COVID-19 and financial fragility

Besides soaring infection rates, the COVID-19 pandemic has delivered widespread lockdowns, shattering declines in output, and spiking poverty. Behind these trends, a quieter crisis in the financial sector is gathering momentum. The financial fallout from the pandemic does not respect differences by region or income status. Financial institutions around the globe are facing a marked rise in nonperforming loans. COVID-19 is also a regressive crisis, disproportionally hitting low-income households and smaller firms that have fewer assets to avert insolvency.

Since the onset of the pandemic, macroeconomic policies have sought to offset the sharp declines in economic activity associated with broad-based shutdowns. Wealthier countries have had greater capacity to respond. Lending by the multilateral institutions has also helped to finance the response to the health emergency in developing countries.

The macroeconomic response has also been supported by temporary moratoria on bank loans to households coping with unemployment and businesses struggling to survive. Grace periods in the repayment of loans have been granted by financial institutions in in all regions. The understandable rationale has been that, because the health crisis is temporary, so is the financial distress of firms and households. But as the pandemic has persisted, many countries have found it necessary to extend these measures. Banking regulation has often been relaxed as to the provisioning for bad loans and which loans are counted as nonperforming. The upshot is that the extent of nonperforming loans may be understated at present and for many countries markedly so.

Adding to these risks, sovereign credit rating downgrades hit a record in 2020. While advanced economies have not been spared, the consequences for banks of sovereign downgrades are more acute in developing countries. In more extreme cases, if the government were to default, banks will also take losses on their holdings of government securities.

Even with available vaccines, significant damage has already been inflicted to balance sheets. Forbearance policies have provided a valuable coping device, but even extended grace periods come to an end.  As 2021 unfolds, more will be revealed as to whether the problem facing countless firms and households is insolvency rather than illiquidity. High leverage will amplify the problems of the financial sector.

This kind of balance sheet damage takes time to repair and often ushers in a long period of deleveraging. Financial institutions become more cautious in their lending practices. A credit crunch is usually a serious headwind to recovery.  In some cases, these financial crises morph into sovereign debt crises, as the bailout transforms what was private debt before the crisis into public sector liabilities.

The first step toward dealing with financial fragility is the recognition of the scope and scale of the problem followed by the expedient restructuring and write downs of bad debts. The alternative of channeling resources into zombie loans is a recipe for delayed recovery.

This article first appeared in the journal «Die Volkswirtschaft / La Vie économique» published by the Swiss State Secretariat for Economic Affairs (SECO).