chapters apply this conceptual framework to the various areas where balance sheet risks have accumulated as a result of the pandemic and highlight priority areas where decisive policy action can support an equitable recovery.
Interconnected financial risks across the economy The initial impacts of the COVID-19 crisis were felt most directly by households and firms, which saw a sharp decline in income and business revenue. These income losses are likely to have repercussions for the wider economy through several mutually reinforcing channels that connect the financial health of households, firms, financial institutions, and governments.
Economic links between sectors create spillover risks The financial health of households is connected to the larger economy through the so-called household–financial sector nexus and household–government nexus. When the financial health of households deteriorates, it can directly affect the financial sector through a rise in loan defaults and an increase in loan provisioning requirements, which reduce the ability of banks to issue new loans to creditworthy borrowers. Similarly, when balance sheet conditions in the financial sector worsen, banks supply households with less credit and charge higher interest rates, which depresses economic activity. The financial health of households is similarly connected with that of governments because governments can provide households with direct support in the form of transfer payments, social safety nets, insurance, and employment. These support measures can help households weather the effects of an economic downturn, or an aggregate shock such as the COVID-19 crisis, that overwhelms conventional insurance mechanisms. Governments, in turn, rely on households as a source of tax revenue, which declines when incomes are low, unemployment is high, and household balance sheets are under stress. Similarly, the corporate sector is connected to the wider economy through links with the financial sector—the so-called corporate–financial sector nexus—and through links with the public sector—the corporate–government nexus. The financial condition of the corporate sector affects banks and nonbank financial institutions directly through insolvency and loan defaults. The health of the financial sector, in turn, affects firms through the availability of credit: when there is stress on financial sector balance sheets, banks extend less credit and charge more for it. There are multiple feedback loops that can reinforce these links. First, banks are often tempted to delay recognition of nonperforming loans (NPLs) and keep channeling credit to firms that are de facto insolvent. Such “zombie lending” misallocates credit to unproductive firms, reduces the access of profit able firms to financing, and has historically been an important factor in prolonged periods of low economic growth. Second, in times of economic crisis lenders may not be able to distinguish between firms that face temporary liquidity problems and those that are truly insolvent. They may, then, ration credit to both, thereby further depressing economic activity.1 In emerging economies, government ownership of banks and the greater opacity of market information make these feedback loops more pronounced. The financial health of the corporate sector is also connected to that of the government. Government spending supports economic activity in the corporate sector directly through public procurement and indirectly through transfers, guarantees, infrastructure investments, and other support schemes, often aimed at priority sectors such as agriculture or small enterprises. Similarly, tax policy can stimulate economic activity and set incentives for the efficient allocation of resources. Through this channel, tax policy has a direct impact on productivity in the corporate sector. The financial
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