Banks and pandemic risk: Conditions before COVID-19

2 juni, 2020 - Joost Busch,

In a series of three blogposts we will zoom in on how banks have been preparing for the current pandemic and how regulatory requirements and global legislative institutions influenced banks to cope with this situation. 

Our first blog will focus on the (macro-) economic and geo-political situation before the pandemic became world news. 

A projected economic growth of 1,3% in GDP (Gross Domestic Product) and an almost historically low unemployment rate of 3,6% (CPB, 2019). These were the projections by the CPB (Centraal Plan Bureau) for the Netherlands in December 2019 for the subsequent year. In March 2020, only three months after their earlier projections, they came up with four scenarios for the Dutch economy based on the persistence of the COVID-19 virus. Now, the most positive scenario entailed a decline of 2.1% in GDP and the most pessimistic one a decline of 7,7% in GDP (CPB, 2020). 

The impact of the COVID-19 pandemic on our national economy, as well as our daily lives, has been devastating and is unmatched in proportion to the last century. In three of the four scenarios the economic decrease would be more severe than that of the Financial Crisis of 2008. 

The COVID-19 pandemic leaves its mark on a global scale. Unemployment figures in the United States amounted to a staggering 14.7% during April, which is nearly 50% higher than during the financial crisis of 2008 (Financial Times, 2020).  
 

Early warning signals 

The current COVID-19 pandemic has not been the first pandemic hitting our economies. On top of that, the World Health Organisation warned the world for a serious pandemic threat during September 2019 – months before COVID-19 became world news (John Hopkins Centre for Health Secutiry, 2019).  

Furthermore, during the last decade numerous studies have already warned for the possibility of a pandemic outbreak and the ramifications on the Global Economy. Studies by Burns, Mensbrugghe and Timmer (2008) and Jonas (2013) showed that a pandemic with the severity of the 1918 Spanish flu, could reduce the Global Domestic Product by as much as 5%. A large proportion of this decline - 60% - would be the result of measures taken by governments to stop the spread of the disease. Other studies (Fan, et al., 2017; McKibbin and Sidorenko, 2006; Osterholm, 2005) showed similar projections in terms of the magnitude of a pandemic and the consequences it would have on our economy.  

This shows that the COVID-19 pandemic cannot simply be viewed as a “black swan”event, like argued by numerous financial institutions such as Goldman Sachs and Sequoia Capital (Posts, 2020). To what extent have these evident warning signals been taken into consideration and anticipated to while preparing for external threats?  

Regulatory preparations against highly unlikely events: Stress tests 

Global banking institutions and regulators have taken big measures after the 2008 financial crisis to increase the robustness of the financial sector against large shocks in the global economy. Additionally, both the ECB and the FRS (Federal Reserve System) have started yearly stress tests for banks after the financial crisis of 2008 and operational risk management shifted to the center of attention of all major banks. 

On the 31st of January this year, the ECB started with a stress test employing its “most severe scenario to date” (ECB, 2020).  Ironically, this scenario, with an expected economic decline of 4.4% cumulatively by 2022, would be amongst the more positive scenario’s if performed now.  
 

How well prepared was the financial sector? 

The increase in regulatory requirements set by the Basel Committee for both expected and unexpected operational risks and resulting capital buffers during the last decade could have prepared banks and made them more resilient against highly unlikely ‘tail events’ such as pandemics. Additionally, yearly stress tests, both by banks themselves as well as by central banks were aimed at testing banks on their resilience against large economic shocks.  

The signals for a potential pandemic were, as mentioned before, plentiful and the projected impact on the global economy was similar to what we are seeing now. Yet, the stress test conditions portrayed by the ECB, which were meant to be ‘the most severe to date’ do not even match the projected economic decline for this year.  

This raises some relevant questions: were the increased regulatory requirements enough to make banks robust against a pandemic like COVID-19? Did banks place enough importance on the Risk Management of very long-tail events, such as pandemics? 

These questions are hard to answer at this point, also because the total impact of COVID-19 on our economy is still unclear. However, we want to have a closer look and dive into these questions with a series of blogposts focussing on the impact of the COVID-19 virus on banks' reporting, their risk management and how this pandemic could affect future legislation. 

We’d like to invite Risk Managers and others interested to further discuss this topic with us. Interested? Please call or e-mail Joost.