Common Equity Tier Research Articles

Impacts of the Transition to the Expected Loss Model on the Portuguese Banking Sector

This study addresses the implementation of the International Financial Reporting Standard 9 (IFRS 9) in the European Union as of 1 January 2018, replacing the International Accounting Standard 39 (IAS 39) to introduce a new model for recognizing Loan Loss Provisions (LLP), based on Expected Credit Loss (ECL). This model responds to criticisms of the former Incurred Credit Loss (ICL) system for its inability to reflect credit losses in a timely manner, potentially exacerbating the effects of financial crises. This study focuses on the effects of adopting the ECL model on the level of Loan Loss Allowances (LLA) in loans, own equity, and the Common Equity Tier 1 (CET1) ratio across 13 Portuguese commercial banks. A mean comparison test is used to evaluate scenarios before and after the application of the ECL model, highlighting the importance of regulator actions and the adequacy of loss recognition policies, including the effects of European Union. The results obtained demonstrate significant negative impacts on the net values of loans, own equity, and the CET1 ratio upon adopting the IFRS 9 ECL model due to the widespread increase in LLAs.

Regulatory and contextual factors influencing earnings and capital management decisions: evidence from the European banking sector

This study investigates whether some regulatory and contextual features influenced Euro Area listed banks decisions to manage earnings and regulatory capital through discretionary provisions in the period 2013–2018. The new regulation factors are the pressure to increase high-quality regulatory capital (Basel III) and more timely recognition of loan losses (IFRS 9). The contextual features are the intensified banking competition at a national level, and the significant money market pressure. Results demonstrate that the pressure to increase high-quality regulatory capital for banks with lower Common Equity Tier 1 capital (CET1) in year t − 1 is negatively associated with upward earnings and capital management in year t. The more timely recognition of loan losses in year t compared to year t + 1 is negatively associated with upward earnings and capital management in year t. The strengthening of banking competition is positively associated with upward earnings management, but not associated with upward capital management. The increasing money market pressure is negatively associated with upward earnings management, but not associated with upward capital management. This study should be helpful to standard-setters, regulators, investors and academics interested in incentives and constraints to earnings and capital management by providing evidence regarding how listed banks reacted to the regulatory, accounting, and contextual factors, observed holistically during a unique historical period (i.e., 2013–2018) and regulatory setting (i.e., European banking sector).

Earnings management, capital management, signalling and the Covid-19 pandemic: the case of listed banks in the United States

Purpose- This paper investigates earnings management, capital management, the impact of the Covid-19 pandemic and signalling by United States listed banks of loan loss provisions. This study is particularly important because there is a relative dearth of research in banking on these topics and thus remain considerably under researched. Methodology- The dataset comprises a pooled cross-sectional and time series data for a sample of 249 U.S. listed banks for the period 2015 to 2020 consisting of 1,494 observations. A panel data analysis is conducted. Findings- Results overall show no evidence of systematic earnings management, capital management or signaling by the banks. Findings reveal the impact of the Covid-19 pandemic is not significant during this period of economic fragility for listed banks. The elasticity of loan loss provisions with regards to the annual growth in gross domestic product is negative and statistically significant overall. This is evidence that U.S. listed banks’ loan loss provisioning exhibits a pro-cyclical nature. Overall, these results provide evidence of the success of restrictions due to tighter bank regulation and supervision that came into effect at the end of 2014. This required U.S. banks to maintain a minimum common equity tier 1 capital ratio of 4 percent, a minimum tier 1 capital ratio of 5.5 percent, a minimum total capital ratio of 8 percent, and a minimum leverage ratio of 4 percent. Conclusion- This study adds to the literature as it provides evidence that restrictions on bank activities in the form of minimum capital and leverage ratios at the end of 2014, restrictions in the use of bank capital, and extension of financial support via government intervention funding during the Covid-19 pandemic crisis period have reduced incentives to smooth earnings in the United States banking system. It therefore represents a tried and tested model that can be adopted by banking systems in other countries. Keywords: Banks, capital management, COVID-19 pandemic, earnings management, loan loss provision, signalling. JEL Codes: M41, G21, C23, G28

Optimal capital adequacy ratios for banks

In this paper, we analyse the appropriate capital adequacy ratio for banks from a socio-economic perspective. More equity capital in banks can contribute to financial stability by reducing the risk of costly banking crises, but lending may become more expensive if banks are required finance their assets with more equity. When assessing optimal capital adequacy ratios, the economic costs of more expensive credit must therefore be weighed against the benefits of fewer and less costly banking crises. Importantly, we compute optimal capital adequacy ratios for Norway which allows us to take into account recent changes in bank capital regulation. The results indicate that banks should have a Common Equity Tier 1 (CET1) ratio of between 12 and 19 percent. The current CET1 ratio of around 18 percent in our sample is in line with this. Our estimates are consistent with results from international studies, but estimates vary considerably with changes in uncertain assumptions. However, banks’ capital needs during the Nordic banking crisis in the beginning of the 1990s show that such estimates are not unreasonable.

Extracting implied volatilities from bank bonds

In this work, we explore the information content of senior, subordinated and additional tier 1 (or contingent convertible) bonds issued by euro-area banks. We analyze both the asset volatility implied in senior and subordinated bonds and credit default swap market spreads, and the common equity tier 1 (CET1) ratio volatility extracted from additional tier 1 bonds secondary market spreads in the period from December 31, 2012 to March 31, 2021. Furthermore, we jointly consider the following important bank variables: asset, equity and CET1 ratio volatilities. In doing so, we can obtain the market view on credit spreads, banks balance sheet and capital ratio dynamics on a daily basis even if bank data are released quarterly. The approach can be used to monitor the risk of each bank, as perceived by the market, and to investigate banking fragility at a stand-alone or at a country level. Finally, we compare our estimated equity implied volatilities with the volatilities implied in equity option quotes and we show that this indicator depends on the model and the financial instruments considered in the calibration.

Competition, Consolidation and Convergence in the Indian Banking Industry- A path to $5 trillion economy

Banking is the backbone of any economy as it has a direct bearing on financial and economic development. India is currently $3.469trillion economy. To achieve the target of a $5 trillion economy, policy changes for India must include reforms in the banking sector. Inthe banking industry, competition is crucial for maximizing efficiency. The banking sector is going through unprecedented consolidationefforts through mergers and acquisitions. Financial inclusion is aided by consolidation. This gives banks greater resources with which tolend money make investments and expand their geographical reach. The financial sector's convergence is expanding quite quickly.Financial convergence aids banks in portfolio diversification. Financial Convergence relates to all types of interfaces between financialsuppliers and the demand for all types of financial products and services. In this paper, we have specifically discussed the convergencebetween the banking sector and the insurance sector. This paper highlights various approaches to assessing competition, models ofbancassurance, benefits, and challenges of bancassurance for banks, and the expected value of the bancassurance market by 2027. This paperhas analyzed the changes in various financial ratios like Gross Non-Performing Assets (GNPA), Net Non-Performing Assets (NNPA),Common Equity Tier- 1(CET-1) etc. of Union Bank of India after merger. This paper aims to study how a more competitive,consolidated, and convergent banking industry would contribute to making India a $5 trillion economy.

The role of artificial intelligence in developing a banking risk index: an application of Adaptive Neural Network-Based Fuzzy Inference System (ANFIS).

Banking risk measurement and management remain one of many challenges for managers and policymakers. This study contributes to the banking literature and practice in two ways by (a) proposing a risk ranking index based on the Mahalanobis Distance (MD) between a multidimensional point representing a bank's risk measures and the corresponding critical ratios set by the banking authorities and (b) determining the relative importance of a bank's risk ratios in affecting its financial standing using an Adaptive Neuro-Fuzzy Inference System. In this study, ten financial ratios representing five risk areas were considered, namely: Capital Adequacy, Credit, Liquidity, Earning Quality, and Operational risk. Data from 45 Gulf banks for the period 2016-2020 was used to develop the model. Our findings indicate that a bank is in a sound risk position at the 99%, 95%, and 90% confidence level if its Mahalanobis distance exceeds 4.82, 4.28, and 4.0, respectively. The maximum distance computed for the banks in this study was 9.31; only five out of the forty-five banks were below the 4.82 and one below the 4.28 and 4.0 thresholds at 3.96. Sensitivity analysis of the risks indicated that the Net Interest Margin is the most significant factor in explaining variations in a bank's risk position, followed by Capital Adequacy Ratio, Common Equity Tier1, and Tier1 Equity in order. The remaining financial ratios: Non-Performing Loans, Equity Leverage, Cost Income Ratio, Loans to Total Assets, and Loans to Deposits have the least influence in the order given; the Provisional Loans Ratio appears to have no influence.

MACRO-FINANCIAL DETERMINANTS OF DEFAULT PROBABILITY USING COPULA: A CASE STUDY OF INDONESIAN BANKS

We investigate the default probability of Indonesian banks using the copula approach and analyze the macro-financial factors that drive them. We use quarterly data comprised of 80 banks from 2005 to 2019. We find empirical evidence that Common Equity Tier 1 (CET 1) ratio, inefficiency ratio, and deposit ratio have negativelyimpacted the bank’s default probability. We also find that macroeconomic variables such as policy rate, real exchange, economic growth, and unemployment reduce the default probability. Our study suggests that regulators should focus on capital and deposit management policies to reduce bank risk-taking behaviour. Additionally, the policy rate effectively anticipated the banks’ default risk.

Assessing banks’ resilience: A complementary approach to stress testing using fair values from banks’ financial statements

AbstractFor more than a decade, supervisory banking authorities in Europe and the United States have sought to assess the resilience of banks to adverse economic episodes to safeguard the financial system's stability. They rely on regulatory capital measures like Common Equity Tier 1 (CET1) relative to risk‐weighted assets in the aftermath of potential economic crises. We propose a new measure of banks' resilience based on financial statements. The fair value margin (FVM) is estimated as the difference between the fair value of assets and the book value of liabilities, scaled by the book value of equity. We find that FVM is positively associated with the surplus or shortfall of CET1 resulting from the stress testing results from 2014, 2016 and 2018. To corroborate the relevance of FVM for supervisory authorities, we compare the ability of the loan component of FVM to predict future credit losses with the capital surplus/shortfall metric derived from the stress test. The findings indicate that the fair value of loans predicts net charge‐offs better than stress test outcomes. Therefore, we suggest that FVM could be used as a readily available and relatively low‐cost tool to assess bank resilience, thus complementing the stress test exercises.

Sustainability and Bank Capital, A Study of Indian Private Banks

Banks’ lending business being risk based must be supported by adequate quantum of capital to ensure sustainability, soundness and resilience of the bank. The Basel Committee on Banking Supervision announced in 1988, a set of capital norms for banks to observe in order to reinforce their financial stability and soundness when struck by potential losses from deterioration of asset quality. This was known as Basel I. For the purpose of capital adequacy, capital has been sub divided into Common Equity Tier 1, Additional Tier1 and Tier 2 capital. Capital Adequacy, on this basis, has also been classified based on component of capital. The study reveals that all the new private sector banks are deeply conscious of the sustainability of their capital from the stand point of their operations and risk profile of assets. As a good strategy, they have been gradually building on their capital funds in consonance with their business growth. A sensitivity analysis of capital sustainability shows that even 10% escalation in risk weighted assets will not impair the capital adequacy significantly as the ratio will continue to be well above the benchmark ratio of 9 %. The role of Indian bank regulator is laudable in this regard as it has been studiously inspecting capital ratios of banks both by on site and off site appraisal of banks.

BASEL III CAPITAL REGULATION FRAMEWORK AND ISLAMIC BANK’S RISK

Basel III modified the requirements for approving new regulatory capital norms to improve capital quality. Because bank liquidity problems were a defining feature of the crisis, Basel III established new requirement ratios while also tightened capital requirements. The Liquidity Coverage Ratio (LCR) was developed to safeguard banks' short-term liquidity, whereas the Net Stable Funding Ratio (NSFR) is being proposed to strengthen banks' medium- and long-term liquidity shock resilience. As a necessary consequence, Islamic financial institutions (IFIs) must issue instruments that satisfy both Basel III and Shari’ah requirements. This study aims to identify the regulatory requirements for Basel III and the Islamic Financial Services Board (IFSB)'s new capital and liquidity rules, as well as the implications for Islamic banks (IB). This study employs a mixed research methodologies approach which includes document analysis of primary and secondary sources, as well as the relevant regulations published by BCBS and IFSB. This study relies on the identification of Standards for each criterion before conducting a systematic review of the 23 publications that meet the study's requirements published between 2013 and 2022. There is a scarcity of Shari’ah-compliant research on capital buffers, tier 1 capital, and common equity tier 1 capital, according to certain findings. Furthermore, the empirical literature suggests that Basel III has a significant impact on the financial risk of the IB sector in the samples collected. However, there is still a significant gap in studies investigating the influence of Basel III/IFSB capital and liquidity regulations on Islamic bank risk, or more precisely, supportive data from empirical investigations. The wealth of research will provide new insights to standard-setters (BCBS and IFSB), regulators, researchers, and academicians.

Bank Financial Performance and its Linkage with Capital: A Dynamic Panel Data Analysis of Public Sector Banks in India

This article empirically investigates the linkage of capital infusion in the Public Sector Banks (PSBs) in India with the capital adequacy, asset quality, profitability, operational efficiency and the market position of the banks. Utilising a balanced panel data of total 21 PSBs over 9 years (2009 to 2017), we analyse the key determinants of the Indian PSBs’ profitability, net interest margin (NIM), solvency and market efficiency. The study applies a two-step dynamic panel generalised methods of moments. We find empirical evidence that the Capital Infusion programme of the Government during 2008–2009 to 2016–2017 has significant impact on the performance of PSBs in India. We have observed that with frequent infusion of capital by the government, banks were able to meet the regulatory Basel II/III capital adequacy requirements and it has positive influence on their market capitalisation as well as NIM. However, capital infusion has an insignificant impact on improving return on assets (ROA) of banks. Our study suggests that a higher common equity tier 1 capital ratio leads to better market reputation and solvency position of the banks. The results of the study provides insight for bank management, regulators and policymakers for improving bank performance and better utilisation of scarce capital and public money. JEL Code: G21, G32, G34

The impact of Tier 1 sukuk (Islamic bonds) on the profitability of UAE Islamic banks

PurposeThe choice between different financing sources is governed by a number of finance theories, particularly, trade-off theory and pecking order theory. However, the special characteristics of Islamic finance, which forces the exclusion of conventional bonds, leave Islamic banks with limited number of alternatives. Tier 1 sukuk are distinguished type of sukuk that combines the features of conventional bonds and stocks. This paper aims to answer the following question: Does the issuance of Tier 1 sukuk positively affect Islamic banks’ profitability or is their impact concentrated on enhancing Islamic banks’ capital adequacy ratios?Design/methodology/approachThe data set used in this study consists of all United Arab Emirates (UAE) Islamic banks that issued Tier 1 sukuk over the period 2010–2020. Pooled and fixed effects panel regressions of Tier 1 sukuk and other control variables on three proxies of Islamic banks’ profitability were run. The selection of fixed-effect model is based on Hausman test, redundant fixed effects and likelihood ratio test.FindingsThis study reveals novel findings. Tier 1 sukuk increases both earnings per share (EPS) and capital adequacy ratios. That is, this study finds that there is a positive significant impact of Tier 1 sukuk on EPS, which indicates that issuing more Tier 1 sukuk will generate more return to shareholders in terms of higher EPS because of the lower cost of Tier 1 sukuk compared to equity. However, this study finds that there is an insignificant impact of Tier on sukuk on both return on assets and return on equity. Hence, it is concluded that Tier 1 sukuk does not increase the risk appetite of UAE Islamic banks.Research limitations/implicationsTier 1 sukuk is a niche instrument that has been recently used by Islamic banks. Hence, there are a limited number of Islamic banks that have issued this type of sukuk and consequently limited number of observations. Therefore, with the increased use of this instrument, a larger set of data will be available for examination. In addition, future research could examine the relationship between issuing Tier 1 sukuk and profitability in other countries where such sukuk have loss absorption feature. The impact of other types of sukuk, such as liability sukuk, on Islamic banks’ profitability could also be an interesting field of study.Practical implicationsThis study recommends Islamic banks to issue more Tier 1 sukuk to enhance their profitability indicators while meeting Basel III accord. This study also recommends investors to purchase the stocks of Islamic banks that issue Tier 1 sukuk because they are able to offer them higher EPS. The authors advise the UAE regulators to allow Islamic banks to issue Tier 1 sukuk with loss absorption feature to enable Islamic banks engage in more risky activities that usually provide larger profits. This study also suggests that the Islamic Financial Services Board (IFSB) reclassifies Tier 1 sukuk, with loss absorption feature, within the highest quality of capital, common equity Tier 1, to encourage Islamic banks to issue this type of sukuk, especially Basel III accord and IFSB 15 require higher ratios of common equity Tier 1 to risk-weighted assets.Originality/valueThis research contributes to the existing literature in two ways. First, it adds to the existing literature on the impact of sukuk on Islamic banks profitability. That is, contrary to prior studies that merely investigate the impact of issuing ordinary sukuk on profitability, this study explores a distinguished type of sukuk, that is Tier 1 sukuk, that has been surprisingly ignored so far. Second, this study shows that it is not only capital adequacy ratios that have improved as a result of issuing Tier 1 sukuk but also Tier 1 sukuk reduce the cost of capital of UAE Islamic banks which has been reflected in a higher profitability proxied by EPS. Hence, these sukuk serve a dual function for Islamic banks by improving both capital adequacy and profitability ratios.

Executive stock options and systemic risk

Employing a novel control function regression method that accounts for the endogenous matching of banks and executives, we find that equity portfolio vega, the sensitivity of executives’ equity portfolio value to their firms’ stock return volatility, leads to systemic risk that manifests during subsequent economic contractions but not expansions. We further find that vega encourages systemically risky policies, including maintaining lower common equity Tier 1 capital ratios, relying on more run-prone debt financing, and making more procyclical investments. Collectively, our evidence suggests that executives’ incentive-compensation contracts promote systemic risk-taking through banks’ lending, investing, and financing practices.

Reconsidering the Prudential Filter for the Cash Flow Hedge Reserve in View of the Purpose of Banking Regulation

Common Equity Tier 1 capital of credit institutions is adjusted by the prudential filter for the cash flow hedge reserve according to art. 33(1)(a) CRR. Thereby, fair value changes of hedging instruments, especially of derivatives, are neutralized by imputed fair value changes of future cash flows that are part of a cash flow hedge. However, these future cash flows are (mostly) expected to occur under market conditions and, thus, imputed fair value changes are not reflected in changes of present values derived from real transactions that exist at the time of the regulatory capital calculation. As a result, positive effects on Common Equity Tier 1 capital can be viewed critically in regard to the prudence principle of banking supervision if an initial reduction in Common Equity Tier 1 capital due to losses from hedging instruments is corrected. Furthermore, the adjustment is case specific and depends on the hedge effectiveness, which is questionable because of consistency reasons. To solve these weaknesses, we suggest to eliminate the prudential filter for the cash flow hedge reserve as a whole. This would lead to a better quality of Common Equity Tier 1 capital by improving its loss absorbency and as a side effect to a reduction in complexity enhancing supervision through regulatory authorities and market discipline. Furthermore, we demonstrate the impact that the proposed abolishment of the prudential filter for the cash flow hedge reserve would have on the Common Equity Tier 1 capital ratios of the largest European banks in 2014–2019

The effectiveness of IFRS 9 transitional provisions in limiting the potential impact of COVID-19 on banks

The purpose of this paper is to assess the effectiveness of the transitional provisions for the impact of International Financial Reporting Standard 9 (IFRS 9) as a supervisory tool to strengthen a bank’s capital base. The new IFRS 9 provisions are a significant banking supervisory measure of the so-called Capital Requirements Regulation (CRR) Quick Fix to mitigate possible adverse effects of the COVID-19 pandemic on banks. With the discharge rules, the supervisor aims to strengthen the banks’ regulatory capital in order to ensure the supply of credit to households and companies at all times. Based on the published disclosure reports of 107 significant European banks at the reporting dates end 2019 and June 2020, our study analysed how many banks already apply the transition rules, whether there are geographical focusses and to what extent banks use the new CRR Quick Fix adjustments. To the best of our knowledge, this paper is the first empirical analysis of the extent to which European banks use the original IFRS 9 transitional arrangements and COVID-19 extension and what effects its use has on their common equity Tier 1 (CET1) capital. The results are of interest to regulators, bank managers and analysts alike, as they fundamentally demonstrate the effectiveness of this particular regulatory tool.

Banks’ Sovereign Exposures: In Search of New Rules

ABSTRACT In this article, we examine the reform of the prudential treatment of banks’ sovereign exposures with the purpose of introducing risk-sensitive capital charges and limiting home bias. We consider six different options and measure their impact on the common equity Tier 1 (CET1) ratio of 82 banks fom 10 euro-area countries, participating in the 2019 European Banking Authority EU-wide transparency exercise and subject to European Central Bank supervision. Our evidence shows that the proposal put forward by the Basel Committee on Banking Supervision in 2017 is the proposal which leads to the most evenly distributed impact across countries, in terms of CET1 ratio decline. That proposal targets the goals of risk sensitivity and diversification, with two independent instruments: rating-based risk weights and concentration add-ons. As a consequence, it is the only proposal which introduces an incentive for banks located in all countries, whether low rated or high rated, to reduce their home bias. Some proposals focus on one objective only: either risk sensitivity or diversification. Others introduce heavy penalization for banks located in low-rated countries, without addressing the home bias of banks located in high-rated countries. Several options are prone to pro-cyclicality, and we measure this effect by simulating the impact of a two-notch downgrading of high debt countries on the CET1 ratio of banks. Some relevant cross-country effects emerge from our analysis, due to the large cross-country exposures of a few intermediaries.

Corporate Social Responsibility (CSR) and Environmental Social Governance (ESG) – Disclosure of European Banks

In the European Union the goal of transition towards a carbon-neutral economy by 2050 is identified as a major aim of the European Commission. The integral role of the financial services sector in funding such investments and enhancing the (re-) direction and allocation of capital flows towards sustainable projects and investments is increasingly acknowledged. Besides the integration of ESG and CSR into the banks’ operations, it can serve and be utilized as risk management tools. This paper investigates the effectiveness of the EU Non-Financial Reporting Directive (2014/95/EU) with respect to the CSR disclosure quality in European banks from 2017-2019. After an overview of the EU’s path towards a sustainable financial sector from 2013 till present, the most important regulations will be assessed in detail, namely the Non-Financial Reporting Directive (2014/95/EU) and the Taxonomy Regulation on Sustainable Economic Activity (2020/852/EU). By constructing a multi-category CSR disclosure index to “translate” and quantify disclosed CSR information in the banks’ annual filings, a positive comparative development over the years is identified – indicating the general effectiveness of the directive. The construction of the disclosure index and the content analysis of the banks’ CSR disclosures is based on textual analysis. In order to not only analyse and evaluate the level of CSR disclosure in European banks from 2017-2019, but also to identify potential factors influencing its quality, the collection of multiple data inputs is necessary. The paper examines the association between three factors of the balance sheet and the P&L on their significance on the disclosure score. These factors are asset size in million euro (proxy for size), common equity tier 1 ratio (proxy for market discipline) as defined in the Basel III regulatory framework (proxy for market discipline) and pre-tax return on assets (proxy for profitability). Furthermore, the association of other non-balance sheet factors and their correlation on the disclosure score is examined which are listing status (listed or non-listed), country of the head-quarter, (external) auditor and bank´s CSR report type. Therefore, this adds detail to research, as existing majorly focus on how CSR-related information is disclosed and not to what extent and quality. This paper targets accountants, financial institutions, regulatory authorities, shareholders, investors and stakeholders in general who are affected by and interested in the overall CSR disclosure quality of European banks.

A Proposal for a Temporarily Amended Version of Precautionary Recapitalisation Under the Single Resolution Mechanism Regulation involving the European Stability Mechanism

European credit institutions are expected to pile up a relevant amount of non-performing loans (NPLs) as a consequence of the crisis provoked by the Covid-19 pandemic. Against this backdrop, one of the most critical issues at stake is whether credit institutions currently hold an amount of capital which is sufficient to absorb the losses that they will likely experience in the forthcoming future. If this will not be the case, then they will have to undergo recapitalisations. In a context of global, generalised and prolonged economic crisis, nevertheless, it could turn out to be extremely challenging to find private investors able and willing to significantly invest in their equity. Therefore, a new solution capable to balance conflicting, yet legitimate, needs, such as credit institutions’ recapitalisation without recurring (again) to excessive and generalised public bail-outs, might have to be quickly found.Accordingly, because of the high bar set in the recent past by the Single Resolution Board (SRB) for the submission of failing or likely to fail (FOLF) credit institutions to resolution (unless a different interpretation of the public interest criterion in light of the current crisis is put forward), and with a view to avoiding credit institutions’ liquidation financed through public resources, what we propose hereby is a temporary, revised and standardised form of privately and publicly funded precautionary recapitalisation, designed beforehand and operating on an quasi-automatic basis. Thus, this paper advocates a temporary amendment of the so-called precautionary recapitalisation under the Single Resolution Mechanism Regulation (SRMR) with the major involvement of the European Stability Mechanism (ESM). Such proposal should, of course, build on the regime currently in place also in light of the European Commission’s (Commission) decision to temporarily suspend the application of the state aid prohibitions laid down in the Treaty on the Functioning of the European Union (TFEU).Along with the European Central Bank (ECB), a major role in the process should also be played by the SRB and the ESM, with a view to keeping as much as possible the same level playing field within the Banking Union (BU). The final goal would be to strike a fair balance between the primary need to avoid the collapse of the whole banking system as a consequence of the Covid-19 crisis and the interest to discourage excessive moral hazard and unsound public policies.Accordingly, for a limited period of time, we propose that some of the conditions currently required by the SRMR for the precautionary recapitalisation of credit institutions established in the BU should be amended in line with the recent measures adopted by the Commission to facilitate public intervention to support the economy. This should be combined with an ESM facility allowing it to buy hybrid instruments issued by the credit institutions that would need to be recapitalised. In this regard, the ESM could raise the resources needed by issuing senior bonds on the market to be then used to buy contingent convertibles (CoCos) with characteristics enabling them to be included in the credit institutions’ Common Equity Tier 1 (CET1) capital, as was the case in Greece in 2015, with a view to divesting as soon as the market conditions will allow it. Such an action, in turn, could be placed within a broader framework permitting the ESM to monitor the credit institutions’ activity against some targets designed to allow them, over time, to pay back the issued instruments.

COVID-19 and SME Failures

We estimate the impact of the COVID-19 crisis on business failures among small and medium size enterprises (SMEs) in seventeen countries using a large representative firm-level database. We use a simple model of firm cost-minimization and measure each firm’s liquidity shortfall during and after COVID-19. Our framework allows for a rich combination of sectoral and aggregate supply, productivity, and demand shocks. We estimate a large increase in the failure rate of SMEs under COVID-19 of nearly 9 percentage points, ab-sent government support. Accommodation & Food Services, Arts, Entertainment & Recreation, Education, and Other Services are among the most affected sectors. The jobs at risk due to COVID-19 related SME business failures represent 3.1 percent of private sector employment. Despite the large impact on business failures and employment, we estimate only moderate effects on the financial sector: the share of Non Performing Loans on bank balance sheets would increase by up to 11 percentage points, representing 0.3 percent of banks’ assets and resulting in a 0.75 percentage point decline in the common equity Tier-1 capital ratio. We evaluate the cost and effectiveness of various policy interventions. The fiscal cost of an intervention that narrowly targets at risk firms can be modest (0.54% of GDP). However, at a similar level of effectiveness, non-targeted subsidies can be substantially more expensive (1.82% of GDP). Our results have important implications for the severity of the COVID-19 recession, the design of policies, and the speed of the recovery.