14 December 2020
The coronavirus pandemic has been a major shock to the European economy, with an unprecedented fall in economic activity and great uncertainty worldwide. Demand has plunged at home and abroad, many companies have had to close as a result of the lockdown and related restrictions, and many people whose income depends on these firms have lost their jobs.
All this has made it difficult for many companies to survive as their sources of earnings have dried up. To help these companies and, thereby, to protect jobs and the economy as a whole, the ECB and national governments have put in place measures that support banks’ lending to businesses. These loans help healthy companies to cope with the crisis.
Critics have raised the question whether our relief measures also support or create zombie firms – companies that cannot sustain their business over time and are artificially kept alive through loans. Are banks giving out loans to firms that will not be able to pay them back? And will non-performing loans skyrocket as a result? Let’s take a closer look.
Many companies that have lost their sources of income because of the lockdown have had to compensate for the loss by asking for loans from their banks. Governments have created public guarantee systems to make it easier for banks to provide financial support to affected companies. Thanks to these guarantees banks have been able to lend more than they would otherwise have been able to. And thanks to these loans many companies have been able to keep operating. But has this led to banks lending to zombie firms?
The rules that banks must always follow in their lending also apply to state-guaranteed loans: banks must always assess the creditworthiness of their customers, in other words their financial situation and the risk of loans not being paid back. This means banks should only give out loans when they think the borrower will be able to repay them. State guarantees do not change this rule and, therefore, should not encourage banks to lend to zombie companies. The ECB has repeatedly stressed that banks must maintain sound lending standards.
Another rule that banks must always follow is to continuously assess the risks associated with the loans they have already granted. This allows banks to identify when borrowers experience financial difficulties at an early stage and to find appropriate solutions for otherwise sound customers in a timely manner. It also enables banks to put sufficient amounts of money aside early enough to protect themselves against expected losses – this is called booking “loss provisions”.
Certain relief measures have made it difficult for banks to determine whether a borrower is in trouble. Normally, the most obvious indicator are missing payments. During the crisis banks in many countries have granted borrowers breaks from loan repayment, either at their own initiative or under a national moratorium. Banks therefore cannot assess the borrowers’ riskiness mechanically and must rely on more qualitative information. For this banks must set up effective risk assessment and early warning systems.
To detect zombie firms early on even during the crisis, the ECB has asked banks to have sufficient capacity to monitor the situation of borrowers and their loans. They should also make greater use of expert judgement in their assessment. Banks need to improve their preparations for expected losses as well. Sufficient loss provisions should help mitigate the increase in bad loans once the payment breaks expire.
In this crisis banks face a dilemma. On the one hand they should keep up or increase their lending. On the other hand the increased risks reduce banks’ capacity to lend as they must digest higher losses.
To help banks square this circle, the ECB has allowed them to make use of their capital buffers, in other words the money they have put aside for crisis times. Banks can use the buffers to offer new loans or to cover losses from existing ones. In combination with the other relief measures, this has allowed banks to continue lending despite the increased risk levels. It does not mean that banks have been allowed to compromise on their lending standards or the management of risks.
Simulations show that the economic situation would be worse if banks had not been allowed to use their capital buffers. After all, banks build up capital buffers in good times precisely in order to use them in bad times.
The ECB’s relief measures, the public guarantees and the payment breaks have helped soften the overall shock of the coronavirus crisis on the economy. They have provided vital help to otherwise sound companies that have run short of funds because of the crisis. The risk management rules and the ECB expectations that banks should have followed should also have prevented these measures from providing support to zombie companies.
This intention is deeply embedded in the design of the relief measures and the supervisory safeguards. But because these are new measures and the volume of loans granted is high, there nevertheless remains a risk that lending to non-viable firms will be overlooked. Therefore, the combined efforts of banks, their auditors, supervisors and policymakers remain necessary to keep this risk under control.