DP14922 Is COVID-19 a threat to financial stability in Europe?

Author(s): Henk Jan Reinders, Dirk Schoenmaker, Mathijs A Van Dijk
Publication Date: June 2020
Keyword(s): bank capital, Covid-19 pandemic, Financial Stability, stress test
JEL(s): G01, G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14922

The severe economic impact of the COVID-19 pandemic could threaten financial stability. However, assessing the gravity of this threat is challenging, since banks' accounting-based loan loss provisions are sluggish. We use a Merton contingent claims model to provide a real-time, market valuation-based assessment of the impact of COVID-19 on euro area banks' corporate loan portfolios. We calibrate the model based on observed stock price responses and use different scenarios for future volatility and incurred losses in case of default. Based on stock prices as of April 20, 2020, we estimate that the market-implied losses for euro area banks could reach over â?¬1 trillion, or 4 to 25% of corporate credits' book value (7 to 43% of available capital and reserves). Our analysis can be viewed as an early warning indicator of potential accounting losses to follow.