The $19,000 Question: How Will the Economic Consequences of the Coronavirus Pandemic Affect the Financial System?

Abstract

The deep recession expected as a result of the COVID-19 pandemic will leave both governments and private-sector companies with a greatly increased debt burden. That will have severe consequences for the financial system. Banks will suffer large-scale defaults on business and personal lending. To work off the debt overhang, interest rates may be held down by central banks for a long period. Inflation may rise, which would deflate the real value of debt, but inflationary pressures are currently weak. Financial repression will add to the pressures on banks and other financial institutions. Major banks enter the crisis period with high capital ratios, but expected losses on loan portfolios will put some under strain. Less strongly capitalized new entrants may suffer disproportionately. Other likely changes are more rapid growth in digital financial services and a decline in cash usage. Central banks will probably issue their own digital currencies, which will make maintaining negative interest rates more achievable. At the same time, the international financial system will be put under strain by global tensions generated by the crisis. In this complex environment, it will be crucial for governments, central banks, and the banking system to collaborate closely and for the European Union to bolster the eurozone with long-planned but long-delayed reforms, in particular to promote a capital markets union that could relieve pressure on banks’ balance sheets.