Coronavirus recovery: protect lenders and borrowers to ease bad loan damage

By Dr. Janus Zhang

In the wake of the Covid-19 pandemic, banks have experienced a spate of credit losses. These might be unavoidable for some time as governments, financial institutions and borrowers all try to navigate through the crisis.

Spurred by the pandemic, S&P Global Ratings expects aggregate global credit losses for 2020 and 2021 to hit about US$1.8 trillion. According to its 2021 forecast published last July, North American and Chinese banks will continue to lose US$240 billion and US$398 billion respectively. Across the Asia-Pacific, loans have plunged as the pandemic has made banks more reluctant to lend. This is in line with their counterparts across the globe.

Amid heightened concerns around risk and borrower creditworthiness, European banks tightened lending guidelines and approval criteria for new loans in the final quarter of last year, taking these measures to levels unseen since the 2008 global financial crisis. Closer to home, HSBC has warned that it could take loan loss provisions of up to US$13 billion.

With spiking unemployment affecting Hong Kong and many other economies, there will be an increasing number of risky borrowers. More than ever, banks must be able to strike a delicate balance between extending much-needed lines of credit to borrowers while also safeguarding themselves against bad debt.

Governments are acutely aware that shrinking credit and capital would have multiple disastrous effects on the economy as a whole. Companies would face financial constraints and cut corporate investment. In extreme circumstances, companies could file for bankruptcy and investors would lose money.

The European Central Bank has provided extremely cheap negative-interest loans to support banks and ensure borrowers still have access to credit. This was especially necessary as a response to stricter lockdown measures across Europe amid a new wave of rebounding Covid-19 cases.

Another way of promoting bank lending during difficult times is to ease the impact of loan loss provisions on regulatory capital requirement. Loan loss provisions are credit losses set aside to protect against individuals and companies defaulting on loans. Taking loan loss provisions will lower banks’ capital ratio and hence restrict their capacity to lend.

A study carried out by my colleagues and I, published in early 2020, provided evidence that banks take more loan loss provisions in times of higher uncertainty around fiscal, monetary or regulatory policy. This is easy to understand because banks believe they will lose more when policy uncertainty induces negative macroeconomic and microeconomic conditions.

The ongoing pandemic creates tremendous uncertainty for the business environment and even for our daily lives. Inevitably, banks will have to set aside more loan loss provisions as a buffer for expected loan defaults.

What can banks and regulatory authorities do to mitigate the negative impact of loan loss provisions on banks’ capacity to lend? First, taking loan loss provisions in a more timely manner can help ease the negative impact when bad times arrive.

This is evident in our study. Banks that have already prepared sufficient buffers in advance will see a limited increase in loan loss provisions when facing uncertainty shocks, which reduces the impact on banks’ lending capacity. Regulators around the globe are already promoting accounting standards that can reflect credit loss in a more timely manner.

Second, during unique circumstances such as the Covid-19 pandemic, regulators could consider temporarily changing the rule of calculating regulatory capital ratios. Specifically, they have the authority to determine to what extent taking loan loss provisions will affect regulatory capital ratios.

In the United States, the Coronavirus Aid, Relief, and Economic Security (Cares) Act provides banks with capital requirement relief during the pandemic. This significantly reduces banks’ capital pressure resulting from taking loan loss provisions.

As companies and individuals grapple with the pandemic, which is drastically reshaping businesses and influencing their careers and livelihoods, loans can quickly become one of the only lifelines available for these parties to survive and ultimately invest in retooling themselves for success in the new normal.

This is especially true in places where direct state support or hardship payments to individuals and companies are far too inadequate. Ensuring credit access via bank loans is a critical part of building the foundation of the favourable financing environment necessary to support an economic recovery.

With the current challenging economic environment, banks must continue to lend while anticipating loan losses. As we look to the future, protecting lenders and borrowers while managing non-performing loans will play a critical role in any economic recovery.

We can see this in China as its economy rebounds. At the height of the pandemic last year, China shored up a huge amount of bank capital to ensure that banks across the country could continue lending to businesses. In doing so, they tolerated rising numbers of non-performing loans across a range of sectors and regions. Many can understand that this was a necessary part of the recovery process.

Reference:

Ng, J., Saffar, W., & Zhang, J. J. (2020). Policy Uncertainty and Loan Loss Provisions in the Banking Industry. Review of Accounting Studies, 25(2), 726-777.

Original article was published on South China Morning Post on 17 February 2021: 
https://www.scmp.com/business/article/3121921/coronavirus-recovery-protect-lenders-and-borrowers-ease-bad-loan-damage