As the COVID-19 pandemic pushes the region and the rest of the world into a deep recession, financial systems are likely to come under significant strain, the Inter-American Development Bank (IDB) has warned in a just-released report.
Because it is unclear how soon regional economies will recover, the IDB in the report, titled “Sound Banks for Healthy Economies: Challenges for Policymakers in Latin America and the Caribbean in Times of Coronavirus”, stated that good policies will be critical to navigate the coming months.
With that in mind, the report
recommends that central banks focus on liquidity provision and avoid the monetary financing of fiscal deficits and taking on private sector credit risks.
“Central banks should ensure all foreign currency-denominated transactions are reported, so the risks can be assessed,” the report states.
“They should take a holistic view, perhaps by developing new stress tests, to model corporates’ roll-over and solvency risks, how they may impact banks and other financial institutions and the likelihood that smaller firms will be crowded out of credit markets. Where the dangers are significant, policymakers may need to take pre-emptive action to help firms restructure debts or even provide equity or equity-like injections.”
Additionally, the IDB advises countries like The Bahamas to seek support from multilateral development banks, including the International Monetary Fund (IMF) – which The Bahamas has already done – before weakening central bank balance sheets.
Regarding support for smaller firms, the report recommends that provisioning rules be maintained allowing supervisors to exercise discretion, which may lead to banks building up greater provisions where required.
“This may imply that bank capital ratios dip from their relatively high pre-crisis levels. To allay concerns about capital losses, authorities may wish to communicate that bank buffers are there to be used on a temporary basis in such circumstances,” the IDB states.
The report continues, “Many countries have introduced payment deferrals or facilitated loan reprogramming in the domestic financial system with long grace periods. Loans included in such programs tend to be reported as in good standing and, therefore, not subject to additional provisioning.
“And yet, credit risk has surely risen given the substantial income losses. A danger is that these policies focus on the liquidity dimension rather than considering the growing solvency risks. Unfortunately, such policies magnify the uncertainty over the quality of banks’ loan books. Payment deferrals should be explicitly designed and announced as temporary. And banks should always report loan quality reflecting the reality of the situation, so supervisors and central banks have good information. Loan classification is normally tied to provisioning requirements.”
Noting the challenging months ahead to maintain financial stability, the IDB highlighted lessons learned from previous financial crises, stating that it is better to confront concerns head on rather than hide them if they emerge.
“Good policies appropriate to the nature of the problem at hand will boost confidence, help overcome the problems and ensure that banks play a constructive role as suppliers of liquidity and credit in order for the economy to recover as swiftly as possible,” the report states.