The COVID-19 pandemic is exacting a severe social and economic toll on Europe. While European banks have substantially raised their capital buffers over the years, many suffer from chronically low profitability due to inefficient cost structures, compressed net interest margins, and the drag of legacy assets from the Global Financial Crisis (GFC) and the European sovereign debt crisis. They now stand heavily exposed to economic sectors that have been hard hit by the pandemic.
This paper evaluates the impact of the crisis on European banks’ capital under a range of macroeconomic scenarios, using granular data on the size and riskiness of sectoral exposures. The analysis incorporates the important role of pandemic-related policy support, including not only regulatory relief for banks, but also policies to support businesses and households, which act to shield the financial sector from the real economic shock. Compared to previous studies conducted by the European Central Bank (ECB) and European Banking Authority (EBA) in 2020, the analysis covers a wider range of policies and a broader set of banks—including smaller banks—within the euro area, while extending the sample to cover most European countries outside the euro area.
The baseline results suggest that despite a significant fall in capital ratios, banks remain broadly resilient to the shock. While there is no aggregate capital shortfall relative to the minimum prudential requirement, a number of the larger euro area banks may struggle to meet their threshold for the maximum distributable amount (MDA), which could create funding pressures, especially with respect to hybrid capital. The data reveal considerable cross-country variation, with the change in bank capital being sensitive both to the size of the macroeconomic shock and the initial condition of bank balance sheets and profitability. Policy is extremely important in reducing both the extent and variability of capital erosion; in particular, good poliExecutive Summary xi cies can substantially weaken the link between the macroeconomic shock and bank capital.
In an adverse scenario with a slower recovery in 2021, the erosion of bank capital would become more pronounced, especially if a premature phase-out of support measures increases default risk. The number of banks potentially breaching their MDA threshold would double, greatly increasing the risk of higher capital costs and funding difficulties.