Stress tests for Banks as Liquidity Insurers in a Time of COVID

Stock prices have declined and credit market conditions have tightened in response to the COVID-19 pandemic. Firms typically respond to such outcomes by exercising their liquidity insurance and drawing down their credit lines. This column uses two ‘stress tests’ to demonstrate that the quantum of credit commitments likely to move onto banks’ balance sheets should be manageable thanks to the healthier capitalisation of banks relative to before the Global Crisis. However, in a severely adverse scenario, the average Tier 1 capital to risk-weighted assets ratio of banks will likely move closer to the regulatory minimum of 8% and well below for some banks. Regulators should plan in advance for such a severe stress test by ensuring that banks prevent any further capital depletion through dividend payouts or share buybacks.