Covid-19: Potential implications for the capital planning buffer and internal capital allocation models
Since the outbreak of Covid-19 and subsequent partial shutdown of the economy practitioners in the financial industry have struggled to align macro-economic projection models. This has become particularly apparent, since fast paced policy changes may impact projections both in the short- and medium term.
During January and February, the consensus forecast was for Swedish GDP growth in 2020 of 1%. By late March and April forecasts had changed and variability ranged between -2.6% to -7% (not including negative-scenario variations).
Put in a historical context, crisis and large swings in the output in the economy is nothing new. The GDP outcome for 2020 may have implications in terms of the capital planning at financial institutions and especially in relation to the Swedish application of the capital planning buffer (being assessed both by the banks as well as by the Swedish FSA – Finansinspektionen).
In the following table the historical data is tested using two variations of starting period where the 1920 take-off is selected motivated by inclusion of 100 years in the series while the second starting period is represented by the deregulation of the Swedish credit market 1985 (Novemberrevolutionen). For both variations two sets of assumptions for GDP growth 2020 is tested (-5% and -10%) to analyze the impact on the historical GDP-distributions (simplified by assuming a normal distribution) that Covid-19 may have.
Finansinspektionen stipulate that the capital planning buffer shall cover a deterioration in capital adequacy corresponding to a scenario of the characteristic “severe but not improbable”. By the measurement as illustrated above, even a GDP growth outcome for 2020 of -5% would shift the GDP-distribution from -1.2% to -1.9% for a scenario correspondent with a 1 in 20-year event measured from 1985. While a 100 data point period is found at a lower level, the shift in distribution is smaller (-2.1% to -2.4%) since the longer period already include historically severe downturns (the Swedish banking crisis during the 1920’s and the build up to WWII.
The early and mid-phases of the crisis are characterized by a human suffering both in terms of death rates and rising unemployment. The financial infrastructure however has proven resilient and where a consensus is that the increased capital- and liquidity requirements have contributed strongly to its recent stability. From this perspective additional conclusions by the Swedish regulators and Nordic colleagues may include:
i. a need to recalibrate the parameters used for assessing the capital planning buffer, and where the additional data point may require banks to set aside additional capital
ii. in addition to recalibration, the introduction of a dependency to the fiscal balance since another contributing factor (to the stability of the financial system) is the strong fiscal position that the Nordic countries are entering the crisis with (but the position going forward?)
iii. harmonized approaches with respect to the capital planning buffer across the Nordics since a pandemic or an alternative stress scenario may be as interlinked across the borders as the institutional set-ups.
From a financial stability and prudential regulatory requirements point-of-view such conclusions are all valid but will inevitably be challenged from market functionality perspective. The combination of investors wanting stable return on investments and increased output from the internal capital allocation models may result in the paradox that additional capital requirements can destabilize the financial markets due to increased cost of credit / credit contractions.
Irrespective of the development from a regulatory point of view, it may be rational for senior management and boards to review their long-term capital planning. This should include challenging legacy assumptions in capital allocation models, taking consideration to the fact that the human nature and behavior is difficult to predict. Especially when taking a 100 year perspective.