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The Silent Financial Crisis

WASHINGTON, DC – The term “financial crisis” has long been associated with dramatic events, such as the rush to withdraw bank deposits and the collapse in asset prices. Charles Kindleberger’s classic books such as The World in Depression, 1929-1939 and Obsession, Panic, and Financial Collapses, and my joint work with Kenneth Rogoff, “It’s Different This Time,” document countless numbers of these facts. In recent years, the term “Lehman moment” has emerged as a reference to the global financial crisis between 2007 and 2009 and even served as the inspiration for a Broadway show.

But some financial crises do not necessarily involve the events of Lehman’s dramatic moments. Asset quality can deteriorate dramatically as economic downturns persist, especially as firms and households become highly indebted. Moreover, years of bank lending to unproductive private companies or state-owned enterprises (the latter type is common in some developing countries) would have a cumulative effect on balance sheets.

Although these crises may not always involve panic attacks and a rush to withdraw deposits, they still impose considerable costs. Banks’ restructuring and capitalization to restore solvency could be too expensive for governments and taxpayers, and new lending could remain low, leading to a slowdown in economic activity. Credit pressures also have distributional effects, affecting small and medium-sized companies and low-income households more severely than others.

The COVID-19 pandemic is sure to continue to deliver many moments of unwanted drama, including high infection rates, widespread lockdowns, unprecedented declines in production, and mounting poverty rates. But in addition to these trends, a calmer crisis is gaining momentum in the financial sector. Even without going through a “Lehman moment,” this crisis will jeopardize the prospects for economic recovery for years to come.

Specifically, financial institutions worldwide will continue to face a significant spike in non-performing loans for some time. Also, the Covid-19 crisis is a downside crisis. It disproportionately affects low-income households and small businesses that do not have much of the assets that could protect them from bankruptcy.

Since the pandemic outbreak, governments have relied on expansionary monetary and fiscal policies to offset the sharp decline in economic activity associated with widespread closures and social distancing measures. Of course, wealthier countries enjoy a crucial advantage in their ability to respond. However, increased lending by multilateral institutions has also helped fund emerging and developing economies’ response to health emergencies.

As documented by the World Bank’s Policy Tracker, unlike the 2007-2009 crisis (or most previous crises, in this case), banks supported macroeconomic incentives with a range of loan deferrals. These measures have provided some relief to families facing the threat of job losses and low incomes, as well as to companies struggling to survive amid closures and general disruptions to regular activity (and tourism-related sectors stand out starkly in this regard).

Financial institutions in all regions granted grace periods to repay existing loans, and many of them renewed loan contracts in favor of lower interest rates and better terms overall. The rationale for these measures was based on the fact that the health crisis is temporary, as is a financial hardship for companies and families. But as the pandemic continues to spread, many countries have found it necessary to extend these measures until 2021.

Besides loan deferrals, many countries have relaxed their banking regulations regarding loan loss provisions and bad loan ratings. These changes’ net result is to lower estimates of the extent of bad loans now and significantly in many countries. In many cases, financial institutions may not be sufficiently prepared to deal with a damaged balance sheet. Simultaneously, the less-regulated non-banking financial sector is more exposed to risk (this problem is exacerbated by inadequate data disclosure).

In addition to developments in the private sector, downgrades of sovereign credit ratings recorded a record high in 2020. Although advanced economies have not been spared from this, the consequences are more severe for banks in emerging and developing economies where governments’ credit ratings fall at the degree of “undesirable.” Therein “or close to it. In extreme cases of sovereign default or restructuring – and such crises are on the rise – banks will also incur losses in their holdings of government securities.

And as I mentioned in March 2020, even if one or more vaccines eliminate the pandemic virtually and immediately, the Covid-19 crisis has severely damaged the global economy and financial institutions’ budgets. Stress policies have indeed provided a vital stimulus tool beyond the traditional scope of fiscal and monetary policy, but grace periods will expire in 2021.

As the US Federal Reserve’s Financial Stability Report for November 2020 shows, political stress or political constraints indicates that the upcoming fiscal and monetary stimulus for the United States will not match the level it reached in early 2020. Indeed, many emerging markets and countries Developing countries have already reached or are nearing their monetary policy limits. By the year 2021, it will become apparent whether many companies and households face financial insolvency rather than a lack of liquidity.

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