COVID-19 and the Impact upon Financial Institutions

COVID-19 is a formidable foe in terms of health (both physical and mental health care) as well as an effective wrecking ball of global economies. It will almost certainly lead to an economic crisis, distringuished from the financial crisis we all recall from the 2008/9 period given the dramatic impact to employment levels, small and large non-financial firm performance, tax policy and personal wealth costs.

UBS's Dean Turner identifies three overaching factors at play: more global debt, less globalisation and greater digitalisation (FT, April 2020). One specific area of note is the forecasted impact of COVID-19 upon bank and regulated insurance balance sheets. This is a difficult area to predict, for one thing we do not know when the global lockdowns will be over and economic activity (however defined) resumes. Nonetheless, we know what we know, and we can spot some signals about future conditions.

For Solvency II regulated insurers, the double whammy of lower sovereign yield curves and wider credit spreads can directly hit solvency levels. The CEO of Lloyd's of London cautioned last week losses could run into the hundreds of billions of dollars dwarfing the 9/11-related market stress (FT, April 2020). The crisis will thus require an updated suite of insurer stress tests going forward (reset given the EOM moves seen in March) for asset and liability portfolios. Oliver Wyman's Astrid Jaekel has published some accessible guidiance in this regard - it is important to stress test vanila and more illquid asset holdings for spread movements, credit rating migration, and equity market disloction. One area raised in practice is whether such stress tests consider correlated moves, that is a spread move wider and downgrade risk at the same time and the impact upon solvency and risk appetite dashboard triggers. Liability side issues also must be considered including mortality risks and the impact of liability structure and liquidity management requirements.

Commercial banks are also assessing the damage. I was kinda shocked (but not really) at the scale of provisioning announced over the last two weeks. JPM, BOA and Wells all have announced circa 50% or more profit declines on the back of reserving. All banks globally are ramping up thier LLPs (not as a sign of confidence or income smoothing) but given their forward view of expected real losses with YOY changes of 300% on more and the ratio of LLPs to revenues jumping six times in the case of JP Morgan. The adoption of IFRS 9 contributes to this debate as well explained by Jonathan Ford in the FT on April 27th 2020. Perhaps COVID-19 will be a call to arms to re-consider the accounting of reserves as advocated in recent research by Abad & Suarez (2020) in Vox/CEPR.  

Of course you say what matters is actual realised losses over time and the actual impact to capital - that is correct. That will take month or longer to know.
But we know what we know - and some will prepare better than others (for an interesting article about profiting from the crisis, check out Nick Paumgarten's article in the April 13th 2020 version of The New Yorker).

Time to prepare for rough seas...  Godspeed to you all and stay healthy!

Photo Credit: The New Yorker March 2020 and the Mortgage Finance Gazette