Thore Kockerols

Using supervisory loan-level data on corporate loans, we show that banks facing high levels of non-performing loans relative to their capital and provisions were more likely to grant forbearance measures to the riskiest group of borrowers. More specifically, we find that risky borrowers are more likely to get an increase in the overall limit or the maturity of a loan product from a distressed lender. As a second step, we analyse the effectiveness of this practice in reducing the probability of default. We show that the most common measure of forbearance is effective in the short run but no forbearance measure significantly reduces the probability of default in the long run. Our evidence also suggests that forbearance and new lending are substitutes for banks, as high shares of forbearance are negatively correlated with new lending to the same group of borrowers. Taken together, these findings can help policy makers shape surveillance and regulation in a future recovery from the Covid-19 pandemic.

We develop a macroprudential contagion stress test framework to examine how a network of Norwegian banks can amplify a shock to bank capital at the macro level. The framework looks at how fire sales of common asset holdings can lead to valuation losses for banks (indirect contagion), and how recapitalisation of banks can lead to direct contagion. We perform Monte Carlo simulations to quantify contagion-driven systemic risk and to evaluate the importance of the mechanisms in our model. Using data for 22 banks from 2019 Q2 we find that losses due to contagion can reach 2 percentage points (pp) of the banking sector's Common Equity Tier 1 (CET1) ratio, but most likely losses are around one-fourth of this. The losses result almost exclusively from indirect contagion. Further, we find that losses are high in the cases where banks quickly run into funding problems. We also find that market liquidity and which assets banks' fire sale first (pecking order) are important determinants of the results. Last but not least, losses due to contagion are highly correlated with losses on covered bonds.

The first part of our study shows that in a static analysis the currently proposed regulatory framework is not sufficient and for shocks of a size comparable to that of 2007-2009 bailouts would still be needed at the expense of the European taxpayer, even if the Banking Union architecture of 2023 were already in place today. The second part of the study finds that the costs to the economy go much further than the billions necessary to bail out banks. Building on a non-linear dynamic macroeconomic model whose baseline scenario coincides with the Commission’s forecasts, we estimate the costs at the euro area level of a medium-sized financial shock (-10% losses in banks’ assets compared to 2007-2009) occurring in 2014 at a cumulated loss of EUR 1 trillion in GDP (approximately -9.4% of the 2016 forecast GDP), job losses amounting to 1.91 million (-1.19% supposing a total workforce of 161.3 million according to the model forecast for 2016) and an increase of EUR 51.4 billion in government debt in 2016 (+0.5% of the 2016 forecast debt). Needless to say, the cost would be much higher in the absence of the resolution pillar of the Banking Union (which is not scheduled to be fully in place until 2023).

The most effective remedy, according to our simulations, is to increase the banking sectors’ equity ratio target to 9% or more and to lower dividends, in order to make the economy more shock-resistant in the medium term. The study does not claim that an equity ratio target of 9% is the optimal value, although we suspect it to be close to the lower bound, below which the purpose of dampening the impact of a significant shock cannot be reached. We show that the cost of implementing this increased equity ratio is more than offset by the reduction in losses caused by a financial shock. In addition, the separation of retail banks from investment banks, euro area deposit guarantees and a review of fiscal policy seem to provide more efficient tools to mitigate the effects of a new crash than what is currently programmed by the European Banking Union project. An augmented Single Resolution Fund (SRF) with more timely implementation would also certainly reduce the cost of a new crash, but would be insufficient to prevent turmoil in the euro area economy.