Grant for research on Covid-19 effect on European banks and financial stability

COVID-19 impact assessment on banks

The COVID-19 pandemic has a severe but uncertain impact on the global economy. The IMF projects the global economy to shrink by five per cent in 2020, which is more than during the ‘Great Recession’ in 2008-2009. The impact on the banking sector will be an important factor in determining how long-lasting and severe the COVID-19 recession will be.

Banks have a central role in the economy. The economic damage will be much greater if banks are hit hard and financial stability is undermined. But assessing the impact of COVID-19 on banks’ loan portfolios is a major challenge, as such assessments are usually based on slow-moving accounting data. There needs to be a timely assessment of expected loan losses – based on market valuations rather than accounting numbers – to evaluate which policy measures are needed now to safeguard banking sector stability.

Intended results

The researchers’ hypothesis is that banks’ current loan loss provisions based on accounting rules severely underestimate the actual expected losses in their loan portfolios. Using real-time market valuations will provide a much more up-to-date assessment of actual expected loan losses. The research outcomes will be of immediate interest to financial regulators and supervisors, who will need to act quickly if the stability of the financial sector is at stake. The option valuation approach of Nobel laureate Robert Merton will be used to assess expected loan losses for banks in Europe based on real-time stock market data. The researchers will estimate increases in default probabilities due to the COVID-19 crisis for 1,981 publicly listed firms in 19 economic sectors in the euro area, and subsequently evaluate the potential impact on the balance sheets of euro area banks under different scenarios.