Financial Stability, Resolution of Systemic Banking Crises and COVID-19: Toward an Appropriate Role for Public Support and Bailouts

COVID-19 is primarily a health and human crisis which has evolved into an ever expanding economic crisis, but not yet a large scale financial crisis. So far, the financial sector has been central to directing financial resources to support economies and societies while governments battle the pandemic.

As the length and depth of the economic contraction continues, the COVID-19 crisis raises critical questions about the structure of the economy and the longer term solvency of the financial sector. Banks around the world are increasing their provisions for losses, and levels of non-performing loans (NPLs) and other credit exposures are increasing.

Banking crises are commonly caused by stressed balance sheets; over-extended loan books  transforming into high levels of NPLs. The longer COVID-19 continues, defaults and subsequently NPLs will continue to rise, threatening a systemic crisis in the banking sector. In the event of a systemic banking crisis, regulators will need to choose the most effective strategies for stabilizing the financial system and the economy.

A wide range of approaches has been applied to address banking and financial crises. The nature of the chosen approach depends on the type of crisis, its origins, evolution and context. Systemic banking crises are among the most common and costly to address. The three major international systemic financial crises of the past twenty-five years – the Asian Financial Crisis, the Global Financial Crisis, and the European Debt Crisis – offer critical lessons for the most effective approach to address a  systemic bank solvency crisis.

One of the most common and effective approaches has been the transfer of NPLs to an Asset Management Company (AMC) that performs workouts (renegotiating loan terms) or liquidates stressed loan portfolios at a more opportune time to amortize losses. In most cases, the use of AMCs has delivered positive results for the taxpayer.

On the other hand, the contemporary consensus for tackling bank solvency during a systemic financial crisis focuses on preventing government bailouts to protect state finances and curb moral hazard. This attitude is strongly influenced by a desire to prevent moral hazard associated  with too-big-to-fail financial institutions, as in the 2008 crisis wherein senior bank executives walked away with large bonuses while leaving the taxpayer to pay for bank failures. Taking an overtly dogmatic approach of preventing public financial support in a systemic banking crisis can place insurmountable obstacles on the use of state-backed AMCs and other typical forms of NPL resolution tools, such as bank recapitalizations.

Our new paper analyzes evidence from these three major international banking crises over the past twenty-five years to explain why restructuring banks’ balance sheets is the most effective approach to resolve a systemic banking crisis. We provide a new perspective that challenges the common belief that public support of systemic bank insolvency – i.e. bank bailouts – is an inefficient use of public funds or conducive to moral hazard.

Our study finds that state-backed AMCs can be effective in recapitalizing banking systems, depending on the modus operandi of the restructuring and funding, and the conditions attached to the fiscal backstop. With respect to systemic banking crises or those caused by exogenous factors, such as the unprecedented disruption of economic activity due the COVID-19 pandemic, policy-makers’ predominant goal should be the preservation of financial stability, not containment of moral hazard. Thus, we suggest that a combination of balance sheet restructuring and the use of AMCs is the optimal approach to the resolution of systemic bank solvency problems. A focus on balance sheet strengthening – adopting a pragmatic rather than a dogmatic approach to bank crisis resolution – will be of paramount importance in supporting a robust economic recovery in the COVID-19 era, for both developed and developing countries.

 

Douglas W. Arner is the Kerry Holdings Professor in Law at the University of Hong Kong, a Senior Fellow of Melbourne Law School, University of Melbourne, and a Non-Executive Director of Aptorum Group [NASDAQ: APM].

Emilios Avgouleas holds the International Banking Law and Finance Chair at the University of Edinburgh and is the founding director of the Edinburgh LLM in International Banking Law and Finance and a senior research fellow at Edinburgh University’s blockchain lab.

Evan Gibson is a Postdoctoral Fellow with the Asian Institute of International Financial Law at the University of Hong Kong.

This post is adapted from their paper, “Financial Stability, Resolution of Systemic Banking Crises and COVID-19: Toward an Appropriate Role for Public Support and Bailouts,” available on SSRN.

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