria SA, said he expected regulators to increase their focus on pandemics, pointing to comments by Dutch central bank head Frank Elderson, who is also chair of the Network for Greening the Financial System — a global network of central banks collaborating on climate change, that supervisors should take a look at other key risks such as biodiversity and human rights.

In a speech at a conference in Frankfurt in August 2019, Elderson said water scarcity, diminishing biodiversity and human rights controversies were all a source of financial risk, and Ballabriga said pandemics fell into the same bucket of risk.

"Now the focus is on climate, but obviously supervisors may decide to move on other key risks, like these other sub risks and physical risks," Ballabriga said.

'Last war'

David Carlin, who oversees a pilot program at the United Nations Environment Programme Finance Initiative to implement the voluntary Task Force on Climate-Related Financial Disclosures' framework at banks, said the coronavirus had brought the idea of including pandemics into stress testing to the forefront.

"People always fight their last war, so people weren't thinking about pandemic stress testing until now [when] we have a pandemic," he said.

In 2008 regulators would not have thought it worth doing negative interest rate stress tests as most of them thought rates would not go negative, he said. But by 2011, with the eurozone crisis and accompanying negative rates, they considered it important to think about.

"I see a similar phenomenon occurring when it comes to the pandemic; rapidly moving dislocations are something that certainly need to be assessed and clearly their potential to cause major harm, if not directly to the financial sector then certainly to the broader economy, surely needs to be considered," he noted.

A pandemic or climate shock needs to take into account factors such as sovereign defaults, falling tax revenue, business closure and the state of the economy when the event takes place, he said.

"When you look at a single factor in isolation, you are not going to be able to capture some of the real-life interactions," he said.