The banking system came into the crisis in good shape; the deterioration during the crisis will depend on its duration and depth

Banka Slovenije’s assessment is that the banking system was in good shape as it entered the crisis caused by coronavirus. Given the sheer magnitude of the shock and the huge decline in economic activity, the banking system’s liquidity position will deteriorate over time, while the downward pressure on capital adequacy will increase. Banka Slovenije drew up two scenarios to assess the banking system’s readiness for the crisis: under the assumption of a decline of around 6% in economic activity, the banking system could approach zero profitability. In the event of a deep recession, the banking system’s capacity to absorb the adverse effects through surplus capital would be strongly diminished.

The measures to alleviate the consequences of the epidemic taken in recent months by governments and central banks will make a significant contribution to maintaining the stability of the financial system. Given the magnitude of the crisis, firms will need loans to bridge liquidity difficulties. Micro and small enterprises, who find it harder to access financing, could be hit particularly hard. Banka Slovenije should reiterate that in contrast to the previous crisis, banks are more exposed to households than to corporates, which introduces new uncertainty into the banking system over the upcoming period.

The banking system’s resilience to systemic risks coming into the crisis is assessed as good: (i) credit portfolio quality has improved in recent years, (ii) the capital and liquidity positions at system level are good, and (iii) last year saw record high pre-tax profits, which could help banks cover future losses. Banka Slovenije’s summary is that the banking system came into the crisis in good shape, but that performance and profitability will deteriorate, given the magnitude of the shock and the huge decline in economic activity.

Two scenarios were drawn up at Banka Slovenije for assessing the banking system’s key risks and resilience: a milder scenario (a decline in economic activity of 6%), and a more severe scenario (a decline in economic activity of 16%).

Under the milder scenario, the simulations suggest that the banking system could operate at close to break-even point this year. Portfolio quality would deteriorate, but given the sound financial and liquidity position of firms, which could mitigate the initial liquidity shock during a shutdown, the inflow of non-performing claims would be small. The scenario also envisages a deterioration in the household portfolio, as a result of rising unemployment and falling income. The banking system’s liquidity position would deteriorate slightly this year, but not significantly. Over time, as the scenario unfolds, the increased risks in the economy and in the banking system would also be reflected in downward pressure on banks’ capital adequacy.

Under the more severe scenario, the banking system would end 2020 with a large loss. In the wake of a large contraction in economic activity, the credit portfolio would deteriorate further, and impairment and provisioning costs would increase sharply, eating up almost three-quarters of the banks’ income. Corporate deposits and household deposits would begin to decline, thus increasing the pressure on liquidity. A significant downturn in the economy would severely reduce the banking system’s capacity to absorb the accumulated adverse effects of risks through surplus capital. The scenarios do not take account of the positive effects of government emergency measures and guidance by the EBA and ECB that could significantly reduce the pressure on earnings.

The analysis indicates that the economic situation in which Slovenia and the whole world find themselves is very serious, and therefore demands even more decisive and coordinated action in the areas of fiscal and monetary policy, and in other areas.

Publication is available on the link.

Figure: Assessment of risks and resilience for the Slovenian financial system