A thorough review of the calibration of bank capital and liquidity buffers, fully taking into account the experience up to the pandemic and the exceptional circumstances of the pandemic itself, would improve confidence in the banking system. So far during the pandemic, there has not been an issue with systemic confidence. Such a review would help to keep things that way.
Continued confidence in the international banking system, supported by the above-mentioned measures in local regimes, would also benefit the industry by lowering society’s overall costs. The holding of buffers carries substantial private costs for banks, while central bank interventions carry a cost for taxpayers. By undertaking a comprehensive review and updating the system of bank capital and liquidity buffers, G20 governments will ensure an international level playing field, support the maintenance of adequate buffers, and keep industry costs under control.
This crisis is far from over, and its effects on banking systems have yet to fully play out. One unknown, for example, is how the eventual unwinding of government support for bank loans will affect banks. Indeed, we don’t know if the uncertainty due to the current pandemic will end in 2021, or whether it will take several years for relatively normal operating conditions to be restored.
There are already potentially important lessons to be learned from the early months of 2020. For example, many banks did have a pandemic scenario on their risk watchlists. However, many banks rated such an event as low-probability, and their financial models did not anticipate such a large hit to GDP as the world is now experiencing (this is in spite of research showing that a pandemic of similar magnitude to the 1918 Spanish flu would reduce US and/or global GDP by 5–15 per cent). This points to a need to re-evaluate both the probability of already-identified risks and the magnitude of their likely impact.
What we do know about the course of the crisis so far is that any piece of news about the virus – e.g. concerning vaccines or new strains – affects beliefs about the length, depth and impact of the economic shock. Thus, financial markets could see additional volatility if bad news emerges, such as vaccines proving ineffective against new strains. At the moment, a rough consensus is emerging that vaccination programmes will render the virus somewhat controllable by the end of 2021. However, the rapid rise and proliferation of new strains of the virus, against which current vaccines may be less effective, could put the return to normalcy further into the future. Uncertainty on the pandemic health front translates into many unknowns for the macroeconomy: for example, how quickly GDP will return to pre-crisis levels, or how long effects on employment will persist.
When banks review their internal stress tests and buffers annually, and regulators individually consider how to include recent events in their risk models, it will be increasingly difficult to claim that supposedly low-probability/high-impact events are in fact as unlikely as previously thought, or to question why resources should be held against such risks.
But to support confidence in the international banking system, regulators will need to achieve the maximum possible degree of consistency in interpreting the implications of recent events for stress-testing and for required levels of capital and liquidity buffers. Regulators will also need to communicate their resulting expectations clearly to the wider financial community.
