The COVID-19 pandemic is hitting economies already reeling from global trade tensions and geopolitical uncertainties. If prolonged, it could trigger a sustained downturn in the global and regional economy that will ripple across industries and sectors. We are already seeing stunted trade and investment, disrupted supply chains, diminished consumer and investor confidence, and volatile financial markets.

This could spell trouble for Asian banks and corporations. While some industries might be hit harder than others, reduced corporate earnings and tighter credit conditions could lead to more nonperforming loans – debilitating debts that are at or near default. With corporate clients –particularly airline, travel, and retail industries – facing difficulties paying back their debts, local banks could be saddled with more troublesome defaults. Micro, small, and medium enterprises are also particularly at risk. Given the dominant role of banks in Asia’s financial systems, this could breed widespread financial instability.

Bank-held nonperforming loans across Asia and the Pacific rose 23% from end-2018 to August 2019, reaching $640 billion. Nonperforming loans are often sensitive to an economic downturn.

These bad debts were a salient feature of past financial crises, including 1997/98 Asian financial crisis, the 2008 US subprime mortgage crisis, and the 2009 European debt crisis. Even after these crises were addressed, nonperforming loans had long-lasting, detrimental effects on economic recovery and financial stability in Asia and around the world.

Monetary policies that stimulated economic activity by lowering interest rates drove recovery after the 2008/09 global financial crisis. But they also created new financial imbalances and distortions in many economies. For example, the private debt-to-GDP ratio rose sharply in many Asian economies. Housing prices in many economies have also soared.

Against this backdrop, a significant decline in economic activity may invite corporate debt downgrades and defaults, while a collapse in asset prices could lead to a serious deterioration in the quality of banks’ assets, leading to tighter credit conditions. These conditions pose a considerable risk to banking system stability in the region.

The good news is that, across the region, policy makers are trying to pre-empt a pandemic-induced loan crisis. Many central banks have already cut interest rates. But more action is needed. Central banks should provide backstop measures against potentially massive defaults and a credit crunch. Some have already introduced programs to purchase commercial paper and provide a range of credit to households and businesses. Temporary financial relief for indebted households and small businesses can be also considered. With the support from the governments, banks are already granting deferments or temporary forbearance of loans and repayments. These measures should be properly targeted and clearly time bound.

  Bank-held nonperforming loans across Asia and the Pacific have hit $640 billion.

However, a widespread economic slowdown suggests some increases in nonperforming loans might be inevitable after the temporary relief. Therefore, authorities should also prepare to act swiftly to avoid a massive buildup of nonperforming loans in national banking systems. This requires the authorities together with banks to develop clear action plans to effectively resolve nonperforming loans.

There are many obstacles to effective resolution of nonperforming loans. These include information asymmetry, coordination failures, and institutional impediments. The region’s policy makers must address demand-side, supply-side, and structural challenges while developing a nonperforming loan resolution framework as part of financial safety nets.

On the demand side, the price that the investors will pay for nonperforming loans can be far less than what banks like to accept. Transaction costs, the underlying collateral values, and the cost of recovery, all exacerbate the divide between buyer and seller. As a result, nonperforming loan markets tend to be dominated by a few large investors with concentrated market power.

On the supply side, banks may not want to sell at a discounted price. Banks usually prefer holding on to nonperforming loans until asset prices recover. Selling nonperforming loans below current book values would be counted as losses on the bank’s books and negatively affect its capital. Additionally, banks’ reluctance to sell nonperforming loans may stem from their desire to avoid the first mover disadvantage.

Structural challenges include poor legal frameworks, legislation, or sufficiently transparent collateral enforcement and insolvency proceedings. These can delay recovery in asset values and add to recovery costs. All of these will limit investment into nonperforming loan markets and keep them from functioning efficiently.

To address these impediments, it is important to enhance data availability, transparency, and integrity. Further, strong public support, institutional quality, oversight, contract enforcement powers, and governance are essential.

What can countries do to help prevent these nonperforming loans from exacerbating economic problems created by the current crisis? Here are three policy lessons we have learned from our work in the region:

First, an early and preemptive response is key to addressing nonperforming loans and preventing them from contributing to banking instability and market panic. Preventive restructuring frameworks can be put in place to ensure proper actions can be taken to preempt corporate defaults. This gives companies a second chance at debt rehabilitation. The efficiency of insolvency frameworks is another important element in reducing a build-up of nonperforming loans and for a well-functioning nonperforming loan market. Also, facilitating out-of-court enforcement for financial collateral will allow banks to recover the value of collateral without going to court, and help speed up the resolution process.

Second, developing private nonperforming loan markets allows financial institutions to dispose of distressed portfolios at fair and efficient market prices. A functioning secondary market allows banks to remove nonperforming loans from their balance sheets and sell them to interested buyers. Without this, banks have to keep nonperforming loans on their balance sheets, pressuring their profitability and limiting capacity to lend to new clients. Secondary markets for nonperforming loans can be promoted by addressing barriers to loan servicing and to the transfer of bank loans to third parties.

And third, crises have taught us that we need stronger regional financial cooperation, with policy makers working collectively on risk identification, mitigation, and response. Safeguarding financial stability requires Asian policy makers to work together through a combined focus on adequate national regulatory policies, effective monitoring and surveillance frameworks, and regional cooperation for emergency liquidity support.

COVID-19 is a significant risk to the region’s financial systems. But one that can be managed through coordinated policy responses to address its impact on economies and finances.