Coronavirus (COVID-19): UK fiscal path – a new approach

The role of the banking and financial system

Channels of impact

Banks' balance sheets have been strengthened since the financial crisis, with the introduction of the Basel III accords and the regular stress testing of their finances by the Bank of England. However, they have issued significant amounts of new loans as a result of the crisis. Much of this debt expansion is through the government's lending guarantee schemes and as such, banks are therefore assumed to face a materially lower level of losses than would be the case without the guarantee. Most loans are guaranteed up to 80%, as such only 20% of banks' lending through these schemes results in additional credit risk for banks. For the Bounce Back Loan Scheme for small businesses, 100% of the loan is guaranteed.

However, the expectations of pay back on some of the government loans scheme are low. An interim report by the Recapitalisation Group projects that businesses will be saddled with between £97bn to £107bn worth of unsustainable debt by March 2021.^[24] Many of these businesses, in banking terms, are no longer seen as viable.

Scale of debt

In an economic downturn, banks would expect to incur significant credit losses on their loans and to experience weaker capital positions. The Bank of England^[25] suggest that the extent to which this may happen will depend on:

• The size of the economic shock faced by households and businesses to which banks have extended loans, which determines the level of impairment on banks' existing loan books;
• Policy measures that are put in place by the government and authorities to support the ability of borrowers to continue to service loans and avoid default through the economic shock.

Chart 11 Description

A chart showing the estimated stock of UK private corporate debt. Capital markets accounted for almost 700 billion pounds of large companies’ outstanding debt in 2019 (59% of the total), whereas banks accounted for 480 billion pounds. Meanwhile, for small and medium businesses, banks are the main source of credit,  accounting for around 170 billion pounds of outstanding debt (89% of the total), while non-banks only for 20 billion.

Capital markets will also continue to play a key role in supporting larger corporates and accounted for more than half of debt outstanding in 2019 (Chart 11). Although the cost of market-based funding for corporates increased sharply in March as result of COVID-19, market conditions have stabilised somewhat.

The role the banking and financial system

Banks have a critical role to play in in assisting businesses in meeting cash flow deficits by expanding the supply of credit to the economy. As argued by the Bank of England, it is in the collective interest of the banking system to continue to support businesses through this period and the transition away from current support schemes.

There is a risk that individual banks have a preference to withdraw from under-performing credit provision. However, if all banks were to do so, more businesses would fail due to cash flow shortfalls, triggering bigger losses for banks on their existing corporate loans and, by pushing unemployment higher, bigger losses on existing household loans too. This action would also shift business debt onto the government's balance sheet.

There is a difficult balance to be found between supporting businesses through the crisis and directing support to those businesses which will be viable in the longer term. There is a risk that businesses become dependent on low-cost finance which cannot be withdrawn, which was seen as part of the reason for the slow recovery in the economy and productivity after the financial crisis. An alternative approach may be for a public policy bank to take on the loans of less viable companies, to allow the banking system to focus on companies requiring less support..

The development of new recapitalisation instruments may provide alternative options. The interim report by the Recapitalisation Group^[26] outlines a number of potential recapitalisation instruments. These fall into three groups:

• Transforming debt into equity – so that it becomes an income stream when businesses return to profit;
• Collecting debt via the tax system – so that companies pay debt out of their profits;
• Debt forgiveness – for businesses in extreme distress.

The package of measures that the banks and financial system introduce should form part of a national debt plan.

Our Proposal: Reset the monetary policy objective of the Bank of England so that long-term growth and reducing inequality are promoted.

The Bank of England will continue to have a central role to play to deliver the Bank's statutory responsibilities for monetary and financial stability. This will include protecting and enhancing the resilience of the system as a whole and supervision of banks and insurers. It is clear, however, that COVID-19 is creating new challenges for the financial system and, since regulation is a means not an end, a renewed debate over the outcomes that regulation should achieve is required.

This debate should also include careful consideration over whether the Bank's current objective of maintaining price stability in the UK is the right one in these challenging times. The Bank's own assessment of the impact of quantitative easing after the financial crisis found that richer households gained more than poorer households, with the poorest 10% actually seeing their incomes fall as a result of the interventions.^[27] It is important to learn from the unintended consequences of previous policy intervention, to prevent this from happening again. The Bank's remit should be broadened to ensure that monetary policy, in line with wider government policy, contributes toward rebuilding a fairer economy.