Real-Time Financial Stability Assessment With an Application to the COVID-19 Crisis

Abstract

The sudden and severe economic consequences of the COVID-19 pandemic have underlined the need for real-time financial stability assessments by banks and their supervisors, which are historically hampered by sluggish accounting-based provisioning. Using a Merton contingent claims framework, we develop a real time market-based approach to assess expected loan losses and apply it to euro area banks’ during the Covid-19 crisis. Although market-based indicators have improved considerably after an initial sharp downturn, they still provide warning signals for a range of (sub)sectors. During the market low point, implied losses on corporate loans amounted to 16-26% of banks’ capital. We uncover a substantial role for monetary policy (lower discount rates) in the subsequent stock market recovery.

Keywords: Financial stability, bank capital, COVID-19, stress test

JEL Classification: G01, G21, G28