A big question looms. We know that the coronavirus will spread, possibly infecting the majority of the global population in time. We know that the economic disruption it may cause has spooked every stock market in the world. And we know that in an effort to conquer the panic, the world’s most powerful policymakers have fired off “bazookas” by the bucketload.
What no one knows — after one of the worst ever weeks in financial markets — is whether Covid-19 will move from a health emergency and resultant market slump into a full-blown financial meltdown.
The last time there was this level of mayhem in the markets, banks such as Northern Rock and Bear Stearns were teetering on the brink of collapse. They turned out to be 2007’s harbingers of a far bigger disaster: by 2008 the global banking system had to be rescued, at a cost of hundreds of billions of dollars. The repercussions for politics and the economy can still be felt around the world.
The good news is that banks today are objectively in far better shape than they were going into the crisis 12 years ago. The regulatory safeguards put in place in the wake of 2008 — far higher capital requirements, big liquid funding buffers and sharper supervision regimes — have given investors confidence in banks’ solidity.
But there were signs last week that this confidence was cracking. On Thursday, amid the worst UK and US trading day since Black Monday in 1987, the Stoxx Europe 600 Banks index fell 14 per cent to a level not seen since the late 1990s. The slump was significantly bigger than the 11 per cent fall in the European market overall.
Given the safeguards in the system, this looks irrational. But there are plenty of reasons why the apparently panicked selling of bank equities might be logical after all.
First, consider the supposedly tough stress tests that regulators use to reassure us about bank safety. Last week they suddenly looked rather weedy. The “stressed scenario” that banks’ balance sheets were subjected to at the start of the year by European regulators involved an equity market fall of 25 per cent — already surpassed in many regions. The Bank of England last year stress-tested for the Vix index of market volatility peaking at an average of 41. That sounded extreme when it was hovering around 12 at the start of the year. Last week it topped 75.
With bad timing, regulators have been easing rules in recent months. The Federal Reserve lightened the capital, liquidity and stress test obligations for all but the top eight US lenders. In Europe, a new capital directive allows banks to use forms of debt, not just equity, as part of their capital calculations.
The US had also never applied global standards for so-called countercyclical capital buffers — extra reserves to fall back on in bad times. Some jurisdictions, such as the UK and a few other European countries, did have buffers. And logically the BoE and European Central Bank last week said these should now be released, freeing up more capacity to lend. But the buffers were never big. And they could be gone long before we know how bad this crisis will get.
It is still unclear how hard lenders will be hit by the impact of Covid-19. Banks now bet their own balance sheets in the markets far less than they did pre-2008, but the hedge funds and other asset managers that are exposed are big borrowers from the banks. At the same time oil companies, airlines, and the hospitality and healthcare sectors have been urgently drawing down credit lines.
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If the coronavirus crisis morphs into a credit crisis, the conundrum will be how policymakers respond: central banks’ debt-and-more-debt policies of the past decade are increasingly looking like part of the problem, not the solution.
The Institute of International Finance said in January that total global debt was on target to hit a record $257tn by the end of this month, 50 per cent more than the tally in 2008. Conventional economic theory holds that if interest rates remain in ultra-low territory, headline debt volumes can grow with relative impunity because they will remain easily serviceable.
Yet the threat of global recession this year wrecks that complacent view. The IMF warned last autumn that, given fragile earnings and high levels of indebtedness, 40 per cent of the world’s corporate bonds — or $19tn in aggregate — would not be serviceable even in a meltdown that was only half as severe as 2008. Financial crisis is starting to look like a real possibility.
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