COVID-19 and financial fragility

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In addition to soaring infection rates, the COVID-19 pandemic has resulted in widespread lockdowns, shattering declines in production and increased poverty. Behind these trends, a calmer crisis in the financial sector is gaining momentum. The financial fallout from the pandemic does not respect differences by region or income status. Financial institutions around the world are facing a marked increase in NPLs. COVID-19 is also a regressive crisis, disproportionately hitting low-income households and small businesses that have fewer assets to avoid insolvency.

Since the onset of the pandemic, macroeconomic policies have sought to offset the sharp declines in economic activity associated with widespread closures. The richer countries have had a greater capacity to respond. Loans from multilateral institutions have also made it possible to finance the response to the health emergency in developing countries.

The macroeconomic response has also been supported by temporary moratoriums on bank lending to households facing unemployment and to businesses struggling to survive. Grace periods for loan repayment have been granted by financial institutions in all regions. The understandable rationale has been that because the health crisis is temporary, so is the financial distress of businesses and households. But as the pandemic has persisted, many countries have found it necessary to extend these measures. Banking regulations have often been relaxed with regard to the provisioning of bad debts and debts considered to be non-performing. The result is that the magnitude of nonperforming loans can be markedly underestimated now and for many countries.

Adding to these risks, sovereign downgrades reached a record in 2020. While advanced economies have not been spared, the consequences for banks of sovereign downgrades are more serious in developing countries. In more extreme cases, if the government were to default, the banks would also suffer losses on their holdings of government securities.

Even with the vaccines available, significant damage has already been inflicted on checkups. Withholding policies have provided a valuable coping mechanism, but even extended grace periods end. As 2021 unfolds, more will be learned about whether the problem facing countless businesses and households is insolvency rather than illiquidity. High leverage will amplify the problems in the financial sector.

This type of damage to the balance sheet takes time to repair and often ushers in a long period of deleveraging. Financial institutions are becoming more careful in their lending practices. A credit crunch is usually a serious obstacle to recovery. In some cases, these financial crises turn into sovereign debt crises, as the bailout turns what was private debt before the crisis into public sector liabilities.

The first step towards managing financial fragility is recognizing the extent and magnitude of the problem, followed by restructuring and writing down bad debts. The alternative of funneling resources into zombie loans is a recipe for delayed collection.

This article first appeared in the journal Die Volkswirtschaft / Economic life published by the Swiss State Secretariat for Economic Affairs (SECO).

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