The European Central Bank (ECB) is contemplating the creation of a “bad bank” to house the assets of banks whose loan books may become heavily battered as a result of the Covid-19 pandemic, Moody’s Investor Service reports.
Officials at the ECB have discussed the potential of establishing a bad bank “in the event of significant systemwide asset deterioration related to the coronavirus,” according to Moody’s.
The rating agency said that regulators are discussing the idea in the event that measures — such as suspending bank dividends and enabling banks to draw down their capital and liquidity buffers — aren’t enough to protect their core capital, meaning “stronger action” is required.
For now though, regulators are taking more limited steps to contain the crisis, it said.
“In its function as banking supervisor, the ECB is seeking the continued enforcement of prudential rules, but with sufficient flexibility to help banks handle effects from the coronavirus outbreak,” Moody’s said.
For example, it noted that the ECB recently issued guidance on certain accounting rules aimed at “avoiding a massive increase in expected credit losses and [non-performing loans], which might overestimate the crisis’ effect, and precluding too large an increase in risk-weighted assets that would disproportionately dilute banks’ capital.”
This sort of approach should be effective as long as the pandemic results in only a short-lived economic contraction and “does not mutate into a full blown crisis” Moody’s said.
However, a deeper crisis remains a possibility.
“Such an adverse scenario would greatly weaken banks’ solvency and compromise their ability to help the real economy,” it noted.
As a result, Moody’s said, “the ECB seems to be exploring all options” before a full-blown crisis develops.
If a bad-bank approach does end up being used, Moody’s said, such a move would be credit-positive for banks, “because it would involve some degree of government support where needed, which would help banks protect their solvency and possibly avoid failures.”