Is the stress caused by the coronavirus pandemic gradually easing in the banking sector? Earlier worries about cash are now forgotten. Liquidity markets are settling down. Most branches have re-opened. It can therefore be said that some of the effects that the coronavirus crisis is having on banks and their customers are indeed diminishing. But other challenges lie ahead. Virologists disagree on whether there will be a second wave of infections. And economists have different opinions in their forecasts on how severe the recession will be. One thing is certain, however: gross domestic product (GDP) is going down.

For this reason, GDP was used as a point of reference for a stress test that BaFin and the Bundesbank conducted on less significant institutions (LSIs) under their supervision. They have experience in this area, as the test was largely based on the findings from the 2019 LSI stress test. In this particular case, a special COVID-19 stress test was exclusively conducted internally by the two authorities. This meant that the LSIs were not required to complete a survey questionnaire – as they did in 2019, for example. This saves resources at the institutions and allows them to focus on their primary task during the crisis: supplying capital to the real economy.

BaFin and the Bundesbank modelled a number of scenarios involving a sharp fall in GDP for the current year. Before the coronavirus pandemic, German LSIs – accounting for around 1,400 small and medium-sized credit institutions – already had a solid capital base with an average Common Equity Tier 1 (CET1) ratio of 15.9%. Assuming a significant decline in GDP of 8.1% in 2020, coming close to the baseline scenario of the Bundesbank’s latest economic forecast of -7.1%, this results in a decrease in the average CET1 ratio of 4.1 percentage points to 11.8% as at the end of 2020. Credit risk and market risk are key drivers here.

Simulation of a severe recession

If GDP were to decrease by 10.8% and have an even more severe impact, this would lead to a decline in the average CET1 ratio by 4.7 percentage points to 11.2% according to the COVID-19 stress test. This higher stress effect is attributable to additional losses arising from credit risk.

But even in this more severe scenario with GDP declining by 10.8% in 2020, German LSIs would still be sufficiently capitalised on average. The measures that the institutions can use to counter this effect and the impact of government aid programmes were not taken into account in the stress test.

Credit defaults with a time lag

Many LSIs do not anticipate a rise in credit defaults until the second half of 2020/the start of 2021; this is also attributable to the support measures taken by the German government. In addition to the impact of persistently low interest rates, it can be said that the coronavirus crisis is expected to affect the profitability of institutions; the impact will just be felt with a time lag.

BaFin ramped up communication with the institutions and associations concerned directly after the first COVID-19 cases were reported in Germany. The objective was to assess the risk situation as extensively as possible and to be able to take measures at an early stage. The COVID-19 stress test is part of this supervisory strategy. In combination with the anticipated credit defaults, it is evident, however, that it is still too early to give the all-clear.