History tells us that instability in the banking system can lead to significant economic crises. The memories of the Great Financial Crisis (GFC) and the following European debt crisis are still fresh. Unfortunately, the world was hit by another shock this year. The spread of the new Coronavirus (Covid-19) led to economic lockdowns in most countries.

Especially countries such as Italy and Spain, which have been struggling since the European debt crisis, were hit hardest in the Eurozone. Yet, the crisis did not originate in the financial system like the GFC. Therefore, one could argue that we don’t need to worry about European banks that much and that when the economy recovers, everything will be fine. But is this really the case?

A really bad crisis originating in the real economy – with possible contagion to the banking sector

The economic outlook for the Eurozone is grim, as Table 1 shows. Whereas the German economy is forecast to rebound fairly quickly in the upcoming years, the Italian and Spanish economies are forecast to experience a “tick-shaped” recovery, meaning that the crisis might drag on for several years. This could exacerbate the impact on the real economy.

The economic lockdowns led to a steep fall in demand and supply and hit large and small firms alike. As the biggest creditors across Europe, banks will struggle if corporate defaults rise sharply. Credit ratings would go down, and bank loans might not get repaid. Together with the already weak profitability of European banks, this could bring some banks close to the edge. So, by no means is the European Banking system safe from the economic fallout of the Coronavirus crisis. If the recovery drags on for long, as is currently predicted for the southern EU member states, the probability of corporate defaults will increase compared in the case of a “V-shaped” recovery.

chart GDP forecastsHow bad will it be? Comparing the economic forecasts with the latest European-wide bank stress test

To get a sense of how banks might be affected by a prolonged crisis, we compared the latest Stress Test (2018) by the European Banking Authority (EBA) with the recent economic forecasts. Chart 2 offers a summary of how the EBA adverse scenario differs from the current forecasts. We see that Germany could be better off than what the EBA assumed in their scenario. Italy and France, by contrast, could be much worse off than the worst EBA scenario.

chart corona stress testBanking resilience – information provided by the forecasts on the development of banks’ capital ratios

The EBA used these adverse scenarios to calculate average banks’ capital losses in EU countries. We used their results to estimate how banks’ capital might be influenced during the crisis and in a “tick-shaped” recovery. Our estimates suggest that average bank capital ratios might steeply decline in all Eurozone countries, but some countries could be hit harder than others.

Especially in Spain, banks’ average capital could decline massively to a mere 2 %. As a result, bank failures seem to be likely. Banks in France might also be hit hard, and their average capital could fall below the Basel III capital requirement of 4.5 %, too.

chart capital impact corona crisisFuture outlook – strengthening the banking sector?

If the recovery is prolonged, as the current forecast projects, then problems in the real economy are likely to spill over to the banking system. The last thing Europe needs today is to face another financial crisis on top of the current crisis. Policymakers should closely monitor the European banking system and be ready to implement necessary policies to strengthen this sector.

Some proposals that could help might not be new. The EU Banking Union is still not complete as it lacks a European deposit insurance scheme, and Europe is still far away from a unified Capital Markets Union. Of course, these proposals have been in the drawer for a long time now, but still, their potential impact to strengthen the banking system could make the difference.

This post is based on a study by Bertelsmann Stiftung’s project Repair and Prepare: Strengthening Europe . Get access to the full study.