The arrival of COVID-19 has brought with it huge levels of uncertainty for individuals, businesses and communities across the globe. With the situation seeming to develop almost by the hour, the finance industry is just one area experiencing fallout as a result of the outbreak.
Currently, governments and central banks worldwide are preparing rescue plans for the economy and starting conversations about stimulus plans for when the virus subsides. Indeed, President of the European Central Bank, Christine Lagarde has called the outbreak “an extreme economic shock”.
Dr Tobias Dieler, Lecturer in Finance at the University of Bristol Business School, weighs in on how exactly some of the world’s major financial markets and institutions are having to adapt.
Firms will draw on credit lines to bridge short term liquidity problems and at the same time some of their loans will become non performing. This causes a liquidity shortage for commercial banks as they have increased outflows and decreased inflows. At the same time, in an environment of falling stock prices, banks are making losses when selling their assets to cover their liquidity needs.
Before the COVID-19 outbreak, some banks were still dealing with the aftermath of the Great Financial Crisis in 2008/09. As a result their liquidity buffers and their asset quality might not withstand another crisis. This is particularly concerning as in modern banking, banks are closely connected to each other through the interbank market where they borrow and lend money to each other for short term liquidity purposes.
In fact, dropping stock prices are a problem for the industry across the board. For investment banks, pension funds, hedge funds, money market funds etc.. One of the most concerning areas for the public are our pension funds. They were already in distress before COVID-19. With this heightened economic uncertainty, pension cuts in the future become more and more likely.
In order to soften the blow from lower economic activity, central banks around the world are decreasing interest rates or extend their bond purchase programs. This is clearly helpful for governments as they can finance their rescue programs at lower rates and similarly firms have access to cheaper loans to get through the crisis. At the same time, protracted low interest rates are bad for bond investors such as pension funds.
Another problem in a low demand environment for many industries is that firms do not have profitable investment opportunities and hence cannot invest which will harm the economy in the medium/long term.
There is a question mark behind insurance companies. Their financial health will depend on whether they gave out policies which cover individuals and businesses against losses in a pandemic. And if they have, did they build enough reserves to pay out these policies. Insurance companies use their clients premia to invest in financial markets. In fact, they are among the largest investors in the market. If they have to pay out insurances while their assets are suffering from losses they might run into liquidity issues.
Consumption and the road ahead
Hopefully consumers will make up for foregone consumption when the virus dies down helping the economy to recover.
The financial industry might use this occasion for the development of a new set of financial products insuring against health crisis, as they themselves will have to adjust their risk models to take into account health risks.
This crisis teaches us that health systems can no longer be thought of nationally but have to be thought of as connected globally. That is health problems in other parts of the world should become more of a concern for our health expenditure decisions.
An efficient health system is a comparative advantage in the global economy. Again, this should be factored in when taking budget decisions on the government level.
About the author
Dr Tobias Dieler is a Lecturer in Finance at the University of Bristol Business School. His research focuses on the Microeconomics of Financial Markets. In particular, on institutional aspects such as the division/integration of commercial bank and investment bank, the role of a CCP in money markets and the effect of differential liquidity needs in asset trade.