Effect of COVID-19 Pandemic on Financial Institutions

Introduction

The COVID-19 pandemic can be described as one of the most devastating public health crises in recent history. The outbreak began in early 2020 and was first reported in Wuhan, China. Since then, the virus has spread across the world, affecting almost all countries. According to Song et al. (2021), some of those most hit by COVID-19 include China, the United Kingdom (UK), the United States, France, Italy, and Spain. The pandemic is having devastating effects on real economic activity. However, the true impact may yet be established because the spread continues, and the responses affected are yet to produce the expected results. Even so, it can be observed that such public health measures as lockdowns and restricted movements and social interactions prevent firms from doing business. The financial institutions have also experienced a shock from the crisis. The purpose of the paper is to explore how financial institutions have been affected by COVID-19.

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Characteristics of the COVID-19 Pandemic

The characteristics of the pandemic can be described from many angles, including its epidemiology, public health, and economic impacts. However, each country has experienced it differently, which makes it difficult to explore the general characteristics. It can be observed that the pandemic has caused many deaths, especially among people who had other comorbidities. In such countries as Italy, statistics indicate that most victims who have died had other health conditions, including heart disease (30%), cancer (20%), diabetes (36%), a history of stroke (9.6%), and atrial fibrillation (25%) (Stang et al., 2020). The statistics in China give the pandemic different characteristics, including the health conditions that were associated with most deaths as a result of COVID-19. For example, diabetes accounted for 9.2%, hypertension recorded for 8.4%, and cancer for 7.6% of the deaths (Stang et al., 2020). Age has also been a factor, with many published materials highlighting that aged people were facing a higher risk of both infection and death from the virus. Therefore, the main feature of COVID-19 is its tendency to have fatal consequences for vulnerable populations.

From an economic perspective, the main characteristic of COVID-19 is its effects on the economy as a whole. From disrupting economic activities to exposing businesses to great systemic risks, the pandemic has shocked global economies. Some industries have been affected more than others depending on the type of business. For example, the hospitality industry is founded on the ability of firms to directly serve their customers within their facilities and premises. Restricted movements have prevented customers from consuming the services from this industry. According to Song et al. (2021), the hospitality industry relies heavily on human mobility, without which businesses cannot function. Therefore, it can be argued that in addition to causing massive health problems, the pandemic has also devastated global economies.

Impact of the Pandemic on the Financial Risk Position of the Financial Institutions

The banking sector is one of the most important components of an economy. The entire industries and economies depend on the banking sector and the financial institutions to help in economic restoration after a crisis. The financial risk position of financial institutions is often devastated by crises, with an example being the global crash of 2008 (Korzeb & Niedziółka, 2020). Such sectors as restaurants, tourism, transport, and services all depend on the favorable risk positions and risk-taking ability of banks. Additionally, the individual sectors are also important to the banks because they offer the financial institutions markets and the possibility of financial losses once such markets underperform. Therefore, it can be argued that the COVID-19 pandemic tends to upset the financial risk position of banks by devastating the financial performance of other industries and sectors.

The COVID-19 pandemic has exposed banks to massive systemic risks, which reflects the nature of the financial institutions during crises. In essence, crises can result in a higher likelihood of nonperforming loans and extreme cases of bank runs. According to Godwell (2020), the prevalence of large pandemics can cause the collapse of the banking industry. The reasoning is that the depositors will be more inclined to make withdrawals of their deposits to cater to personal concerns, including treatment and upkeep during a downturn. Such a scenario can be visible with COVID-19, where many patients have inadequate insurance cover for COVID-19. Therefore, such individuals can only pay for their treatment with their own money, which will be withdrawn from the banks. In such countries as the United States, where massive cases of infections are reported, means that the banking sector faces a risk of bank runs. Therefore, the pandemic has the effect of threatening closures of banks due to excessive withdrawals.

The true extent of the effects of the pandemic on the financial position of the financial institutions is yet to be fully understood. This is because, since the global crisis of 2008, banks have been required to hold buffers of capital above the required minimum (Giese & Haldane, 2020). Such buffers are intended to build resilience for the banks during a period of stress. Additionally, banks are also required to hold a systemic risk buffer, which applies to the banks categorized as systemically important. Theoretically, the banks are expected to use these buffers as automatic safeguards. Therefore, it can be argued that such buffers can help banks overcome the stresses of the pandemic. The extent to which they can survive remains unknown, especially at a time when the crisis is prolonged. As mentioned earlier, the pandemic was first reported early in 2020, which means that the pandemic has persisted for more than a year. The basic question now is how much of the buffer has been used by banks and how long it will keep the banks afloat.

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Understanding the concept of systemic risk can help establish how financial institutions experience the pandemic. The systemic risks for banks are often elevated, which can be attributed to three key elements (Rizwan et al., 2020). First, liquidity risk rises due to the slowing down of the economy accompanies by reduced access to capital markets and financial forbearance. In other words, credit ratings for companies tend to drop, which makes certain markets unattractive for the banks. Second, regulatory and policy responses cause the loss of intermediation income, including the reprieves on loan repayments and the access to the government-guaranteed loans that carry low rates of interest. Lastly, the declines in the intermediation business adversely affect the ability of the financial institutions to fund operations. The funding costs are also higher, which means the firms suffer significantly through inadequate capital. The spread of these risks through the interconnection of financial institutions means that an entire sector is at risk of failing during a crisis.

The presence of systemically important financial institutions means that systemic risks are spread rapidly throughout the financial system. It can be argued that the COVID-19 pandemic will continue to devastate financial institutions majorly because of its persistence. While some countries across the world have managed to ease the challenge, others are finding it hard to develop proper recovery mechanisms, which means that sector continues to suffer. The question of policy responses may also need to be addressed because it affects how banks respond and the extent to which they suffer from the systemic risks. The government offers support through the central bank, often in terms of monetary and policy responses. In the United States, the central bank has developed action plans, which include liquidity provision to the financial system (Mosser, 2020). The central bank is the lender of the last resort, and such risks as bank runs can be avoided through the monetary policies of the central bank. Therefore, the devastation to the financial risk position can be mitigated through the cushions offered by the central bank.

Impact of the Pandemic on the Lending Policy

The lending policy of banks during times of crisis often changes to a more conservative one. The rationale is that as the lack of resilience appears, banks resort to cutting lending to households and businesses to protect their balance sheets (Giese & Haldane, 2020). Cutting lending has an effect of increased economic costs, and the economies suffer as a result. The banks themselves remain without markets for their financial products, which further curtails the growth of the banks. During the COVID-19 pandemic, such authors as Goodell (2020) explain that it is not clear for long the banks will maintain their conservative lending policy, even after the pandemic. In essence, the magnitude of the macroeconomic effects of the pandemic is still under investigation, which means that the banks are facing an extremely uncertain economic environment. The basic idea is that the banks see the conservative lending policy as a means to mitigate potential financial losses from nonperforming loans.

The conservative lending policy can be understood by the behavior of firms pre- and during the crisis. According to Li et al. (2020), businesses often go to banks first during a crisis to borrow funds in anticipation of shortages and economic shocks. Such a scenario was observed during the last three weeks of March 2020, where firms increasingly sought finances on an unprecedented scale from bank credit lines. The asset prices had fallen, which resulted in the commercial and industrial loans on the balance sheets of banks exploding. A similar occurrence was observed during the 2008 financial crisis, where the bankruptcy of Lehman Brothers saw an increase in lending by approximately 6% (Li et al., 2020). Over the last three weeks of March 2020, the weekly growth surpassed 6%, which represented 50 times more than the average. Such behavior by businesses often exposes the banks’ ability to supply the liquidity needed. The commercial banks can rely on the central banks to help, but even this help can be insufficient. The conservative approach is often an automatic response triggered by the inability of banks to meet the liquidity demanded.

Banks across the world have been affected in the same manner by the pandemic. This means that even Islamic banking has been devastated by COVID-19, which means that they also have had to become more conservative. The case study of Indonesia presented by Disemadi and Shaleh (2020) serves as an example of how Islamic banking responds to the pandemic. Regardless of the type of banking, the banks have to manage the credit risk caused by nonperforming loans, faulting of loans, and even the collapse of businesses indebted to the banks. The conservative lending policy means that banks only lend to firms with sound economic performance, which should guarantee banks that the interests and principal will be repaid in the future. Additionally, the banks can only sustain those key businesses or the main borrowers to help them stay afloat during a pandemic. The financial institutions understand that allowing certain businesses to fall may have a devastating effect on the future of their markets.

Even with the conservative lending policy, it is important to acknowledge that banks can and are still offering credit to businesses. A commentary by Didier et al. (2020) reveals that modern business relationships are of a strategic nature and can be costly to rebuild. Therefore, sustaining such relationships even throughout the crisis is seen as a cheaper alternative. The implication for banks is that they have to continue offering credit even to those businesses in hibernation, especially their relationship-specific investments. The policy of financing strategic businesses has a long-term perspective where banks expect that facilitating business continuity for their clients assures them of future partnerships, investments, and revenues. However, it is important to highlight that even this approach can fit within the conservative approach because all other clients are turned down to help conserve the funds needed to meet the liquidity demands of other businesses. The bottom line is that even with the need to maintain strategic relationships with commercial firms, businesses remain keen on limiting their credit to protect their balance sheets.

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In essence, previous financial crises have resulted in the improvement of banks’ responses to pandemics. Even though such behavioral improvements were facilitated by government regulations, it can be argued that the financial institutions are now keen on effectively managing the risks they face during crises. Therefore, the lending policy by banks changes to a conservative one, majorly as an automatic response to the excessive liquidity demand. Credit risks increase, which means that banks are keen to reduce them through selective lending practices.

Bank Case Affected by the Crisis

One of the banks affected by the COVID-19 pandemic is Zions Bancorporation, a bank holding company with headquarters in Salt Lake City, Utah. The effects of COVID-19 on this institution have been outlined in an interview in Risk Management Association (n.d.), which featured Industry Insider and Michael Morris, executive vice president and chief credit officer (CCO) at Zions Bancorporation. Regarding the credit risk, the CCO states that the bank has downgraded the loans in those cases where the bank has visibility into the current risk profile of borrowers. However, the deferral portfolio is affected differently, where the total loans deferred are running at an estimated 8-8.5%. These percentages reflect the risk position of the bank, which implies that certain risks or financial losses have started to materialize as a result of the pandemic. However, certain investments have remained relatively safe, including the real estate portfolios where scheduled rent collections are still relatively strong. Therefore, the bank faces major credit risks, but liquidity risks are perceived to be lower due to the assured sources of liquidity.

Additionally, Zions Bancorporation is maintaining lending and credit to their clients during the pandemic. Such an approach is aligned with the concept of maintaining relationships with firms with expectations of continued cooperation after the pandemic. Most importantly, the bank constantly engages with the clients to help them manage the effects and to stay afloat. In other words, the bank encourages businesses to rethink their business models, which should help them adapt and survive. Revisions to credit underwriting are also made as a response. Therefore, the argument presented earlier that the true extent of the effects of COVID-19 remains unknown is reflected in Zions Bancorporation’s business activities and policy responses to the crisis. The fact that Zions Bancorporation admits to suffering some financial losses while excelling in certain investments means that with discipline the financial risk position of a bank can be protected during a crisis.

Conclusion

The COVID-19 pandemic is one of the most devastating crises in modern history. Financial institutions remain highly vulnerable to the systemic risks associated with crises. The financial risk position of banks is often upset due to the potential losses. When the economies slow down, loans may cease performing, and businesses may collapse, which often leads to loan defaults. The concept of systemic risks described above illustrates how financial institutions are affected by crises and how they respond. Lastly, the lending policy is also altered as the banks become more exposed to systemic risks. In other words, high demand for credit affects liquidity, which forces banks to reduce lending to protect their balance sheets.

References

Didier, T., Huneeus, F., Larrain, M., & Schukler, S. (2020). Financing Firms in Hibernation during the COVID-19 Pandemic. World Bank Group. Web.

Disemadi, H., & Shaleh, A. (2020). Banking credit restructuring policy on the impact of COVID-19 spread in Indonesia. Journal of Economic Innovation, 5(2), 63-70. Web.

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Giese, J., & Haldane, A. (2020). COVID-19 and the financial system: a tale of two crises. Oxford Review of Economic Policy., 29, 1-15. Web.

Godwell, J. (2020). COVID-19 and finance: Agendas for future research. Finance Research Letters, 35, 1-5. Web.

Korzeb, Z., & Niedziółka, P. (2020). Resistance of commercial banks to the crisis caused by the COVID-19 pandemic: The case of Poland. Equilibrium. Quarterly Journal of Economics and Economic Policy, 15(2), 205-234. Web.

Li, L., Strahan, P., & Zhang, S. (2020). Banks as Lenders of First Resort: Evidence from the COVID-19 Crisis. The Review of Corporate Finance Studies, 9(3), 472-500. Web.

Mosser, P. (2020). Central bank responses to COVID-19. Business Economics, 55, 191-201. Web.

Risk Management Association. (n.d.). Credit impacts interviews: Michael Morris, COO, Zions Bancorporation. The Risk Management Association. Web.

Rizwan, M., Ahmad, G., & Ashraf, D. (2020). Systemic risk: The impact of COVID-19. Finance Research Letters, 36, 1-7. Web.

Song, H., Yeon, J., & Lee, S. (2021). Impact of the COVID-19 pandemic: Evidence from the U.S. restaurant industry. International Journal of Hospitality Management, 92, 1-7. Web.

Stang, A., Standl, F., & Jöckel, K. (2020). Characteristics of COVID-19 pandemic and public health consequences. Herz, 45, 313-315. Web.

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"Effect of COVID-19 Pandemic on Financial Institutions." NerdyTom, 20 July 2022, nerdytom.com/effect-of-covid-19-pandemic-on-financial-institutions/.

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