The quiet financial crisis

Global COVID-19 has caused a rise in infection rates, widespread locking down, record-breaking declines in production, and increased poverty. A quieter crisis gaining momentum could also threaten economic recovery for many years.

Financial crises have long been associated with dramas like bank runs and asset price crashes. The classic books The World in Depression, 1939-1939, Manias, Panics, and Crashes by Charles Kindleberger, and My Work with Kenneth Rogoff, This Time Is Different, both document scores of episodes. The term “Lehman Moment” has been used to describe the global financial crisis of 2007-09. It even inspired Broadway shows.

Some financial crises are not as dramatic as the Lehman moment. Asset quality can decline significantly when economic downturns continue, particularly if firms and households have high leverage levels. Bank lending to state-owned or unproductive private companies (common in developing countries) can have a cumulative effect on balance sheets.

These crises can have multiple costs, even if they don’t always involve panic and running. Restructuring and recapitalizing banks to restore solvency may be costly for taxpayers and governments, and lending can continue to decline, slowing the economy. The credit crunch also has distributional effects because it affects small and medium businesses and lower-income families more severely.

The COVID-19 Pandemic is still causing a lot of drama. This includes soaring rates of infection, widespread lockdowns, and rising poverty. In addition to these trends, a quieter crisis is taking hold in the financial sector. It could threaten economic recovery prospects for many years, even without a Lehman-like event.

For a while, financial institutions will face a significant increase in non-performing (NPL) loans. The COVID-19 Crisis is also regressive. It disproportionately affects low-income households and smaller companies with fewer assets to cushion them against insolvency.

Since the outbreak of the pandemic in 2009, governments have used fiscal and monetary policies that are more expansive to counter the sharp declines in the economy caused by widespread shutdowns and social distancing. Wealthier countries had an advantage in responding to the pandemic, but multilateral institutions have also played a role in financing emerging and developing economies.

As the International Monetary Fund (IMF) has shown in its policy tracker, banks support macroeconomic stimulus through various temporary loan moratoria. These measures have given some relief to households facing a loss of income and jobs and businesses struggling to maintain regular business activity.

All financial institutions have given grace periods to repay existing loans. Many have also re-contracted their loans with lower interest rates or better terms. Understandably, the economic hardship of households and firms is temporary because the health crisis will pass. As the pandemic continues, many countries are extending these measures to 2021.

In addition to the temporary moratorium, many countries have also relaxed their banking regulations regarding bad-loan provisions and non-performing classifications. These changes have led to a significant underestimation of NPLs in many countries. Financial institutions must often be adequately prepared to handle the impact on their balance sheets. In contrast, the less regulated financial sector of non-banks is even more exposed to risk, compounded by poorer disclosure.

In addition to the private sector, sovereign credit ratings were downgraded to a record level in 2020 (see below). The consequences of the downgrades for banks in emerging and developing countries are greater than those experienced by advanced economies, where government credit ratings are near or at junk grade. In the most extreme cases of sovereign defaults or restructurings – which are also on the rise – banks may suffer losses on their government securities.

Argued back in March 2020 that even if an effective vaccine is available to end the COVID-19 pandemic quickly, it would not be enough. The COVID-19 crisis will have caused significant damage to the global economy as well as financial institutions. Forbearance policies are a helpful stimulus tool beyond conventional fiscal and monetary policies. Grace periods will end in 2021.

The US Federal Reserve’s November 2021 Financial Stability Report highlights that the future US fiscal and monetary stimulus will be less than the early 2020 levels. Many developing and emerging countries have reached or are nearing their monetary policy limits. By 2021, it will be clearer if countless households and firms are experiencing illiquidity or insolvency.

The high level of leverage in the financial sector during the pandemic is likely to exacerbate the problems with the balance sheet. The two biggest economies in the world, the United States of America and China, have high levels of debt and many high-risk lenders. The European Central Bank expressed concerns over the increasing share of non-performing loans in the Eurozone. Meanwhile, the IMF warned against the sharp increase in dollar-denominated corporate debts in many emerging economies. In many countries, exposure to the commercial real estate and hospitality sectors is a concern.

Repairing balance-sheet damage can take time. Deleveraging is often a result of previous overborrowing as lenders become more cautious. This muddle-through stage, usually associated with a slow recovery, can last for years. These financial crises can sometimes develop into sovereign debt crises as bailouts convert private debts into public sector liabilities.

First, you must recognize the extent and scope of the problem. Then, you need to restructure the debts and reduce them. A zombie loan scenario is the opposite of what you want. It will delay recovery. Averting this scenario is a priority for all policymakers, given the pandemic’s already high economic and human costs.

The original version of this article appeared in Project Syndicate. Copyright Project Syndicate.

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