Impact Of COVID-19 On The Global Financial System

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Platform for Shaping the Future of Financial and Monetary SystemsImpact of COVID-19on the Global FinancialSystemRecommendations for Policy-Makers Basedon Industry Practitioner PerspectivesApril 2020

Impact of COVID-19 on the Global Financial SystemBackgroundThis briefing is the outcome of several multistakeholderdialogues organized by the World Economic Forum’sPlatform for Shaping the Future of Financial and MonetarySystems. Since mid-March, the Forum has virtuallyconvened senior leaders from financial institutions,international organizations, central banks and otherinstitutions for several discussions about the impact ofCOVID-19 on the financial system.These discussions aimed to identify emerging financialstability risks, understand adjustments to consumption andinvestment due to COVID-19, discuss where policy-makerattention is required, and share emergency measuresimplemented by firms as well as lessons learned from thiscrisis and earlier times of market stress.This briefing summarizes the key findings of thesediscussions, providing insight into financial market trends,private-sector views of government responses to date andpriorities for future policy, areas of risk and uncertainty, andexpectations for the future. While some context on marketactivity and policy decisions is provided, the focus is onsharing the views expressed by the participants in theseForum-hosted discussions, rather than a comprehensiveoverview of the situation.The goal is to present the current state of debate among keyfinancial system stakeholders. As the human and economicimpacts of COVID-19 continue to be felt, the Forum willconvene similar discussions and share this learning.2

Impact of COVID-19 on the Global Financial SystemSummary of policy recommendations1234“Flattening the curve” of firm mortality mustbe a top policy priority, and governments willhave to expand the size and scope of supportprogrammes over time.Governments, including regulators andcentral banks, must continue to coordinatepolicy on a global level to help maintainfinancial stability. Within countries, policyguidance must be clear and consistent acrossregulatory agencies.Policy-makers must ensure that the financialsystem remains capable of safely meeting thepublic’s need for financial services throughdigital channels.Advanced economies may need to furtherexpand the support offered to emergingmarkets and developing economies.3

Impact of COVID-19 on the Global Financial SystemKey insights1. The global financial system hasemerged from an initial period of extremestress, in large part due to governments’efforts to stimulate the economy, centralbanks’ speed at addressing marketdisruptions, and the resilience of financialinstitutions.markets from propagating into market-widedisruptions. At the same time, central banksannounced plans to expand asset purchaseprogrammes, with the goal of reintroducingliquidity into key asset classes, surprisingsome participants, who said they expecteda more moderate central bank response.At the end of February 2020, financialmarkets entered a risk-off phase withsignificantly increased volatility acrossmarkets. Equity markets began decliningrapidly, losing around 30% of market value ina matter of weeks, with the speed of the selloff exceeding that of the global financial crisisof 2008-2009 (GFC).In late March, equity markets began torebound following announcements ofsubstantial fiscal support packages bylarge advanced economies. According tomarket participants, this rebound reflectsexpectations that the size and targeting ofthe fiscal packages – averaging 10% of GDPacross the United States and Europe, witha focus on supporting small businesses andhard-hit industries – will effectively address themacroeconomic slowdown.By early March, short-term funding marketsand international US dollar funding marketsstarted to show signs of stress and, in theweeks to follow, there were signs of illiquidityin the US Treasury market, the deepest andmost liquid financial market in the world.These stresses carried through into creditmarkets, making it difficult for firms andgovernments to borrow funds at any tenure.Moreover, throughout this period, equitymarket infrastructure remained remarkablyresilient, which, according to someparticipants, enabled markets to remainfully functional and begin to rebound.Exchanges utilized tools like market-widecircuit breakers, stock-specific guardrailsand dynamic restrictions on short sellingto maintain both orderly functioning andmarket liquidity. Participants also notedthat post-trade infrastructures remainedfully operational at record high volumes andvolatility, in addition to effectively managingmargin requirements to prevent potentialsettlement failures from spilling over.Central banks reacted quickly to theemerging signs of stress, applying lessonslearned during the GFC. Participantsfrom across the financial system notedthat the US Federal Reserve and othercentral banks began addressing fundingmarket impairment in a matter of days, asopposed to the months it took in somecases during the GFC. In doing so, theyprevented stresses in underlying funding4

Impact of COVID-19 on the Global Financial SystemIn credit markets, the story has beensomewhat mixed to date, but participantshave been generally encouraged by thedirection of developments. Whereas primarybond markets had effectively closed in earlyMarch, by early April investment banksreported strong demand for new creditissuance by investment-grade borrowers.Participants attributed the re-opening ofprimary credit markets to central bankaction as well as a somewhat improvedmacroeconomic outlook. On the other hand,high-yield markets and secondary bondmarkets remained largely closed, althoughthere is some optimism that new centralbank corporate credit facilities could providea backstop in these markets.2. While the initial acute phase of thefinancial crisis may have eased, firms andpolicy-makers remain concerned about arange of risks that could present a threatto financial stability and, ultimately, theeconomic recovery.Participants from the private sector andpolicy-makers agree that a key differencebetween the GFC and this crisis has beenthe role of banks. Unlike the GFC, this crisisis fundamentally a public health emergencythat has become an economic downturn asgovernments have taken measures to stopthe spread of the disease. But, rather thancontributing to the problem, banks are now amajor part of the solution, due in large part tothe strength of their balance sheets.While financial system resilience, fiscal support,regulatory flexibility and liquidity provision todate have helped ensure that the financialsystem is supportive of economic recovery,a more protracted slowdown may presentnew risks to the financial system. Thus,while the initial phase of the crisis has eased,participants are keenly aware that there maybe greater turmoil affecting the financial systemas the economic fallout continues, potentiallyprecipitating a financial crisis down the line.The post-crisis regulatory framework hasled to substantial increases in capital heldby large advanced economy banks, inaddition to more liquid assets and morestable sources of funding. Not only are banksrelatively stable, but they are also servingas the primary transmission mechanism formuch of the business support components ofmany countries’ fiscal packages. Participantsadvocate that the focus of regulatory andcentral bank policy should be on maintainingthis stability while enabling banks to meet theneeds of the real economy, which may be adifficult balance to achieve.While equity markets have reboundedsomewhat since their March lows, theserebounds may be premature, with marketvaluations not reflecting potential extremedownside scenarios. Participants notedthat volatility in equity prices likely reflectsoscillation between more optimistic andpessimistic macroeconomic outlooks amonginvestors. However, some participants arguedthat, even when equity markets reached theirlowest levels in March, market valuations offirms may not have priced in the most severe,yet plausible, downside scenarios.All stakeholders have repeatedly highlightedthe degree of uncertainty currently plaguingfinancial markets and institutions. Thereis uncertainty about how badly the viruswill affect different countries, how longcontainment measures must persist indifferent markets, how effective policywill be at mitigating lost activity, and howhouseholds and firms will change theirbehaviour in the medium term.5

Impact of COVID-19 on the Global Financial SystemOne view of such a scenario would involvea severe protracted recession in advancedeconomies leading to a credit crunch – asbanks face greater credit losses than theirbalance sheets can withstand, despiteongoing central bank support – which, inturn, would deepen the recession. Whilethis scenario is not seen as likely, someparticipants said they believe that equitymarket investors should be more cognizantof downside risks.high-yield credit markets – middle-marketfirms’ traditional source of capital and liquidity– are largely closed due to crisis-driven riskaversion. Given the scale of high-yield andleveraged loan markets globally, participantsfear that failure to support these firms couldlead to large balance sheet losses for bothbanks and investors, in addition to additionalblows to employment and income.3. The economic and financial crisisin emerging market and developingeconomies may be more severe than inadvanced economies.While investment grade borrowers havebegun issuing new bonds, secondarymarkets have remained largely closed. Assetmanagers have reported that it is difficult tofind any price signals in the markets. Manyparticipants argued that this illiquidity hasbecome a structural issue, as banks are nolonger the primary market makers for muchof the fixed-income market, stemming frompost-crisis regulatory changes.Both private-sector participants and policymakers remain concerned about the rangeof risks presented by weaknesses in manyemerging market and developing countries.Most importantly, participants highlighted therisk of a true human tragedy if countries areunable to contain the spread and deadlinessof COVID-19.While it is too early to judge how effectivethe US Federal Reserve’s corporate creditpurchasing programmes will be at easingilliquidity in these markets, there is concernthat persistent illiquidity could present a risk,particularly in the event of forced sell-offsby asset owners or managers due to creditrating downgrades. Although there havebeen limited ratings downgrades to date,a longer slowdown with limited additionalgovernment support could push manyfirms’ debt profiles below investment grade,thereby requiring certain asset owners, suchas pension funds, to offload bonds into anilliquid market.While these issues were not the focus ofthe discussions, participants from certaincountries in sub-Saharan Africa, LatinAmerica and South Asia spoke of economicconditions that could lead to the virus’s rapidspread (e.g. lack of access to clean water insome areas, limited infrastructure for remoteworking and population density), in additionto weak public health systems that arenot equipped to manage the needs of thepopulation in a pandemic.Participants are also vigilant about thefinancial and economic risks for emergingmarket and developing economies, manyof which face a multifaceted crisis unlikethose experienced in the 1990s or duringthe GFC. Factors include the massivedecline in commodity prices stemming froma simultaneous supply-and-demand shock,disruptions in supply chains, dramaticallyreduced exports given recessions inadvanced economies and, of course, theneed to implement COVID-19 containmentmeasures domestically.A number of participants have arguedthat middle-market firms in the hardesthit sectors are the firms most at risk ofinsolvency, which could lead to significantmacroeconomic and financial fallout.Whereas many small businesses and largecorporates have been targeted by a range offiscal and central bank support programmes,participants said they feel that mid-size firmshave been largely excluded. Concurrently,6

Impact of COVID-19 on the Global Financial SystemWhereas most advanced economies areaddressing emerging recessions with largefiscal packages, many emerging-marketand developing economies lack the fiscalspace to adequately respond. Moreover,since the beginning of the crisis, investorshave fled from emerging markets, withportfolio outflows exceeding those duringthe GFC and other periods of major stress.disbursing household support throughfintech platforms, and banks developingpartnerships with fintechs to rapidlytransform their digital and contactlessofferings.However, in other countries, there is growingconcern that many fintech companies –which have grown rapidly over the pastdecade by lending to SMEs and households– could collapse under the stress of severecredit losses. Given that in many countriesfintechs have helped expand access tofinancial services, participants felt that theloss of fintech ecosystems in these countriescould be a major blow to financial inclusion.While some emerging markets are betterpositioned to withstand and addressthese shocks, many are seeking variousforms of liquidity support from advancedeconomies. There has been recorddemand for emergency programmes fromthe International Monetary Fund (IMF) andmultilateral development banks, whichthese institutions have met by expandingthe size and breadth of the support offered.Some emerging market economies withoutaccess to bilateral swap lines with theUS Federal Reserve have instead begunusing the Fed’s new FIMA Repo Facility;participants representing banks fromsome of these countries said they areoptimistic that this facility will effectivelyprovide much-needed short-term US dollarliquidity.Nevertheless, despite the increase insupport to many countries, participantsremain concerned that deep crisesacross emerging markets could preventgovernments from being able to protectvulnerable populations, in addition topresenting significant losses to investorsand lenders that could hurt balance sheetsglobally.One area of uncertainty for emergingmarket and developing countries is thefuture of financial technology (fintech)companies. In some countries, like China,fintech companies have been important inthe policy and financial system response,with regulators allowing fintechs to digitallyoriginate loans to SMEs, local governments7

Impact of COVID-19 on the Global Financial SystemRecommendationsfor policy-makersMany participants said they feel theexperience of China – where banks,fintechs and government worked handin-hand to deliver emergency support toSMEs – is instructive. Many also felt that,as the economic crisis unfolds, it will benecessary for the government to providesupport to so-far-excluded companies,such as middle-market firms lackingaccess to capital markets.1. “Flattening the curve” of firmmortality must be a top policypriority, and governments will have toexpand the size and scope of supportprogrammes over time.Most participants agreed that supportingSMEs and larger businesses is keyto maintaining both employment andfinancial stability, and many have beenencouraged by the speed with whichadvanced economies have rolled outsupport packages to firms. However,there is concern that the size of packagesmay prove insufficient for the durationof the crisis; that disbursement may beslower than is needed; that not all firmsin need would be targeted; and that suchprogrammes may be overly reliant on debtfinancing.While most agreed that, in the short term,the focus should be on liquidity support,there was also some consensus that,ultimately, governments might need to takeequity in some firms in order to keep themafloat, which would require developing thetools to fairly and efficiently do so. Someparticipants highlighted the risk of addingadditional debt to firms, which, beforethe crisis, already had record levels ofborrowing.To prevent short-term liquidity problemsfrom becoming solvency issues,participants agreed, governments mustremain vigilant about the availability offunds for SMEs and larger firms as thecrisis persists. Moreover, given that SMEshave short windows of cash on hand,programmes must be designed to ensurerapid disbursement of funds throughsimple, all-digital channels.Many participants said they feel that, as thecrisis develops from a “liquidity phase” intoa “solvency phase”, it will be necessaryfor governments to consider a range ofpolicy tools, including efficient bankruptcyand restructuring systems, governmentguarantees and other support for privateinvestments, programmes for sectorspecific government equity injections,and establishing asset managementcompanies.8

Impact of COVID-19 on the Global Financial SystemGiven that many governments lack therequisite expertise and structures forowning and operating businesses, theyshould build on domestic institutionswith relevant experience (e.g. sovereignwealth funds), partner with the privatesector where appropriate, and moveearly to design these programmes, withtransparency and fairness in mind.firms, which often receive guidance fromsecurities regulators. Policy-makersshould ensure that regulatory andsupervisory changes are coordinatedacross the relevant domestic institutionsto prevent confusion from limiting theeffectiveness of policy action.3. Policy-makers must ensure thatthe financial system remains capableof safely meeting the public’s needfor financial services through digitalchannels.2. Governments, including regulatorsand central banks, must continue tocoordinate policy on a global level tohelp maintain financial stability. Withincountries, policy guidance must beclear and consistent across regulatoryagencies.Given the need to quickly disbursefiscal support to households and smallbusinesses – in addition to the broaderneed to deliver financial services ata time when populations are beingasked to socially distance – financialinstitutions must have leading digitalcapabilities. However, the crisis hasso far exposed the variation in digitalmaturity among institutions. While manyhave rapidly adapted to digital operatingmodels and met customers’ needsthrough digital channels, some bankslack the operational and customerfacing capabilities to deliver in this newenvironment.Much as health experts have called forgovernments to work together to containthe spread of COVID-19, participantsadvocate deep coordination by financialsector policy-makers. Most agreed thatinternational cooperation to date has beenmeaningful, including through fora like theBasel Committee and the Financial StabilityBoard. However, many said they feel that,given the speed with which the crisishas evolved, small differences in policyadjustments between countries couldplace undue operational burden on firms.Thus, regulators, supervisors and centralbanks should continue to coordinatefinancial stability policy across countries, asis appropriate.In the short term, policy-makers shouldleverage the strengths of the entirefinancial system, including fintechs, torapidly deliver support to small businessesand households. Moving forward, bankscan explore partnerships with fintechsto quickly and safely introduce newproducts. Policy-makers should alsoencourage banks to continue to exploreother technologies and partnerships thatenable them to better serve digital-firstcustomers and to operate in a more agilefashion.While participants agreed that regulatorypolicy within countries has generallymoved in the same direction, manyexpressed concern that, in certain areas,regulators and supervisors are notsufficiently harmonized in their approach.For example, with regard to calculatingexpected credit losses under IFRS 9accounting regulations, some participantsrepresenting banks said they feel they arereceiving mixed messages from prudentialsupervisors and from their accou

markets. Equity markets began declining rapidly, losing around 30% of market value in a matter of weeks, with the speed of the sell-off exceeding that of the global financial crisis of 2008-2009 (GFC). By early March, short-term funding markets and international US dollar funding markets started to show signs of stress and, in the

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