Author: Jacek Osiński

Advisor in the NBP Financial Stability Department

Long-term impacts of COVID-19 vs. financial system stability

Some economic consequences of the COVID-19 pandemic may also be experienced long after it has ended. What long-term effects of COVID-19 could pose risks to the stability of the financial system in the future?
Long-term impacts of COVID-19 vs. financial system stability


In the world economic history, the COVID-19 crisis appears as an unprecedented event − representing a simultaneous shock to aggregate demand and supply and uncertainty which affects the entire global economy. The COVID-19 shock has a strong impact on the financial system and its stability despite the fact that, unlike the 2007-2012 crisis, the source of the shock lies outside the system. The negative short- and medium-term economic consequences of the pandemic itself and the required mitigating measures have been effectively contained by public interventions in the areas of fiscal, monetary as well as micro- and macroprudential policies.

However, the consequences of the pandemic may also be experienced long after it has ended. Assessing such long-term effects is a major challenge because even its medium-term consequences are still not fully recognised; besides, the pandemic has not finished yet. Thus, there is no comprehensive research on the overall impact of COVID-19 on the economy, the financial system and its stability. So far, only studies on some potential specific long-term consequences have been conducted.

This article is an attempt to indicate some key potential long-term consequences, as assessed by the author, exerting direct or indirect impact on the financial system and its stability. The COVID-19 can play here multiple roles: it may be a direct source of these phenomena/trends or their catalyst, it may also amplify or accelerate processes previously initiated in the economy. The literature on the subject points to seven potential long-term consequences:

  1. Weakening of the long-term growth rate of the economy and a decline in the level of the real natural rate of interest.
  2. Growth of the risk of persisting excessive public and private sector indebtedness.
  3. Consolidation of the lower-for-longer interest rate environment and the resulting risks.
  4. Reinforcement of the ” moral hazard” phenomenon as a source of systemic risk.
  5. Structural changes in financial markets increasing the likelihood of their instability.
  6. Increased funding risk for a significant part of the commercial real estate market.
  7. Increasing cyber risks.

Financial system stability is largely determined by the momentum and sustainability of the economy as a whole. The conclusion on the possible decline in long-term GDP growth and the natural real rate of interest which can negatively affect the development and stability of the financial system, can be drawn from: the analysis of historical experience regarding the impact of epidemics on economic growth in various countries; the likelihood of occurrence of the so-called scar of beliefs following the pandemic; the increase in the share of so-called zombie firms in the economy and expectations of enterpreneurs.

Historical experience of the impact of epidemics on the economy (Federal Reserve Bank of San Francisco Working Paper 2020-09) refers to 19 cases of large (where over 100,000 people died) pandemic events in Europe dating back to the 14th century. After each epidemic, a significant economic downturn was identified. Persistent post-epidemic periods with depressed investment opportunities were observed as a result of excess capital per unit of surviving labour or an increase in precautionary saving, or a long period required to rebuild depleted wealth. This was accompanied by a decline in the real natural rate of interest of around 150 bps over 20 years after the epidemic. However, lessons from past events are not necessarily entirely applicable to the current reality. The COVID-19 crisis is different – the death toll of COVID-19 relative to the total population is likely to be lower than in the worst pandemics of the past, while aggressive fiscal expansion that increased public debt contributed to reducing the current national savings rate.

The pandemic has changed companies

However, the largest economic cost of COVID-19 may arise from potential changes in the behaviour of economic agents long after the crisis is resolved rather than from the shock itself. These changes may be the effect of the so-called scar of beliefs (Scarring Body and Mind: The Long-Term Belief-Scarring Effects of COVID-19) stemming from a permanent change in the perceived likelihood of an extreme, negative shock in the future. Such a change may negatively affect production and investment, economic growth and contribute to an increase in savings and maintaining the interest rate at a low level.

Historically, an increase in the share of zombie firms in the economy took place (from 4 percent towards the end of 1980s to 15 percent in 2017). Public financial support of companies during the pandemic may encourage this process to continue.

The effect of COVID-19 may be a futher increase of the share of so-called zombie firms in the economy (COVID-19 and Lending Responses of European Banks by Özlem Dursun-de Neef, Alexander Schandlbauer), which will reduce its growth potential. Zombie firms are nonviable firms but are still active on the market which absorb economic resources but do not use them efficiently, thus limiting potential growth. Studies conducted in 14 developed economies indicate that historically, an increase in the share of zombie firms in the economy took place (from 4 percent towards the end of 1980s to 15 percent in 2017). Public financial support provided to firms during the pandemic may encourage this process to continue. The pandemic has also seen an increase in the relative share of worst-capitalised banks in the financing of weaker firms (as a result of public guarantee schemes, introduction of the possibility of deferring loan loss recognition and capital write-offs, etc.), which may also be conducive to keeping zombie firms alive. In the future, if the situation of these companies deteriorates, weaker banks will not limit supplying credit to them, since they would then have to create provisions or compromise their own low capital. Such behaviour would be in line with the zombie lending literature. In an environment of permanently low interest rates and low bank profitability, incentives for such behaviour may be even stronger.

The potential long-term anti-growth effect of the COVID-19 shock is also indicated by firms’ expectations. The ECB survey (The long-term effects of the pandemic: insights from a survey of leading companies), involving 72 leading (large) euro area companies representing  industrial and services sectors showed that in most cases companies indicated a net negative impact of COVID-19 on their future activities (e.g. investment, employment, sales). The only exception was a positive impact of the pandemic on productivity in business, which was probably an anticipated consequence of the higher digitalisation of the economy.

High debt, low interest rates

COVID-19 contributed to a significant increase in global debt (Global Debt Monitor), which may be difficult to contain. During COVID-19, public debt-to-GDP ratios reached their all-time highs in many countries. On the other hand, leverage in the corporate sector reached the all-time high even before the pandemic, which was mainly related to financially weaker firms (Global Financial Stability Report, April 2021). A large fraction of corporate debt is now rated BBB, the lowest investment grade rating, and corporate debt rated below investment grade is at an all-time high (Corporate debt burdens threaten economic recovery after COVID-19). While COVID-19 will result in lower long-term GDP growth, it may reduce the capacity of entities to reduce debt. If the low interest rate environment persists, the capacity to service debt would be higher in a standard situation, but high debt also means higher vulnerability of indebted entities to shocks. The assumption of permanently negative (adjusted for GDP growth) interest rates is questionable even with the current low cost of debt servicing (see the example of Greece in 2001-2011). In addition, high debt has also an adverse impact on economic efficiency: highly indebted firms may forgo even profitable investment opportunities due to limited access to funding (Insolvency and debt overhang following the COVID-19 outbreak: Assessment of risks and policy responses). The limits of how much you can borrow have not disappeared and the need to stay away from them is even sharper in the world where interest rates and growth are uncertain.

Despite the inflationary disturbances currently observed, the long-term consequence of COVID may be the persistence of the low level of interest rates in developed countries (lower-for-longer). Interest rates (natural, nominal and real market rates) have been falling in this group of countries since the mid-1980s. By weakening the potential for economic growth, COVID-19 will increase the likelihood and sustainability of the low-for-long scenario. Although upward drivers of real interest rates can also be identified, most analyses using long-term modelling of economic interactions associated with the COVID-19 shock conclude that it has exerted further downward pressure on interest rates (Lower for longer – macroprudential policy issues arising from the low interest rate environment). If this scenario materialises, the importance of risks to financial stability that low interest rates may trigger or catalyse will increase (Final report on issues arising from low interest rates and structural changes in the EU financial system): the unsustainability of certain business models (e.g. banking); incentives to take excessive risks (low cost of such behaviour); or an increase in overall exposure to market risk and interconnectedness risk (due to structural changes as a consequence of financial institutions adjusting to permanently low interest rates).

Risk of abuse, casinoisation and memeification of markets

A spill-over effect of strong public intervention in financial markets during the pandemic and increased moral hazard among investors may be an increase in risky investment behaviour. The COVID-19 shock required far-reaching interventions by central banks in many markets, the extent of which proved even greater than during the Great Financial Crisis. Such response was fully justified by the need to mitigate systemic risk (maintain the functioning of financial markets, the ability of firms to raise funding in the market and prevent a „run” on investment funds and squeeze-out sales of assets) but may foster expectations of further expansion of market support in the future. As interventions imply ex-post assumption of some investment risk by the public sector from private investors, this may create incentives for riskier investment behaviour (Moral hazard, the fear of the markets, and how central banks responded to Covid-19). This, in turn, may foster the creation of price bubbles in asset markets (financial, real estate). An increase in the frequency and scope of such interventions may also foster the reduction of the role of market mechanisms in the economy, which will negatively affect its efficiency (by distorted evaluation of investment effectiveness, costs and investment risk).

COVID-19 may – as a catalyst for the so-called “game-ification” or “casinoisation” of markets – contribute to an increase in the importance of non-economic factors in asset pricing, an increase in the sensitivity of financial markets to herd behaviour and, consequently, an increase in their volatility. The lockdown in the economy provided a stimulus in many countries, but mainly in the United States, to increase households’ interest in speculative activity on financial markets, primarily the stock market. Technological and business developments have already emerged to facilitate „costless” trading of shares by households.

The enforced changes in the structure of the portfolios of passively managed ETFs, the share of which has risen sharply in recent years, constitute a volatility strengthening factor.

The effect was not only a significant increase in the share of retail investors in US stock market trading, but also a significant change in the nature of markets – for many new investors, markets are no longer a means of valuation of investments, but a casino or a kind of online game. Major shareholders of the well-known investment firm, Berkshire Hathaway, described this phenomenon as the game-ification of stock market trading. According to Warren Buffett, it provides an incentive to gamble – an example being the famous speculation that took place on shares of the GameStop company. Another term for the changing nature of financial markets is their “memeification” , i.e. the selection of shares by retail investors influenced by information coming from social media and internet gurus. All these changes are leading to increased price volatility in these markets which have seen an increasing direct participation by retail investors. The enforced changes in the structure of the portfolios of passively managed ETFs, the share of which has risen sharply in recent years, constitute a volatility strengthening factor.

Remote work, online shopping and cyber risk

COVID-19 can also be a catalyst for commercial real estate financing risk (the so-called CRE sector)The increased risk of virus infection and lockdowns led to an increase in companies’ use of remote work, as well as online trading. While remote work will become permanently widespread and online shopping habits will strengthen, the demand for office and retail space could fall significantly, so that valuations of CRE-related financial assets – both existing and future – could also decrease substantially. While the exposure of banks to this real estate market segment is not considerable in Poland, it is significant in many banking systems of the EU.

Cyber risks have become one of the important sources of threats to financial system stability.

The COVID-19 pandemic containment measures resulted in the acceleration of the digitisation of the economy and the rise of remote work, however, with the spill-over effects of increasing the exposure of financial services to cyber risks. During the peak of lockdowns, a 24-32 per cent increase in the relative rate of daily downloads of finance-related mobile apps was recorded across the 71 countries surveyed (Fintech in the Time of COVID-19: Trust and Technological Adoption During Crises). Companies have also increased the scope of their digitisation, e.g. 82 per cent of companies increased their use of cloud services in response to pandemic constraints (Study: How the ‚New Normal’ is Changing Cloud Usage and Strategy). At the same time, the number of cyber attacks grew from fewer than 5,000 per week in February to over 200,000 in late April 2020. (Covid-19 and cyber risk in the financial sector). Cyber risks have become one of the important sources of threats to financial system stability. The importance of COVID-19 as a catalyst for these changes cannot be overstated, but it is not the only driver of digitisation of the financial services sector and increased risks associated with this process.

Finally, I would like to stress that some of the conclusions in the article are speculative due to the fact that pandemic shocks are very rare events, past epidemics were not global and such a strong economic shock and such a strong public policy response had never happened. By their very nature, the conclusions presented in the article are universal and they do not apply to specific countries and their specific situation.


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