**3. What about banks?**

From a historical point of view, some of the most striking examples of contagion in the financial sector have involved international banks; recall for example the GFC and the euro area crises, or the crisis in South East Asia in the late nineties, among many others1 . According to Beck [5], this time banks are not likely to be a major 'channel' of transmission, due to the fact that adherence to stricter regulatory requirements in recent time has meant that their capital buffers are much stronger now, and the system—as a whole—is presumably safer. In particular, the author argues that in the case of European banks even under a scenario of an 8.3% decline in GDP over 3 years, banks would still be in good shape. Furthermore, the coordinated and substantial action by central banks in providing ample liquidity to banks in several countries has further 'insulated' the banking system, at least for now.

Nonetheless, others such as Cecchetti and Schoenholtz [6] appear to be more concerned in case there is a confidence crisis, which in turn might result in 'bank runs' that are, by definition, contagious; as the authors put it *The news about a run on a specific bank alerts everyone to the fact that there may be other 'lemons' among the universe of banks, turning a run into a panic.* As such, it is of paramount importance that people are well informed about the 'linkage' between the economic and the medical effects of the pandemic, so as not to over-react without reason; effectively, what we should be looking for are honest and transparent governments. Cochrane [7] 'paints' an even bleaker picture pointing out that 'shutting the economy down' could cause large financial problems related for example to companies that will have to continue paying their debts and bills and people that will have to pay rent or make mortgage payments; all this could lead to a wave of bankruptcies and insolvencies.

Eventually, how things will turn out for banks will depend, to a great extent, on how the situation evolves going forward; for example, if the global spread of COVID-19 requires imposing tougher containment measures, these are likely to lead to an even more severe economic downturn. Such a development would probably unveil crucial vulnerabilities of the financial system; for instance, investment managers are likely to face substantial capital outflows and thus will be forced to sell assets in falling markets thus accentuating the downward prices 'spiral'. At the same time, companies are more likely to face distress, with default rates rising; recall for instance what happened to Flybe, the UK airline, which struggled to meet

**7**

Equity Tier 1 capital.

*Introductory Chapter: Financial Crises DOI: http://dx.doi.org/10.5772/intechopen.93415*

grade bonds).

**Figure 6.**

the world.

buffers2

losses resulting from the above.

its obligations and went into administration in early March, 2020. Events like this are likely to harm credit markets, especially their riskier parts (e.g. non-investment

*Decline in bank market capitalisation. Source: IMF, global financial stability overview, April 2020.*

If such a scenario was to unfold, despite the fact that banks have more capital and liquidity than in the past, it is plausible that their resilience might eventually be tested. Declines in asset prices are likely to result in losses in the investment portfolios of banks (especially with respect to risky assets), while rising bond yields for highly indebted governments might just remind us of the sovereign-financial sector nexus, which provided so much pain in the course of the euro area crisis. In addition, the longer the pause in economic activity, the more likely it is that the banking sector will register credit losses on their lending portfolios to companies and households, especially the more vulnerable ones (e.g. think of energy companies and falling oil prices or a shutdown factory that nonetheless still has to pay its workers and debt). Finally, lower bank profitability would imply—by default—that banks will have less income (and potentially reserves) against which to write-off

Actually, looking at the market reaction of bank stock prices during the unfolding of the pandemic, we observe large declines, which indicate investor concern regarding the prospects of the sector. Interestingly, **Figure 6** seems to suggest that bank capitalisations fell more in 2020 than during the GFC in several parts of

Given the above, financial regulators and supervisory authorities have taken some bold steps (in addition to those of central banks discussed in Section 2), which may be summarised as follows: (a) some countries have allowed banks to operate below their normal liquidity requirements and to utilise their capital conservation

<sup>2</sup> According to the European Systemic Risk Board (ESRB), the capital conservation buffer is a capital buffer that equals 2.5% of a bank's total exposures that needs to be met with an additional amount of Common Equity Tier 1 capital. The buffer sits on top of the 4.5% minimum requirement for Common

; (b) some countries have also adjusted (temporarily) their supervisory priorities and eased regulatory requirements (e.g. delay of stress-tests and flexibility in the treatment of non-performing loans); (c) restriction of bank dividend payouts. It is worth noting that similar measures have been taken to support other non-bank financial sector firms such as insurance companies and asset managers; for example, in the case of the latter, we have seen measures such as bans on short sales.

<sup>1</sup> A comprehensive discussion of international banking crises can be found in the work of Reinhart and Rogoff [4].

### *Introductory Chapter: Financial Crises DOI: http://dx.doi.org/10.5772/intechopen.93415*

**Figure 6.**

*Financial Crises - A Selection of Readings*

'speaks for itself').

**3. What about banks?**

among many others1

be noted that investor sentiment is still fragile.

central banks have also provided liquidity to the financial system through Open Market Operations (OPM). These actions have certainly helped to 'calm' markets, some of which have substantially recovered lately; however, despite this, it should

Putting all the above together, the deterioration of the global economic outlook has dramatically changed the 1-year ahead projections of global economic growth; actually, according to the IMF [2], it has shifted it massively to the left (there is a 5% probability that it will fall below −7.4%; same as referring to an event that is expected to happen once every 20 years). It is quite possible that, as so often happens at times of financial crises, emerging markets are hit the hardest, since investors tend to withdraw their capital and look for so-called 'safe-haven' assets (**Figure 5** below

From a historical point of view, some of the most striking examples of contagion

. According to Beck [5], this time banks are not likely to be a

in the financial sector have involved international banks; recall for example the GFC and the euro area crises, or the crisis in South East Asia in the late nineties,

major 'channel' of transmission, due to the fact that adherence to stricter regulatory requirements in recent time has meant that their capital buffers are much stronger now, and the system—as a whole—is presumably safer. In particular, the author argues that in the case of European banks even under a scenario of an 8.3% decline in GDP over 3 years, banks would still be in good shape. Furthermore, the coordinated and substantial action by central banks in providing ample liquidity to banks in several countries has further 'insulated' the banking system, at least for now. Nonetheless, others such as Cecchetti and Schoenholtz [6] appear to be more concerned in case there is a confidence crisis, which in turn might result in 'bank runs' that are, by definition, contagious; as the authors put it *The news about a run on a specific bank alerts everyone to the fact that there may be other 'lemons' among the universe of banks, turning a run into a panic.* As such, it is of paramount importance that people are well informed about the 'linkage' between the economic and the medical effects of the pandemic, so as not to over-react without reason; effectively, what we should be looking for are honest and transparent governments. Cochrane [7] 'paints' an even bleaker picture pointing out that 'shutting the economy down' could cause large financial problems related for example to companies that will have to continue paying their debts and bills and people that will have to pay rent or make mortgage payments; all this could lead to a wave of bankruptcies and

Eventually, how things will turn out for banks will depend, to a great extent, on how the situation evolves going forward; for example, if the global spread of COVID-19 requires imposing tougher containment measures, these are likely to lead to an even more severe economic downturn. Such a development would probably unveil crucial vulnerabilities of the financial system; for instance, investment managers are likely to face substantial capital outflows and thus will be forced to sell assets in falling markets thus accentuating the downward prices 'spiral'. At the same time, companies are more likely to face distress, with default rates rising; recall for instance what happened to Flybe, the UK airline, which struggled to meet

<sup>1</sup> A comprehensive discussion of international banking crises can be found in the work of Reinhart and

**6**

Rogoff [4].

insolvencies.

*Decline in bank market capitalisation. Source: IMF, global financial stability overview, April 2020.*

its obligations and went into administration in early March, 2020. Events like this are likely to harm credit markets, especially their riskier parts (e.g. non-investment grade bonds).

If such a scenario was to unfold, despite the fact that banks have more capital and liquidity than in the past, it is plausible that their resilience might eventually be tested. Declines in asset prices are likely to result in losses in the investment portfolios of banks (especially with respect to risky assets), while rising bond yields for highly indebted governments might just remind us of the sovereign-financial sector nexus, which provided so much pain in the course of the euro area crisis. In addition, the longer the pause in economic activity, the more likely it is that the banking sector will register credit losses on their lending portfolios to companies and households, especially the more vulnerable ones (e.g. think of energy companies and falling oil prices or a shutdown factory that nonetheless still has to pay its workers and debt). Finally, lower bank profitability would imply—by default—that banks will have less income (and potentially reserves) against which to write-off losses resulting from the above.

Actually, looking at the market reaction of bank stock prices during the unfolding of the pandemic, we observe large declines, which indicate investor concern regarding the prospects of the sector. Interestingly, **Figure 6** seems to suggest that bank capitalisations fell more in 2020 than during the GFC in several parts of the world.

Given the above, financial regulators and supervisory authorities have taken some bold steps (in addition to those of central banks discussed in Section 2), which may be summarised as follows: (a) some countries have allowed banks to operate below their normal liquidity requirements and to utilise their capital conservation buffers2 ; (b) some countries have also adjusted (temporarily) their supervisory priorities and eased regulatory requirements (e.g. delay of stress-tests and flexibility in the treatment of non-performing loans); (c) restriction of bank dividend payouts. It is worth noting that similar measures have been taken to support other non-bank financial sector firms such as insurance companies and asset managers; for example, in the case of the latter, we have seen measures such as bans on short sales.

<sup>2</sup> According to the European Systemic Risk Board (ESRB), the capital conservation buffer is a capital buffer that equals 2.5% of a bank's total exposures that needs to be met with an additional amount of Common Equity Tier 1 capital. The buffer sits on top of the 4.5% minimum requirement for Common Equity Tier 1 capital.
