In the first half of 2020, the global coronavirus pandemic led to the most severe economic slump in Germany in decades. Governments and central banks around the world have taken extensive measures to stabilise the economy as well as labour and financial markets. “The German financial system has proven to be stable. During the coronavirus pandemic, it has so far fulfilled its key functions,” said Claudia Buch, Vice-President of the Deutsche Bundesbank, at the presentation of the 2020 Financial Stability Review. In the further course of the pandemic, insolvencies in the corporate sector are likely to increase. This requires sufficient preparation. Banks should make use of their capital buffers to mitigate the impact on lending. The reforms implemented after the global financial crisis are paying off: banks are now better capitalised, have additional capital buffers, and can use them more flexibly. In the future, limiting existing vulnerabilities will be one of the main priorities.

Liquidity crunch averted

In the spring, many enterprises saw their production and sales drop sharply. But financial obligations did not decline on the same scale, thus leading to a sharp rise in liquidity needs in many sectors. In the corporate sector, a liquidity crunch was looming; however, this was averted, particularly thanks to extensive government measures. 

So far, the coronavirus crisis has hardly led to higher loss allowances on banks’ balance sheets. “Banks are functioning and loans are being granted. The banking system is thus currently fulfilling its key role,” said Joachim Wuermeling, the Bundesbank Executive Board member responsible for banking supervision. “It is now important that banks continue to fulfil their task of distinguishing good risks from bad ones, and subsequently granting loans to good borrowers.” 

Prepare for increasing corporate insolvencies

Thus far, the effects of the crisis have not been reflected in rising insolvencies in the corporate sector. This is due, not least, to government measures and special arrangements adopted to mitigate the crisis, particularly the temporary suspension of the obligation to file for insolvency. In the future, however, the number of corporate insolvencies and market exits is likely to increase. If these adjustments are similar to those seen in the past, banks should be able to cope. 

However, scenarios are also possible in which insolvencies and the associated credit defaults rise unexpectedly sharply. This would weigh on banks’ capital ratios. Banks could then restrict their lending in order to meet the capital ratios required by the market and by supervisors. This would put a brake on the economic recovery or exacerbate an economic slump. “Banks should use their existing capital buffers to continue lending in an adequate manner,” said Ms Buch. The buffers were built up in good times as a preventative measure so that they can be used in times of crisis. This scope was created by the supervisory reforms implemented following the global financial crisis. 

For banks, policymakers and public authorities, the key to being well-prepared for rising insolvencies is in creating sufficient administrative capacity, ensuring experienced staff are available, and examining whether insolvency proceedings can be simplified.

Facilitating structural change and limiting vulnerabilities

A functioning financial system will be vital to the forthcoming structural change. With the passing of time, future economic structures will gradually become discernible. “Unlike in the global financial crisis, it is not a matter of repairing the financial system, but rather of using the financial system to facilitate adjustments in the real economy,” emphasised Ms Buch. This requires stable banks and functioning markets for debt, but also the financing of innovation and investment with equity finance.

As a result of the pandemic, existing vulnerabilities in the financial system are amplified. Debt in the private and public sectors has risen, and low interest rates are encouraging a search for yield and an underestimation of credit risk. “The financial system needs to be sufficiently robust to be able to deal with negative developments. That is why it is essential to press ahead with the reform agenda pursued over the past decade,” said Ms Buch. Thanks to the reforms, better instruments are available for dealing with banks in distress. During the crisis, the existing supervisory flexibility is being used on a temporary basis. However, this does not mean that the requirements for the resilience of the financial system may be permanently lowered.