Banking

A banking sector pandemic

Bank stocks and the response to financial policy initiatives 

The spread of COVID-19 represents an unpresented global shock, with the disease itself and mitigation efforts—such as social distancing measures and partial and national lockdown measures—having a significant impact on the economy.  In the immediate aftermath, the financial sector, particularly banks, were expected to play an important role in absorbing the shock by supplying vital credit to the corporate sector and households.  In an effort to facilitate this, central banks and governments around world enacted a wide range of policy measures to provide greater liquidity and support the flow of credit. An important policy question is the potential impact of these countercyclical lending policies on the future stability of banking systems and to what extent their strengthened capital positions since the global financial crisis will allow them to absorb this shock without undermining their resilience.

In a recent paper, we use daily stock prices and other balance sheet information for a sample of banks in 53 countries to take a first look at this issue.  Our contribution is twofold.  We first assess the impact of the pandemic on the banking sector and investigate whether the shock had a differential impact on banks versus corporates, as well as by different bank characteristics. Second, using a global database of financial sector policy responses and an event study methodology, we investigate the role of different policy initiatives in addressing bank stress as perceived by markets, in the aggregate, as well as across different banks.[1]

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Our results suggest that the adverse impact of the COVID-19 shock on banks was much more pronounced and long-lasting than on corporates and other non-bank financial institutions, revealing the expectation that banks are to absorb at least part of the shock to the corporate sector (figure 1). We also show that banks with lower pre-crisis liquidity buffers and higher exposure to the oil sector experienced larger than normal price drops.

Figure 1. Average Stock Returns of Banks vs Firms and Non-Bank Financial Companies

Note: The figures plot the average daily stock market returns of banks, firms, and non-bank financial institutions in the sample normalized to January 1, 2020. The average returns of firms in panel A are equally weighted across countries and net of bank returns. The average returns of banks are weighted by the contribution of each bank to total bank assets in each region. The regional average bank returns are then equally weighted across regions. The same approach is used to obtain the average returns of non-bank financial institutions (panel B).

We investigate more than 400 policy announcements between February and April 2020. The financial sector policy initiatives are classified as follows: (i) Liquidity support measures are used by monetary authorities to expand banks’ short-term funding in domestic and foreign currency. (ii) Prudential measures deal with the temporary relaxation of regulatory and supervisory requirements, including capital buffers. (iii) Borrower assistance measures include government-sponsored credit lines or liability guarantees. (iv) Monetary policy measures includes policy rate cuts and quantitative easing. To investigate the market response to each policy measure, we study abnormal returns to bank stocks around announcement days. Our results (summarized in figure 2) are as follows:

  • Announcements of liquidity support were associated with large increases in banks’ stock prices. It appears that access to central bank refinancing and initiatives that address shortages in bank funding had a calming effect on markets, as evidenced by the overperformance of bank stocks around these events. These initiatives also seem to reduce the liquidity risk premium, as banks with lower liquidity provisions experienced larger abnormal returns after the announcements.
  • Borrower assistance announcements had a strong an immediate impact on bank stock prices in developed countries. Such policies, which typically include the introduction of government guarantees, automatically transfer risks from banks’ balance sheets to the sovereign, often requiring large fiscal commitments. Relatedly, we find that for developing countries, where there is less room for fiscal expansion, borrower support initiatives had no effect on bank stocks.
  • In contrast, prudential measures seem to have only a minor impact on bank stock prices, and in some cases the effect appears to be negative. The results suggest that markets are pricing the downside risk from the depletion of capital buffers, as well as the additional expansion of riskier loans in the balance sheets of banks. It is possible that in countries with financial vulnerabilities before the start of the crisis, banks were deemed to be in a worse position after the use of countercyclical measures.
  • The results for monetary policy announcements are more mixed. Although such announcements were not associated with aggregate bank stock price increases, they did seem to reduce the liquidity premium, confirming that policy rate cuts and quantitative easing represented a key tool during the crisis.
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Our evidence suggests that the countercyclical lending role that banks around the world are expected to play has put the sector under significant pressure. Although policy measures such as liquidity support, borrower assistance and monetary easing moderated this adverse impact for some banks, this was not true for all banks or in all circumstances.   For example, borrower assistance measures and prudential measures exacerbated the stress for banks that were already undercapitalized and/or operated in countries with little fiscal space.  These vulnerabilities will need to be carefully monitored in the coming year as the pandemic continues to take its toll on the world’s economies.      

Figure 2. Abnormal Returns of Bank Stocks around the Announcement Window

Note: The variable plotted on the vertical axis shows the accumulated abnormal returns in percentage points within the window of one day before the event and three days after the event, scaled to zero on the day before the announcement. Accumulated abnormal returns are averaged across banks for each policy category. The horizontal axis shows days within the event window, with “0” corresponding to the day of the announcement. The restricted sample excludes days with overlapping announcements of different categories within each country.

[1] This data set was compiled and made publicly available by the World Bank.

Source : blogs.worldbank.org

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