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 hampered by sluggish accounting-based provisioning. Using a Merton contingent claims framework, we develop a novel market-based approach to financial stability assessments – and apply it to assess euro area banks’ vulnerability to the Covid-19 crisis in real time. Although market-based indicators have improved considerably after an initial sharp downturn in March 2020, they still provide warning signals for a range of (sub)sectors. During the market low point, implied losses on corporate loans amounted to 12-38% 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