The coronavirus pandemic will cost many lives. It will not wipe out the population, but it will make us wiser and poorer. In the medium term, economic activity will resume, albeit with some major impact on our wealth, work, and social habits.
In the short term, widespread lockdowns have hit the world economy during a phase of economic and financial stagnation. Unlike a financial crisis, this is a real shock that reduces production and income, affects both demand and supply, and disrupts value chains. Avoiding a rapid contraction thus requires broadly targeted fiscal measures (Baldwin and Weder di Mauro 2020), such as tax postponement or direct income support, perhaps via ‘helicopter money’ (Galí 2020, Turner 2020).1
A key question is whether and where a financial panic may strike. If this were to happen, the coronavirus shock would imply a quick and sharp recession.
The immediate effect would be a sudden repricing of financial and real assets, together with a heavy withdrawal of liquid reserves by household and firms. A short-lived reduction in savings is not alarming per se. Withdrawals made to fund spending are largely redeposited in other banks, and central banks can redistribute liquidity across the regulated banking sector. Due to the Basel III framework, at a time when everyone seeks safety there should be no immediate risk for banks and sovereign bonds, provided the more vulnerable cracks in the euro area are protected with a collective backup mechanism.2 Banks will suffer credit losses, but there is no indication of panic at the moment. However, their fate will depend on the timely resolution of the crisis, since a default wave is likely to occur.
Our claim is that the immediate risk for financial stability is illiquidity, rather than insolvency.
What stability risks may lie ahead?
So, what stability risks may lie ahead, given the state of the financial system before the shock?
The major risk is a systemic illiquidity shock on shadow bank constructions that proliferated during quantitative easing, as Figure 1 shows. How serious is this risk?
Figure 1 Bond mutual fund outflows
Source: Financial Times
Figure 1 shows massive outflows of bond funds in response to the coronavirus shock.
Is the panic justified? What type of debt has been funded by these shadow banks? A broader perspective can help answer these questions.
First, it is useful to consider the effects of ECB policies. For mainly political reasons, ECB bond buying has targeted many ‘super safe’ assets, compressing sovereign yields at the EU core. This ’risk channel’ of monetary policy boosted demand for private ‘safe asset’ constructions such as bonds and ETF mutual funds. Such shadow banks can no longer promise the safety of principal, but they do promise immediacy. As they have no central bank or fiscal backing, they rely heavily on market liquidity to support their promises.
This is a classic profile of any shadow banking boom. A pattern of increasing liquidity mismatch is common in phases of abundant savings in excess of investment opportunities, often defined by falling interest rates.
There is a risk that many investors in bond funds were mainly seeking a bit of yield with moderate risk, reassured by the right of immediate redemption and the assumption of limited downside risk for bonds. Once individuals and professional investors consider withdrawing from these funds, market liquidity will be tested. A key question is how risk-intolerant these shadow bank investors may be once mutual share prices drop fast. Already at present, even after large price corrections, many fund shares trade at a large discount to net asset value.
Regulatory reform for mutual funds has lagged the Basel process, under the view that investors were aware they were acquiring risky assets with no principal guarantee. Last year, Bank of England Governor Mark Carney advocated for measures to realign fund redemption terms with their actual asset liquidity. The preparedness of these investors for a liquidity shock is soon to be tested.
How large is the illiquidity risk for these assets?
Because of a steady decline in demand for credit by healthy firms, and a massive shift to intangible assets, banks responded to demand for highly leveraged transactions in the syndicated loan market. Most syndicated loans have been repackaged as collateralised loan obligations (CLOs). While the senior tranche of this securitisation is smaller than the asset-backed securitisation 15 years ago, these loans are extended on the basis of cash flow rather than real collateral.
Figure 2 Global covenant-light share of debt issuance
The Financial Stability Board has become alert to the rising risk associated with the rapid expansion of CLOs (see Figure 2), issuing a report assessing the associated financial stability risks (Financial Stability Board 2019).
Disturbingly, studies from legal and financial scholars have reported an alarming decline in the quality of debt coverage covenants, now relying on weaker notions of earnings in violation of proper accounting standards (Badawi and de Fontenay 2019). In a sharp recession, such unsecured loans are potentially exposed to much larger losses than the historical average.
Figure 3 Falling lending standards: Debt-to-EBITDA ratios
Are these concerns excessive? What about market discipline in pricing debt? Dispersed market participants have historically relied on banks as gatekeepers of bond issuance, establishing covenants to control leverage and risk. Unfortunately, a long period of few good lending opportunities and low rates has tempted banks to satisfy demand for highly leveraged loans by private equity, often by funding buyouts and equity payouts in sunset industries rather than new investments (see Figure 3). These bonds are protected only by current cash flows, which will be hit very hard by the coronavirus shock.
Recent evidence suggests that the issuance of covenant-lite bonds, their securitization into CLOs, and the emergence of CLO-related structured products appears to be a response to high inflows into mutual funds, who are also the main investors (Becker and Ivashina 2016). In a sharp recession, these bondholders will be left as sitting ducks.
Academic research has shown how bond investors are often oblivious to rising risks at times of abundant funding (López-Salido et al. 2017). This was also highlighted by Jeremy Stein, a leading Harvard professor and ex-Fed board member, at the recent ECB Macroprudential Policy Conference.
In conclusion, if redemptions accelerate, bond illiquidity may soon prove to be extreme. The downside risks have been increasing markedly in recent years, and investors have little insight on potential losses on covenant-lite unsecured loans which private equity funds used to extract equity while often retaining secured rights on real assets.
The rapid recession caused by the coronavirus shock will be a major test of these choices. A final question concerns the amount of retained CLO tranches on bank balance sheets.
Mutual funds cannot default by design, but once redemptions pass a certain level, they may be forced into liquidation or seek close fund status, producing massive shocks to confidence for both liquidity and safety. While central banks will be under pressure by demands for liquidity support, the top policy priority should be given to real and diffused needs.
A final word is that caution is needed in the ongoing EU bankruptcy reform plans, originally aimed at harmonisation while potentially allowing weaker protection of unsecured debt. History teaches us that poorly designed bankruptcy reform always creates new financial stability risks.
Badawi, A and E de Fontenay (2019), “Contractual Complexity in Debt Agreements: The Case of EBITDA”, Duke Law School DP 2019-67.
Baldwin, R and B Weder di Mauro (eds) (2020), Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, a VoxEU.org ebook, CEPR Press.
Becker, B and V Ivashina (2016), “Covenant-Light Contracts and Creditor Coordination”, SSRN paper no 2756926.
Boot, A, E Carletti, R Haselmann, H Kotz, J P Krahnen, L Pelizzon, S Schaefer and M Subrahmanyam (2020), “The coronavirus and financial stability”, VoxEU.org, 24 March.
Financial Stability Board (2019), "Vulnerabilities associated with leveraged loans and collateralised loan obligations", 19 December.
Galí, J (2020), “Helicopter money: The time is now”, VoxEU.org, 17 March.
Garicano, L (2020), “The COVID-19 bazooka for jobs in Europe”, VoxEU.org, 20 March.
López-Salido, D, J Stein and E Zakrajšek (2017), “Credit-Market Sentiment and the Business Cycle”, Quarterly Journal of Economics 132(3): 1373-1426.
Turner, A (2020), “We need tax breaks and direct grants to sectors hit by pandemic”, Financial Times, 20 March.
1 A distribution targeting immediate needs may be coupled with restatements or suspension of fixed rent and mortgage obligations, as in the statutory elimination of the Gold Clause in debt contracts during the Great Depression.
2 Funding a joint EU response to the coronavirus crisis directed at firms and households may require a major ESM bond issuance, which would also ensure an adequate supply of euro safe assets at a critical juncture.