Financial markets appear to have rallied. Here’s one way to mitigate further shocks due to COVID-19

In recent weeks, a certain calm has returned to financial markets. Presumably driven by optimism around an economic recovery – as lockdowns begin to end in several countries and certain US states – volatility fell last week to its lowest level since February, while equity indices have rebounded significantly, despite this week’s sell-off.

However, many are surprised by these improvements in market sentiment, considering economic news and expectations continue to be dismal despite substantial efforts by governments to support economies.

While fiscal, monetary, and regulatory policy-makers have moved quickly since March to preserve financial-market functioning and support households and businesses, experts warn that greater policy action is needed to ensure that financial risks do not lead to greater economic dislocation.

Since mid-March, the World Economic Forum’s Platform for Shaping the Future of Financial and Monetary Systems has virtually convened a community of financial-system stakeholders to discuss the impacts of COVID-19.

These conversations have brought together public sector officials and financial sector executives to share views on emerging financial stability risks and financial and economic policy responses. While the conversations did not aim to generate an exhaustive list of risks, a number of key themes and recommendations emerged, published last month in a white paper.

Most participants in these discussions agreed that the primary risks to financial stability stem from a potentially worsening macroeconomic context. While there is enormous uncertainty about the shape and timing of the economic recovery, it seems increasingly likely that economic activity will remain significantly subdued for an extended period of time, as is the case in China’s modest recovery.

In advanced economies and some emerging markets, governments rapidly provided emergency loans (or in some cases, grants) to businesses, in particular to small and medium sized enterprises.

Most of these programmes were designed to address a temporary shortfall in liquidity: otherwise healthy businesses were facing an unprecedented slowdown in economic activity, and needed to be able to pay salaries and other immediate expenses.

However, as the crisis persists, practitioners fear that we may be moving into a phase where an increasing number of firms will become insolvent. Of most concern are small and micro-businesses, firms in the hardest hit sectors, and firms that have so far been unable to access government programmes, including many small and mid-sized corporates.

Beyond the damage of businesses shutting down or having to sell assets at a loss – which would have immediate effects on income and employment – widespread insolvency could present serious threats to financial stability.

Banks have served as a source of strength and stability since the beginning of this crisis, using their substantial capital and liquidity buffers to offer flexibility and credit to firms and households in need.

But mounting insolvencies would lead to credit losses that could threaten banks’ capacity to extend new credit. If severe enough, losses could ultimately lead to the kind of bank-centred crisis that occurred in 2008, further hampering an economic recovery.

Bank Equity Performance: Unsurprisingly, bank equities have underperformed broader indices as threats to their profitability grow:

1. Additional liquidity assistance for well-capitalized firms While additional liquidity assistance from banks or governments may be valuable for some better capitalized firms, many practitioners from both the public and private sectors fear that doing so may only “kick the can down the road” for firms that already have unsustainable levels of debt.

2. Restructuring with private capital under bankruptcy provisions While some jurisdictions have efficient bankruptcy codes that enable continued operations to downsize and restructure debt, many do not.

Where necessary, policy-makers should explore how to adjust bankruptcy laws—permanently or temporarily— to enable businesses to undergo organized restructurings with private capital. Regardless, it is clear that many insolvent firms would still face liquidation—and significant losses for all creditors—without additional capital support.

3. Devising effective tools for government equity in private companies In many cases, it may ultimately be necessary for governments to take equity in private firms in order to keep them operating and providing employment. Governments have varying levels of expertise in taking equity stakes in businesses; some have existing policy frameworks and institutions for doing so, whereas in some countries there is an aversion to government control of businesses.

Several countries – including the UK, Germany, and Poland – have moved quickly to introduce government equity programmes, often relying on existing infrastructure like government development banks. Others are actively considering doing so.

Different countries will likely continue to design programmes based on unique factors, and within countries, programmes for different sized businesses and different industries might utilize different capital structures and programme infrastructures. Tools include hybrid credit instruments (such as convertible bonds), subscription warrants, participant rights, indirect investments through venture capital or private equity firms, and other options.

Regardless of whether governments use existing institutions or build entirely new frameworks, policy-makers need to develop options fit for the nature of this crisis that optimally distribute profits and losses between the public and private sectors, ensure fairness and transparency in the allocation of funds, and preserve employment and financial stability. Governments should continue to work with financial institutions, and both public and private investors with relevant expertise, to develop these programmes.

A deep credit crunch triggered by credit losses from a wave of insolvencies is only one of several major risks about which industry practitioners are concerned. As the crisis persists and evolves, policy-makers must remain vigilant about protecting livelihoods directly and preserving the stability of the financial system so that it is able to support the recovery.