In February 2020, central banks and financial authorities faced their biggest challenge since the global financial crisis (GFC) 12 years earlier.
As it became clear that a far-away virus was morphing into a global pandemic, uncertainty froze financial markets and real economies alike. Central banks needed to act fast to unstick the global economy, often in combination with Government actions.
Here, I examine the unique challenges they faced, what they did, and six lessons for the future. For brevity, the definition of central banks also extends to financial authorities to cover cases when the two are separate.
Though the financial crisis left many broken businesses in its wake, its legacy included the improved regulation of banks and financial buffering should another large shock occur. COVID-19, however, proved that no two crises are ever the same.
The GFC was a shock specific to the financial sector that began with the uncertainty of certain US housing-related assets and the resulting 'credit crunch'. The cost of dealing with the financial collapse threatened certain governments.
COVID-19 on the other hand was initially a supply-side shock to the real economy, in which lockdowns impacted the production and provision of goods and services. It soon, however, had a demand-side impact as unemployment rose and consumption fell. All this had to be managed from kitchen tables as working from home became a reality, a scenario that had never been tested previously.
What actions did central banks take during the pandemic?
Banks were the source of the problem during the GFC; this time they were part of the solution.
The authorities’ goal during COVID-19 was to keep viable firms and jobs in existence during (what was assumed to be) a temporary situation. For central banks that meant making sure that corporate finance conditions remained supportive and that the financial sector could continue to operate.
Actions were taken across many areas to stabilise markets and ensure continued access to liquidity. Individual and system-wide buffers were released, often alongside measures to help direct available capital to the real economy as opposed to investors, shareholders, or staff, and flexibility was provided around loan classifications.
International standard-setters were quick to provide clear and consistent messages. Foreign exchange swap lines were quickly activated, new International Monetary Fund facilities were put in place, and there were significant G20 pledges of support as part of a 'united’ response.
We may see further co-ordinated approaches should there be reduced cashflow availability for real economy firms, a rise in impairments in retail, small and medium-sized companies or corporate loan books, or a sustained disruption in financial markets resulting from reduced liquidity. However, interest rates are already close to zero and many Government budgets already over-extended. This constrains the potential for conventional policy action.
Actions taken on a country-by-country basis included:
- Reduction of interest rates: Policy rates have generally been reduced, in some cases to even lower than seen in the GFC.
- Individual support measures: Central banks have relaxed the terms of access to central bank lending arrangements should banks find themselves with liquidity mismatches. Measures included widening the suite of collateral accepted and reducing acceptable quality thresholds. In some cases the central bank suspended collateral requirements, but this is not recommended on risk grounds. Central banks also provided longer-term liquidity with fewer conditions, so banks had more certainty over funding.
- Lending to non-banks: In some cases central banks extended the scope of their lending operations to include non-banks, such as payment firms. In limited cases, support was also extended to the Government, where overdrafts were provided to help cash management.
- Quantitative easing: To remove barriers to lending, some central banks turned on the liquidity taps by buying securities on the open market. In some cases this required amendments to law and several central banks now hold significant portions of some securities' markets, making any future unwind a challenge, particularly in the case of less liquid assets.
- Foreign Exchange support: Many actions were undertaken including bilateral foreign exchange swaps between central banks; swaps with the market; direct intervention in foreign exchange markets; and the provision of foreign exchange loans. But the actions of the US Federal Reserve were probably the most significant, with support measures established for commercial banks and central banks with US dollar needs.
- Market making: Calls for liquidity following declines in asset valuations, or participants looking to redeem their holdings, put pressure on markets. Some central banks intervened in markets to curb increasing volatility. Some bought longer-term bonds and sold shorter-term bonds to better manage interest rates.
To date, the measures undertaken by central banks have worked well and effectively propped up institutions and markets while supporting lending to the real economy. Now, thoughts are turning to the consequences of the actions taken. Here are six lessons from central banks’ response to COVID-19:
1 Establish parameters around any flexibility measures and avoid forbearance
When calibrating flexibility measures, it is easy for the authorities to slip into thoughts around forbearance. Regulatory forbearance is the provision of temporary permission for a bank, firm, or other market participant to operate in violation of regulatory standards.
This measure should be considered only as a last resort after all market-wide support measures have been implemented. Failing to do so would set unhelpful expectations for future crises.
2 Plan for remote supervision
Pre-COVID, regulators would physically spend time at a bank, sitting beside employees and examining systems. To protect their reputation and fulfil their statutory obligations, central banks must redesign this process for a world in which hybrid working – for both the banks and the authorities - is a norm.
3 Scan the horizon
Central banks need to keep a close eye on the ongoing fallout of COVID-19. Borrowers are making repayments, but systems worldwide are fragile and stocks of private and sovereign debt are high.
What, for example, would be the knock-on effect of an increase in global interest rates? What would this mean for the finances of governments that have borrowed heavily in recent years, and for financial systems?
4 Better capture intangible losses
Like all organisations, central banks have been subject to unexpected side-effects that can’t be quantified on a balance sheet.
For example, new staff may struggle to integrate into their place of work. They will miss out on knowledge gained from water-cooler discussions and spontaneous engagement with colleagues, which could have a knock-on effect on knowledge-building and future productivity.
5 Support wider markets and not just banks
Central banks need to stand ready to support markets beyond just asset purchases, particularly as markets transition to becoming more sustainable.
This puts an emphasis on central banks to have the legal basis to perform this role and being operationally ready to support systemically important markets.
If non-bank products have deposit-like features in terms of liquidity, then the regulations around liquidity monitoring, the investment universe and the pricing of any central bank support needs to reflect these attributes.
6 Redefine business continuity
The pandemic has placed an increasing focus on operational resilience.
Previously, lockdowns and illness across a significant number of employees were not part of business continuity planning.
Institutions must now factor this into their plans, while also considering other scenarios in which banks might be forced to operate without a physical staff presence, for example, extensive flooding.
This requires thorough scenario planning for all imaginable low probability but high impact events, while recognising the growing threat of climate risk.
As we have seen, there is no one-size-fits-all response plan to a crisis. Central banks should therefore plan not so much on what levers to pull in new crises but how to analyse and adapt.
Diarmuid Murphy is Head of Fintech Authorisations & Advisory at the Central Bank of Ireland. He is Co-Lead on the Comparative Central Banking module on the MSc Global Central Banking and Financial Regulation.
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