Coronavirus and banking: assessing policy options to avoid a financial crisis

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Coronavirus and banking: assessing policy options to avoid a financial crisis

Arnoud Boot, Elena Carletti, Hans – Helmut Kotz, Jan Pieter Krahnen, Loriana Pelizzon, Marti Subrahmanyam January 25, 2021

The Covid-19 pandemic will leave deep scars across the world, especially in the euro area. Since the health of banking systems is inextricably linked to the performance of the underlying economies, bank nonperforming loans (NPLs) are a significant problem. What are the policy options to protect the integrity and functionality of the banking system? And what are the criteria defining the desired response? This column will address these issues in the context of the EU.

What makes identifying an appropriate policy response particularly difficult is the heavy reliance on banks and the apparent “overbanking” in Europe (Pagano et al. 2014). Nationally, banking markets are highly concentrated and many institutions are considered too large to fail. The structurally low profitability of European banks makes this even more worrying.

Policy responses should take these structural issues into consideration. In particular, policy measures should neither reinforce substantial dependence on banks, nor perpetuate a nation-centered “ traditional banking ” architecture subject to a “ fatal loop ” between the fiscal state national governments and the state of the bank. system. The extent to which financial markets could play a larger role should also be considered.

In this column, we discuss and assess a variety of policy options that are being considered in the current debate on how to deal with potential problems in the European banking sector, magnified by the Covid-19 crisis.2 The assessment is based on a set criteria which, in our opinion, capture the effectiveness and credibility of an appropriate policy response.

Assessment of policy options

We carefully distill the requirements that a desirable policy response should meet in light of two objectives of policy intervention: (i) the stability of the banking system and (ii) the ability of the banking system to fulfill its important role in society. We then apply the criteria to the policy options.

Evaluation criteria

We define the following five criteria:

1. Effectiveness: can the overall objectives be achieved? Does the option effectively resolve the issue in question? Does the model implemented make a difference?

2. Feasibility: is the option feasible in the broad sense? We consider different dimensions regarding feasibility:

a. Is the option feasible (eg not rejected out of hand by the legislative process or by the treasuries concerned)? Is a political mandate for the option possible? C. Are decision-makers and regulators able to execute the policy? D. Is the option strictly viable (ie not too complex)?

3. Credibility of the policy: if it is put in place, can it be applied over time?

a. Is the problem of “regulatory capture” resolved? B. Is the option resilient to the “too many failures problem” in policy development? vs. Is political time coherent, in the sense that the incentives to readjust are kept at bay so that ex post credibility can be ensured?

4. Alignment with the incentives of private actors: does the (public) intervention leave the right incentives and initiatives ex ante to banks and companies? This question includes the following aspects:

a. Does the option prevent “zombification” of businesses and / or banks? B. Can Regulatory Arbitration Be Contained? C. Does the option allow private initiatives to …

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