As with the BoE, the EBA highlighted that the banks would hold, on average, a management buffer of about 1.1 percentage points above the overall capital requirements, even after absorbing those hypothetical losses.
Lessons Learned to Support Economies in Transition Post the Crisis
Small- and medium- sized enterprises (SME) are the drivers of growth in Europe. In the UK, they make up 50% of GDP and get 85% of their debt funding from banks. The BoE highlights that the UK has around 5.8 mn smaller businesses, each with less than £10 mn in annual turnover. These businesses account for 25% of UK turnover. The smaller businesses are likely to be concentrated in sectors vulnerable to the COVID-19 shock. It took seven years for net bank lending to SMEs to recover from the GFC shock. Therefore, it is critical that banks continue to service this segment. For the banks to have the capacity to do so, post the pandemic, several options could be utilized and optimized with public support:
- First, governments can help clear the stock of non-performing debt as a consequence of the COVID-19 crisis to allow banks to continue to provide credit to stimulate economic growth, creating a virtuous cycle.
- Second, improved securitization markets with public support could help both the banks and the SMEs diversify their sources of funding.
- Third, a longer-term goal is to continue to build a capital markets union in the euro area.
In the UK, the Open Market Platform initiative would be an opportunity to ease credit provisions to SMEs. Banks need to facilitate its full implementation.
On the first point, it is important to continue to facilitate longer-term financing to SMEs and to ring-fence any NPLs. The EBA has discussed the establishment of Asset Management Companies, which can be particularly effective if there is public support. Securitizations can be used to complement outright NPL sales and allow governments to participate. According to the ex-ECB vice president Vitor Constancio, government participation can jump-start the NPL market, for example by co-investing with private investors in junior or mezzanine tranches. Therefore, setting up such an instrument in a post-COVID-19 environment would allow banks, supported by public funds, to ring-fence and off-load NPLs related to the crisis.
Incentives of all participants are aligned: banks have the incentive to use these schemes to offload the NPLs as they have a high cost to carry and manage. Governments benefit from resolving NPL issues thereby increasing the financial stability of their economies and allowing more credit to flow to SMEs, advancing economic growth.
To be effective, these instruments need to be optimized by kickstarting the secondary market of NPL sales. Also, such schemes need to be part of a reform agenda for the SME operating environment, including preferential funding to support SME recovery. Overall, these schemes should improve the risk/reward trade-off for investors taking on NPLs and make the asset class open to a wider investor base – i.e., asset managers.
Asset-backed securities (ABS) are another option that allows large pools of institutional funds to be channeled to SMEs. A well-functioning securitization market for SMEs will allow banks to diversify their funding and get capital relief that will provide further resources for other productive borrowers. The structured nature of ABS allows for a wider range of investors to participate, depending on their risk profiles, and this can include insurance companies and institutional asset managers. The benefits of ABS could be extended beyond the banks and investors to the SMEs themselves if in the transaction there is public participation that comes with a commitment from the originating banks to extend new loans to SMEs.
A final lesson learned is the need to develop deeper capital markets for SMEs. As mentioned above, bank lending makes up 85% of the stock of outstanding debt of SMEs. SMEs need to be able to diversify their sources of funding and find an effective alternative to bank financing.
The key takeaway is that banks are clearly part of the solution to the crisis caused by COVID-19. This is a real opportunity for the banking sector to improve its image with the public as well as with investors who are increasingly focused on ESG considerations. Lessons learned from the past suggest that the public sector needs to be ready to implement schemes that will facilitate this process but also achieve its macro-prudential objectives. As ESG-focused investors, the potential improvements are considered in sector allocations.