Can the banking system meet the challenges of recovery?
If there is a silver lining to the economic shock brought on by the Covid-19 pandemic, it is that the financial system has not contributed to the crisis. In fact, unlike in 2008 when a credit crunch plunged the global economy into a tailspin, banks have played a supportive role through the pandemic rather than making everything worse. As the Central Banks most recent Financial Stability Review makes clear, banks absorbed some losses last year, which hurt their profitability, but they did not amplify the problems in the economy. On the contrary, they used their abundant capital to help borrowers through tough times. Along with generous Government financial supports, these efforts helped cushion the hardship experienced by households and businesses over the last 15 months. But the trickiest part of this downturn may be yet to come. Relative to six months ago, the degree of uncertainty around downside risks has diminished and there is now a clearer path to economic recovery. Yet as the country reopens and commerce returns to normal, the true scale of financial damage is going to become clearer as the Government withdraws financial support, potentially causing an exit shock that draws in the banking sector. As the Central Bank analysis shows, credit supply hasnt tightened that much during the pandemic and Ireland isnt an outlier in Europe as it was during the financial crisis. Thats good. It means the banking system is working as intended by handing out umbrellas when its raining. However, as Government supports start to taper, what the Central Bank calls latent borrower distress could reveal itself. As the Government steps away, businesses and consumers will naturally look to the banks for working capital or access to personal credit. The concern, as expressed by Central Bank Governor Gabriel Makhlouf, is that banks will see that distress and lose their appetite for lending, cut back on risk exposures, and choke off the recovery. Add in a global repricing of risk on financial markets or even a standard correction to valuations and you could easily see a reflexive tightening of domestic credit supply. And while Mr Makhlouf has said nobody will gain from maintaining unviable businesses on life support, he also expects lenders to think carefully about the impact on borrowers of their credit policies. The X-factor in all this is what happens to the billions in savings accumulated by Irish households during the pandemic. The Central Bank expects some of it to wash back into the economy, but it wont fully replace Government supports euro by euro or, more importantly, sector by sector. Where people choose to spend might not match sectors where supports are most needed today. Right now Irish banks are well-capitalised and have access to abundant liquidity from customer deposits, financial markets and the the European Central Bank. They are primed to lend. Apart from mortgages, though, demand is pretty tepid, especially among SMEs. The lack of risk appetite at the moment is a problem of borrowers, not banks. The question is how banks respond to a reversal of that dynamic in the next six months.