Normally when a recession starts banks cut back on credit to overextended companies. Companies react by cutting costs and jobs in an attempt to shore up their own finances. Households run down savings and deposits as they struggle to survive. Governments run deficits to smooth the adjustment.
But in the COVID 19 recession the chain of events is very different and economists are struggling to work out what it all means. The good news is that banks have not cut credit – they have extended it.
In the euro area, bank lending to non-financial corporations grew by €75bn in April after €122bn in March, according to a recent report by Jeffries called ‘Why Banks Matter So Much Right Now’.
“How many of these loans end up as non-performing remains a moot point, but the important thing is that there is a flow of credit supporting economies right now,” says the report.
“Ultimately some of this may end up as a contingent liability on governments’ balance sheets, but this is helping keep businesses afloat as economies gradually re-open.”
Never before in history have governments pushed their economies into recession deliberately and the result will be budget deficits of between 10% to 15% over this year and next. Bank lending is vital as economies adjust.
There is one positive sign on the corporate front as businesses struggle to stay afloat – the freezing of dividends. Usually, companies are reluctant to do this as it sends out a message of panic. But in the COVID 19 recession, a dividend cut is being seen by the market as a sign a company is taking swift action and has a viable future.
Finally, there is the household sector. Usually, in a recession there would be a rise in loan defaults and a running down of savings. So far in this recession lending for house purchases has been maintained while consumer credit has slowed. In the UK, banks have given mortgage holidays to 1.9 million homeowners during the lockdown. Household bank deposits in the euro area rose by €100.9bn in April as more affluent households saved rather than spent.
It’s still early days of course. If GDP contractions of 20% to 25% last for a considerable period, tougher decisions will need to be made. Inequality will rise anyway as poorer households suffer a decline in earnings and have no savings to fall back on. Government programmes are the only answer to that problem.
In general, the banks’ role has been a positive one. They have assisted borrowers rather than walking out on them. They need to focus all their intelligence and expertise on trying to keep it that way for the next couple of years.
Brian Caplen is the editor of The Banker. The article appeared first in The Banker.