COVID-19 Outbreak Requires Prompt and Innovative Regulatory Response

Courtesy of Mete Feridun

The COVID-19 outbreak has resulted in a significant and sudden decline in economic and financial activity across the world, bringing back bad memories of the 2007-2008 global financial crisis. There are indeed strong similarities between the current COVID-19 pandemic and the 2007-2008 crisis, particularly in terms of capital market dysfunction, uncertainty, and volatility. However, this time around, the crisis did not emerge from the banking sector. Furthermore, the financial sector is in a relatively better position to absorb shocks due to stringent post-crisis regulatory reforms.

While the global financial system now has more capacity to mitigate interruptions to banking services, the scope of the current crisis is much broader than that of 2007-2008. The current crisis has a direct and immediate impact on the real economy, thereby raising a larger number of “unknown unknowns” regarding the future of the global economy. Thus, the regulatory and fiscal response must be more concerted. In most countries, an unprecedented wave of distressed and defaulted clients is expected, as well as significant deterioration and high volatility in prices for bonds and equities that serve as high quality liquid assets or collateral in repo transactions. Furthermore, the banking sector is also facing severe operational and business continuity challenges.

As a result, striking the right policy balance between fighting COVID-19 and containing its economic fallout remains a delicate exercise, as is identifying the optimum regulatory response to achieve regulatory and supervisory objectives. Amidst these economic and financial stability challenges, the highest urgency lies in providing funding to businesses and maintaining the liquidity of the banking and financial system. In line with these objectives, financial regulators must ensure that banks are lending to the real economy and that banks are able to absorb losses in an orderly manner.

While regulators should be careful not to undermine banks’ capital structures by relaxing prudential regulations, this is certainly not a time for narrow, micro-level mandates. In recent weeks, regulators have been issuing emergency regulations, guidance, and rules to support financial institutions and the economy. In particular, regulators have granted banks flexibility in the fulfillment of certain capital and liquidity requirements. Regulators have also taken measures to increase banks’ ability to provide credit to the real economy.

Around the world, regulators have taken unprecedented actions to provide banks and supervisors additional capacity to respond immediately and effectively to the impact of the crisis, without diluting the capital strength and the liquidity conditions in the global banking system. In the EU, the European Central Bank (ECB) has announced a number of measures in response to the crisis. It has activated capital relief measures, allowing firms to operate below Pillar II guidance levels. The ECB now allows banks to use their capital buffers during the crisis, including the Capital Conservation Buffer and the Pillar 2 Guidance (P2G). It has also provided relief in terms of the composition of capital instruments, allowing banks to partially use capital instruments that do not normally qualify as CET1 capital, i.e., additional Tier 1 and Tier 2 instruments, to meet their Pillar 2 capital requirements.

Many national regulators in the EU have followed suit. For instance, the Netherlands has provided capital relief to firms not under the direct supervision of the ECB by allowing them to go below their P2G capital requirements and to partially use capital instruments that do not normally qualify as CET1 capital. The Dutch regulatory response also includes reductions in Systemic Risk Buffers for the three largest banks: ABN Amro, ING, and Rabobank. Portugal has also allowed firms to operate below their regulatory capital requirements.

In the UK, the Prudential Regulation Authority has delayed the phase-in of new capital rules from the Basel Committee. In the US, the Fed has announced a temporary change to its supplementary leverage ratio rule, removing both US Treasuries and banks’ reserves from the calculation of the ratio for the next 12 months. The Fed has also allowed banks to use their capital and liquidity buffers to lend to households and businesses who are affected by the crisis, as long as the banks continue to manage their capital and liquidity risks prudently.

Many countries have also introduced measures at the macro-prudential level, such as reducing the Countercyclical Capital Buffer (CCyB). In a number of European countries—the UK, Germany, Ireland, Belgium, and Sweden—CCyB has been decreased to 0%. In some of these countries, the reduction represents significant relief. For instance, in the case of the UK, Denmark, and Iceland, the rate has been reduced from 2% to 0%. And in Sweden it has been reduced from 2.5% to 0%.

In addition to capital requirements, liquidity rules have also been relaxed in many countries. For instance, in the EU, the ECB has allowed banks to make use of their liquidity buffers during the crisis, i.e., to operate below the 100% liquidity coverage ratio, as long as they immediately notify their supervisors of a “liquidity restoration plan.” Many national regulators have followed suit. In the Netherlands, Portugal, Denmark, and Sweden, banks are also allowed to operate under the regulatory liquidity coverage ratio levels. Italian regulators have adopted a similar approach and have also provided relief from a number of regulatory requirements and submissions. In the US, the Fed has provided the banking sector with similar regulatory reporting relief.

Measures have also been taken at the global level to ensure that the flow of credit to households and businesses continues. For instance, the Basel Committee has postponed the implementation of the outstanding finalization of the Basel III standards (“Basel IV”) to 2023 to allow banks to commit their full resources. As a result, global implementation of the standards at the national level is expected to be delayed. In the EU, for instance, the European Commission is already considering postponing the finalization of Basel III in the EU. Similarly, routine supervisory activities have also been postponed in most countries to reduce the operational burden of banks. The EBA has decided to postpone the EU-wide stress tests to 2021 and the Bank of England has followed suit. Regulators across the EU have also postponed on-site inspections and internal model investigations. As the financial impact of the crisis continues to cause more disruption across the globe, the Financial Stability Board has taken the initiative to coordinate policy responses so as to maintain global financial stability, ensure the continuity of critical financial services functions, and keep markets open and functioning.

Meanwhile, public expectations for banks to stop distributing capital back to their shareholders is mounting. Some banks have already stopped share buybacks and dividend payouts (as well as cash bonuses). In response to a request from the Prudential Regulation Authority, banks in the UK have suspended dividends and buybacks on ordinary shares until the end of 2020 and have cancelled payments of any outstanding 2019 dividends. The ECB has also recommended that banks not pay dividends for financial years 2019 and 2020 and to refrain from share buybacks. However, given that this has resulted in banks’ stock prices being hammered, regulators should remain vigilant as this may pose new risks to financial stability by eroding confidence in banking sector stocks and making it more difficult for banks to raise capital in the future.

Therefore, a national-level policy response and stronger regulation are also needed to ensure that financial sector balance sheets are robust enough to withstand the challenges of raising capital and the influx of demand from customers in financial difficulty. Regulators must also focus on firms’ operational resilience and contingency planning. In the interest of financial stability, national regulators responsible for financial stability should continue to provide relief to the markets in other novel ways to support firms and consumers, particularly addressing the short-term liquidity difficulties caused by the limited or suspended operation of businesses and individuals. This is a “fire-fighting” time, not the time for prudence about capital requirements and other regulations. The goal must be to ensure that everyday banking services remain available. To give an example, the Financial Conduct Authority now allows banks in the UK to accept smartphone selfies from users seeking to verify their identity.

Given that the duration of the crisis remains uncertain, national regulators in other jurisdictions should follow suit and continue to think creatively and aggressively about how to boost banks’ capacity to support lending to households and businesses during the crisis. Regulators must ensure that the current liquidity crisis does not become an insolvency crisis with an outbreak of businesses in the real economy going bankrupt, which may spread the contagion to the banking sector.

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