Resiliency of banking system on display during pandemic – but questions remain ahead, FSB states in report

While the international financial system displayed resiliency in dealing with the coronavirus crisis last year, the impact of the pandemic may include further tests to resiliency ahead, according to a report published Tuesday by an international regulators’ group.

The Financial Stability Board (FSB), in an interim report titled “Lessons Learnt from the COVID-19 Pandemic from a Financial Stability Perspective,” noted that while economic forecasts have been revised upward, and asset valuations could be tested by a further rise in government bond yields, some doubt about the future lingers.

“Uncertainty remains high against the backdrop of uneven vaccination progress and the continuation of containment measures,” the FSB – and umbrella group of regulators from nations in the G20 – wrote in the report. “Asynchronous economic cycles could lead to widening interest rate differentials between economies, potentially inducing disorderly capital outflows from EMEs (emerging market economies) as dollar denominated investments are suddenly reallocated across jurisdictions.”

The report warns that identifying systemic vulnerabilities remains a priority. “The current low level of corporate insolvencies may be predicated on continued policy support. Banks and non-bank lenders could still face additional losses as these measures are unwound, revealing the extent of the economic scarring across sectors and jurisdictions,” the report states.

Acknowledging that results of recent bank stress tests suggest large banks are well capitalized, the report questions banks’ willingness to sustain real economy financing in an environment of deteriorating non-financial sector credit quality. “Preserving financial stability is a necessary precondition for ensuring the smooth flow of finance to the real economy,” the report states.

The FSB is currently chaired by Federal Reserve Board Vice Chair for Supervision Randal Quarles. The report echoes themes he has recently aired publicly about resiliency of the financial system.

The report suggests that a “gradual and targeted future unwinding of COVID-19 support measures” should support financial stability during the recovery.

“Authorities may follow a flexible, state-contingent approach, adjusting and withdrawing gradually, by ensuring that measures are targeted; requiring beneficiaries to opt in; making the terms on which support is provided progressively less generous; and sequencing the withdrawal of support measures.

“Clear, consistent and timely communication about policy intentions can help the economy adjust to changes in policy,” the report states.

In other issues covered, the report notes:

  • Addressing debt overhang, including by facilitating the market exit of unviable companies and an efficient reallocation of resources to viable firms, may be a key task for policymakers going forward.
  • Evidence suggests some specific aspects of how the post-crisis regulatory framework functioned should be further examined. “This includes the role and usability of capital and liquidity buffers; the performance of countercyclical elements in prudential regulation; and potential remaining sources of excessive procyclicality whose impact may have been dampened or delayed as a result of the official sector support,” the report states.
  • Vulnerabilities among non-bank financial institutions (NBFIs) need to be prioritized, “keeping momentum and ambition in the work underway.” The report asserts that the underlying structures and mechanisms that exposed the financial system to considerable strains in March 2020 are currently still in place. “It is important to advance the comprehensive work program the FSB has developed, in collaboration with standards-setting bodies (SSBs), to enhance the resilience of the NBFI sector while preserving its benefits.” The report asserts that includes policy work to enhance resilience of non-government money-market funds (MMF) and analysis of vulnerabilities in open-ended funds, the role of margins, and the drivers of bond market liquidity.

Lessons Learnt from the COVID-19 Pandemic from a Financial Stability Perspective