was extended until June 2021 at least, with its envelope raised to EUR 1.35 trillion and maturing principal payments reinvested until the end of 2022 at least.
On the prudential regulation side, several measures were decided by the ECB, the European Commission and supervisory authorities to provide temporary capital relief for banks. Banks were allowed to operate below the level of capital defined by the Pillar 2 Guidance for the capital buffer and the liquidity coverage ratio. Supervisory flexibility regarding the treatment of non-performing loans was allowed and the capital requirements for market risk were reduced. To counteract the potentially destabilising impact of the more stringent banking regulations that were on the horizon, the implementation of certain new measures was frozen or postponed (ECB, 2020d).[9]
This extensive set of monetary and prudential measures proved very effective in keeping credit flowing. The coronavirus recession has resulted in large-scale changes to the balance sheets of euro-area banks. Corporate borrowers frontloaded their liquidity needs by taking out loans and placing the financing obtained in liquid assets, mostly held in commercial bank accounts. Banks significantly increased their funding from central banks while also building up their liquidity buffers there. The funding markets for banks have not shown the major signs of the distress they exhibited during the global financial crisis. In addition, most EU national governments provided state guarantees for bank loans, mainly targeting small and medium-sized enterprises (SMEs). In some countries these guarantees amount to more than 20% of GDP and represent over half of the existing stock of loans to non-financial corporations.
Fiscal policy
In Europe, central banks have retained their key roles, but are no longer the only major players. This time, governments and the European Commission have acted swiftly and strongly to cushion the economic shock caused by the pandemic with fiscal measures. Around EUR 2.7 trillion will be mobilised in response to the pandemic. This amount includes national liquidity measures, including the schemes approved under the temporary EU state aid rules, and measures taken under the flexibility arrangements of the EU budgetary rules (general escape clause).
Policymakers have fully grasped their crucial role in mitigating the impact of the crisis, avoiding a prolonged and painful slowdown and supporting a rapid and strong recovery. Government policies are key to stemming the amplification of the demand-side shock, and can help cushion the impact on the long-term potential output of EU economies. Within the European Union, governments have taken a wide array of measures to support households and firms. Support at the European level comes on top of these national measures and helps to preserve a level playing field as governments’ capacities to respond to the shock are not equally distributed across the European Union. The option of common support instruments continues to be important in light of the varying capacity of Member States to weather a further economic shock brought about by a second wave of infections. These common support instruments are also crucial to avoid repeating the pattern of the Europe’s last crisis, which was followed by a prolonged period of subdued investment and widening divergence (Anderson et al., 2020).
Economic and fiscal policies have also been set up at the EU level. A temporary Support to Mitigate Unemployment Risks in an Emergency (SURE) instrument was designed to provide Member States with temporary funding of up to EUR 100 billion by covering part of the cost of creating or extending national short-time work schemes. In addition, direct EU budget support of up to EUR 70 billion will be made available, mainly through the Coronavirus Response Investment Initiative. The initiative uses unspent EU cohesion funds and allows for greater flexibility and more upfront spending by providing 100% EU financing for measures to fight the crisis. Through the European Guarantee Fund, the EIB Group can support up to an additional EUR 200 billion of liquidity and risk finance, targeting SMEs in particular. The European Stability Mechanism (ESM) also introduced a Pandemic Crisis Support credit line. The credit line includes a liquidity facility of up to a maximum of 2% of Member States’ GDP. The facility can be drawn in several tranches until the end of 2022 at least, representing a maximum of EUR 240 billion.
The NextGenerationEU recovery plan tops up the immediate crisis response. The NextGenerationEU recovery plan aims to raise money by temporarily lifting the limit of 2% of EU gross national income it is allowed to raise for its own funds. The change enables the European Commission to borrow EUR 750 billion on the financial markets. This additional funding will be channelled through EU programmes and repaid over a long period of time through future EU budgets. In addition, the Commission has also proposed a revamped long-term EU budget and will dedicate some of its own resources to round out the NextGenerationEU programme.
Public debt is on the rise, but this is not the most pressing issue. The October 2020 IMF Fiscal Monitor estimated that the global fiscal response to the pandemic totals an unprecedented EUR 10 trillion, about 12% of the world’s GDP (IMF, 2020c). The pandemic will continue to drive up public debt, which the IMF expects to reach 99% of GDP in 2020 and to stabilise at around 100 % of GDP by 2025. The IMF urges governments to maintain/extend support at least into 2021 to sustain the recovery and limit long-term scarring. Investment should therefore focus on health, education, digitalisation and green infrastructure to address climate change and future pandemics.
After the crisis, the attention will need to shift towards boosting the recovery by ensuring that the pandemic’s legacy does not weigh on economic activity. Creating a favourable environment for private investment and fostering structural change will be important. In the EU context, it is important that the recovery plan be combined with measures that tackle the key structural challenges that Europe faces, such as climate change, digitalisation and inclusiveness.
With non-performing loans looming, are financial markets correctly pricing risk?
The EU banking sector entered the COVID-19 crisis on a stronger capital footing than after the global financial crisis. The current economic crisis triggered by the pandemic did not originate in the financial sector and ten years of structural transformation has put banks in a much stronger capital position and given them a much deeper understanding of the various risks and interdependencies. The average core tier 1 capital ratio in the European Union now stands at 18.3% of risk-weighted assets, 8 percentage points higher than in 2008 (Figure 21). Although the rise masks some major differences between countries, countries with a weaker capital position are still in a much stronger position than before the onset of the global financial crisis.
Non-performing loans (NPLs) might increase at a faster pace than during past crises, despite the payment deferrals put in place in most EU countries. Prior to the COVID-19 shock, NPL ratios were declining in most countries (3.2% of total loans in the euro area). However, they are now likely to increase, and will possibly do so faster than in the past two recessions as the fall in GDP is expected to be much steeper and more broad-based, with households, small businesses and companies in several economic sectors affected simultaneously. The allotment of credit lines to firms hit by the lockdown is likely to be accompanied by a rise in the risk for banks. However, the ECB has taken several measures to guarantee the liquidity of European banks, limit haircuts on debt and extend the pool of eligible collateral.
Figure 21
European banks’ core tier 1 ratio (percentage of risk-weighted assets)
Source: IMF and EIB calculations.
Banks have significantly improved the quality of their assets in recent years, but the crisis could take a toll if it wears on. After peaking in the fourth quarter of 2014 (at 7.1%),
