The deep recession expected as a result of the COVID-19 pandemic will leave both governments and private-sector companies with a greatly increased debt burden. That will have severe consequences for the financial system. Banks will suffer large-scale defaults on business and personal lending. To work off the debt overhang, interest rates may be held down by central banks for a long period. Inflation may rise, which would deflate the real value of debt, but inflationary pressures are currently weak. Financial repression will add to the pressures on banks and other financial institutions. Major banks enter the crisis period with high capital ratios, but expected losses on loan portfolios will put some under strain. Less strongly capitalized new entrants may suffer disproportionately. Other likely changes are more rapid growth in digital financial services and a decline in cash usage. Central banks will probably issue their own digital currencies, which will make maintaining negative interest rates more achievable. At the same time, the international financial system will be put under strain by global tensions generated by the crisis. In this complex environment, it will be crucial for governments, central banks, and the banking system to collaborate closely and for the European Union to bolster the eurozone with long-planned but long-delayed reforms, in particular to promote a capital markets union that could relieve pressure on banks’ balance sheets.

Since 2008 almost all discussions on the future of finance have started with the Great Financial Crisis (GFC) that began in that year. In “Can Financial Markets Be Controlled?” (Davies 2015), I summarized the state of the debate at that time. Broadly, it was accepted that the reforms led by the Financial Stability Board (FSB), under the auspices of the G20, had corrected some of the most obvious flaws revealed in the turmoil of 2008–9. Banks were obliged to hold far larger capital reserves, some three or four times as big as in 2008, making them far less likely to collapse if asset prices fell and loan defaults rose. The off balance sheet vehicles that had allowed banks to hide some of their liabilities had been outlawed by regulators. Transparency rules in capital markets had been overhauled. Insurance company regulation had been tightened, with far tougher solvency rules in place. The Basel Committee, and other international regulatory bodies, had seen their membership expanded to cover China and other emerging markets, enhancing their legitimacy and coverage. And the FSB, reinforced with stronger political support, sat above the regulators with a remit to identify emerging threats to stability.

So far, so good. But there were also obvious weaknesses and lacunae:

• Credit creation had moved from the banking system to various forms of shadow banks. Regulators could be caricatured as playing a version of financial whack-a-mole. Whenever regulations were imposed to restrict leverage, it reappeared in a less regulated part of the forest.

• The US regulatory system remained a balkanized mess: a complex set of bodies with overlapping responsibilities and no central coordination. One could have no confidence that the true risks in the US system were being properly addressed. Former Federal Reserve chairman Paul Volcker described it, even after the extensive Dodd-Frank reforms, as “highly fragmented, outdated and ineffective” (Volcker 2015).

• International monetary cooperation was weak. It “displayed elements of order and disorder” (Eichengreen 2016). The Federal Reserve, whose actions are decisive in determining financial conditions across the globe, paid little attention to the impact of its decisions on financial markets elsewhere (Rajan 2014).

• The fundamental bias in the tax systems of all major economies in favor of debt financing (interest charges may be offset against tax, while dividend payments may not be) had not been addressed (Mooij 2011). So the conditions for a further rise in debt were in place.

• In Europe, in particular, while the introduction of banking union had rebuilt some confidence in the regulatory oversight of the banking system, the union was incomplete. Without a common deposit protection scheme, banks in vulnerable countries could be threatened by a bank run, and the mechanisms for lender of last resort support lacked a firm legal base. As a result, the single financial market had broken down, with the European Central Bank (ECB) left to manage the interbank market itself.

• The financial system had been stabilized by massive central bank intervention: low interest rates and massive quantitative easing programs. Even so, economic recovery remained sluggish, especially in Europe, and it was not clear that the central banks had sufficient firepower in reserve to cope with a new crisis, if one emerged in the near term.

To say that the above shorthand assessment represented a consensus view would be to overstate the case. There were those, in the official sector at least, who presented a more positive view of the impact of the postcrisis reforms (Carney 2019). On the other side of the argument, some capital hawks maintained that bank capital should be even stronger, with banks required to hold capital amounting to 25 percent of their liabilities, if not more (Admati and Hellwig 2013). Others advocated a more fundamental repositioning of the financial system, to restore it to the position of a servant rather than the master of the real economy, echoing Winston Churchill’s desire, expressed in 1925, that “finance should be less proud and industry more content.” In The Value of Everything, for example, Mariana Mazzucato presents a manifesto of reform. In her view, unless the financialization of the real economy is arrested, there will be continued instability (Mazzucato 2018).

Through to the end of 2019, these debates ebbed and flowed with the tide. Regulators and banks had declared a temporary truce on bank capital. The Basel Committee came to adopt what we might describe as an Augustinian approach. Perhaps, in an ideal world, more capital should be required—but not yet. The risk of provoking a credit crunch if banks were required to hold higher reserves was seen as potentially dangerous. The data showed that in an environment of low interest rates and depressed profitability, some banks, especially in Europe, had achieved a higher capital ratio more by reducing lending than by raising new equity (Cohen 2013). Regulators reassured themselves by conducting stress tests of banks’ portfolios, to understand if and how they could survive a sharp downturn without breaching the minimum requirements for staying in business. Across Europe and North America, banks were deemed to have passed these rigorous tests.

On the monetary side, central banks maintained that they retained the ability to react to a downturn. Even though the typical monetary response to recessions since the Second World War has been a reduction in interest rates of some five percentage points, and rates were not above 2 percent in the United States and barely positive in the European Union, at the end of 2019, the Fed and the ECB argued that there was still more they could do, especially in terms of expanding their asset purchases, without entering into the radical territory of monetary financing of government deficits.

Such was the financial background against which the novel coronavirus made its appearance in Wuhan.

The crisis through which we are now living did not emerge in the financial sector, as its 2008 predecessor clearly did. We will never know whether those who forecast a renewed bout of financial instability arising from what they saw as the continued fragility of the banking system, or from the excesses of the shadow banks, would have been proved right or wrong in the end. But while banks and brokers cannot realistically be accused of precipitating this crisis, they will inevitably be affected by it, and the state of the financial sector will influence the transmission through the economy of the massive demand and supply shocks we are currently experiencing.

It is highly likely, too, that the financial system will be significantly affected by the crisis as it evolves. We might characterize it as an extremely severe stress test. In the last Bank of England stress test on UK banks, in 2019, they were required to model the impact on their lending portfolios and deposit funding of a severe recession. The main parameters of the stress test were that GDP would fall by 5 percent and as a consequence unemployment was assumed to double, house and equity prices to fall by 30 percent, and short-term interest rates to rise to 4 percent. (Similarly severe stress tests have been used by the Federal Reserve and the European Banking Authority.) The last visitation—a sharp interest rate rise—is highly unlikely now, but the fall in GDP and rise in unemployment precipitated by COVID-19 are likely to be more severe, probably considerably more severe. We do not yet know how property and equity prices will fare, but the direction of change is clear. And from a bank perspective, an interest rate rise is, in terms of profitability, a positive offset that will not now occur. Government loan guarantees, not built into the regulatory stress test, will partially offset the cost to the banks of bad debt, but the net impact of those support schemes on banks will be negative, perhaps quite strongly so. The banks pay for the government guarantee and will incur costs trying to recover defaulted loans.

The short-term impact of the crisis on the financial sector will undoubtedly be to generate large losses for most banks and insurers. There will be some pockets of success. It is, as they say, an ill wind that blows nobody any good. Insolvency practitioners are gearing up for a massive rise in workload. Some parts of the capital markets businesses of banks have improved their profitability. Market volatility, and the need for businesses to find ways of protecting themselves against new types of risk, are creating opportunities. But for most banks, that will not begin to offset the losses they will incur on corporate lending as bankruptcies emerge, and on unsecured personal lending as unemployment rises. The prospect of continued very low or even negative interest rates rubs salt into the wounds. The behavior of their share prices this year has shown what investors think of the short-term prospects for banks. Most large EU and UK banks have lost around half their value this year and are now trading at half their net asset value or below.

It is very early to speculate on what the long-term consequences might be. We do not yet know the shape of the crisis in economic terms. Debate swirls around the letter we might use to describe it. Will it, as most governments fervently hope, be a V, with a sharp upturn quickly reversing the GDP losses this year? Or perhaps a W, if we experience a second peak, but again followed by a robust bounce back. Or a U, where we wallow for a while and then recover, as people take time to adjust to new ways of working to accommodate the continued activity of the virus in our societies until the happy day when a vaccine is available. Or maybe an L, where the effect on productive capacity, and on the propensity to spend, is long lasting and we settle at a lower level of prosperity for a considerable time. Or (my own current bet) a Q, where we go around in circles for a while before finding a way to break out.

But with every possible health warning about the dangers of peering through a glass darkly, I will offer some speculative thoughts about the longer-term impacts. To provide a framework, I will divide my observations into three categories:

1. Certainties

2. Probabilities

3. Big unknowns

## 1. Certainties

The first certainty is that there will be a huge increase in public-sector debt. The governments of all the major economies have decided that they must support the private sector during the lockdown period and beyond, in some cases with payments directly to households, in other cases through employment support or grants and guaranteed loans to employers. There are lively debates about the best route to take, but the financial outcomes for the governments are similar. Debt-to-GDP ratios will rise, almost everywhere. The US government forecast in February that its net borrowing in the second quarter of 2020 would be very slightly negative. They expected a very small general government surplus. By early May, its estimate was of a borrowing requirement of almost $3 trillion, an astonishing turnaround (McCormick 2020). The signs are that these deficits—and the relative scale is similar in Europe and Japan—can be financed at very low interest rates, so the current debt interest burden should be manageable in the near term. Much of the financing is in practice provided by the central banks, which have become the government debt buyers of first resort. The consequences will vary from country to country, partly depending on the starting point. The US debt-to-GDP ratio is likely to rise from 81 to well over 100 percent. The United Kingdom enters the crisis period at 89 percent and will soon also be over 100 percent. Italy began the year with a government debt-to-GDP ratio of 135 percent, so it will inevitably move into territory normally explored only in the aftermath of costly wars. Emerging markets, heavily dependent on external financing of their deficits, will be especially challenged if their COVID-19 outbreaks are as severe as those in the richer countries. There are already calls for debt forgiveness. It is highly likely that a lot of forbearance will be needed if the virus spreads aggressively in Africa and elsewhere. According to Eichengreen, “More than$100 billion of financial capital has flowed out of these markets—three times as much as in the first two months of the 2008 financial crisis” (Eichengreen 2020). He argues for a new Brady Plan “in which debts rendered unsustainable through no fault of the borrowers are written down and converted into new instruments.”

We will discuss the longer-term consequences of this massive increase in public-sector debt later.

The second certainty is that debt will rise sharply in the private sector too. Government support programs for businesses are heavily based on the provision of cheap debt. The rationale is based on the notion of a V-shaped recovery and the need to provide a bridge across the V for firms that, in the normal way, are viable. Even if that assumption proves correct, there will be many more heavily indebted firms in the future, and if the recovery is more prolonged or uncertain, there will be many companies with a debt burden they will find it hard to sustain. That in turn will result in more bankruptcies, whose impact will be most strongly felt in the banking system, unless more equity can be found to substitute for the debt. There will be opportunities for private equity firms, where they have the appetite, but I would also expect governments themselves to come under pressure to construct equity-like investments to replace the increased debt. The penal capital treatment of equity holdings by banks makes them unlikely candidates for the provision of that support, unless regulators have a change of heart. I discuss that issue further below.

A consequential certainty is that there will be many corporate debt downgrades effected by the credit rating agencies; indeed, the process has already started. That will be a challenge for institutional investors, who will find themselves unintentionally holding non–investment grade debt and who may need to adjust their risk appetites as a result.

Another certainty is that more financial services will be provided digitally. Although, in the United Kingdom at least, most bank branches have remained open through the crisis, customers have been understandably reluctant to visit them. Many older customers previously resistant to online or mobile banking have become converted. The same is true in insurance and asset management. This will, over time but quite quickly, have significant consequences for costs and employment in financial firms.

## 2. Probabilities

In the banking system, the strongest, best capitalized banks seem reasonably well placed at present to survive the crisis, unless it is more severe than even the gloomiest forecasters currently assume (Beck 2020). All the large UK banks survived last year’s stress test, and while, as I have explained, the GDP and unemployment consequences were not as severe as we now expect, there is an offset in the form of government-backed lending programs.

But there are banks elsewhere in Europe, in particular, whose capital may not be as strong. If loan defaults rise very sharply, some bank balance sheets will be put under severe pressure, and they may fall below their regulatory minimum, which would trigger recovery and resolution plans. Regulators have responded to this deteriorating outlook by using the macroprudential tools introduced after the GFC—in particular, the additional buffers imposed when credit conditions are judged to be excessively loose. Those additional capital buffers have been withdrawn in the crisis, thus reducing the regulatory minimum a bank must hold.

But some banks may nonetheless find themselves close to the threshold. In those cases, I would expect to see some attempts to raise more equity capital, which will be very challenging, and probably some consolidation. One key difference in this crisis is that banks have all been required to prepare recovery and resolution plans that have been submitted to their regulators and approved by them. In 2008 that was not the case, and when Lehman Brothers was allowed to fail, the experience was not encouraging. The consequences for the rest of the system were severe. Lehman creditors were on average paid out around 45 percent of what they were owed (Denison, Fleming, and Sarkar 2019).

Will regulators therefore be less reluctant to see banks fail, on the basis that they have a resolution plan in their back pockets that, in theory, can click into action? My assumption is that regulators and governments will nonetheless be reluctant to put these plans to the test. While public support for rescuing banks is very low, this crisis, as we have seen, cannot be attributed to their excesses, and I would expect regulators to be very nervous about the practicality of any resolution plans in a full-scale economic depression. Recovery plans typically depend on a combination of asset sales (where buyers will be hard to find) and equity raises, which will be extremely difficult now that regulators—in Europe at least—have prevented the banks from paying dividends for last year and quite likely this.

So my expectation would be that the preferred route for failing banks will be a shotgun marriage, with the shotgun held by the central bank. Shareholders will be wiped out. I doubt if there will be any appetite for a government purchase of shares that leaves private shareholders in place, even if heavily diluted.

The difficulty will be the adverse impact on competition. There are several banking markets in Europe where concentration is already high. Will competition regulators, who have tried hard to promote the entry of new competitors in recent years, be prepared to see competition further reduced? Will the European Commission’s Competition Directorate be prepared to look at the EU banking system as a whole when contemplating in-country mergers? And will regulators be prepared to facilitate cross-border mergers, which the ECB has long wanted to see but which in practice have been extremely hard to deliver? There is a chance that the crisis could have the side benefit of promoting the creation of strong pan-European banks, which have often been contemplated but so far never consummated.

The competition arguments may be made more difficult if another development I regard as probable comes to pass.

A number of new competitors have entered the banking market in Europe and the United States in recent years. Some will be put under severe pressure as a result of the deep recession we now expect.

We may roughly categorize them in four groups:

1. Challenger banks, offering services comparable to those of the large incumbents, perhaps with a sectoral focus or an original business model or marketing approach

2. Peer to peer lenders

3. Fintechs, often private equity–backed start-ups

4. BigTech entrants, like Apple or Google, principally focused on the payment system

Some of these competitors are agile enough, with a sufficiently persuasive customer proposition, and are so robustly funded that they will survive. And we need not worry about the finances of BigTech firms that have entered the payments business in recent years. They will survive if they wish to.

Others may struggle in a credit environment that will be far more hostile than they have encountered hitherto. I suspect that some may be crushed under the wheels of an unforgiving credit cycle. There will be an element of chance in who survives and who does not, sadly. Those that had completed a funding round shortly before the crisis hit may well have the resources to ride out the storm. Others, who need more capital to grow (and many are still loss-making), will find that money harder to raise except on terms that may constrain their growth ambitions. We have already seen examples of that. And there are signs among customers of a return to safety, as they fear that new bank competitors may not have the funds to support them through a difficult period. I would judge that, in the UK market at least, some of the challenger banks and the peer-to-peer lenders will struggle the most. Some failures there will be inconvenient but probably not systemic.

It is possible, too, that the crisis will, in the European Union, provide the stimulus needed to energize the capital markets union project, which has been languishing for some time. If I am right that there will be a need for more equity to stabilize heavily indebted corporates, deeper and more robust capital markets should be part of the solution. That will require braver action by the European Commission and the European Parliament than has been envisaged so far. The crisis coincides with the negotiations on the terms of Brexit. In financial services, those negotiations center on the degree to which the EU 27 and the United Kingdom will regard each other as equivalent in terms of financial regulation. The issues are partly political and partly highly technical. At present, it is hard to see what the outcome will be. But anything short of full equivalence, and an effective reinstatement of the internal passport system (which is highly unlikely) will require change in both London and elsewhere. A very recent Bruegel paper (Christie and Wieser 2020) concludes, “Historically, European politicians have been able to keep finance at arm’s length, because of London’s dominance as a financial centre. The EU now loses this shield. But the EU also has an opportunity to reshape its financial infrastructure for the better. If policymakers take up the challenge, the EU may emerge with a more unified and functional financial market, which enhances confidence in the euro area and will better serve the European economy.”

Another probable consequence of the crisis response is that for the foreseeable future, governments, central banks, regulators, and banks (and other financial institutions) will need to work more closely together than they have done in the recent past. They did so after 2008, of course, but in a rather different way. Politicians and central bankers saw overpaid financiers as the source of the problems that they were then obliged to resolve. There was no love lost between the two. This time banks are more often seen as part of the solution than as the source of the problem. The dividend issue caused friction as most banks would have preferred to make some payments (and a few resisted regulatory pressure to abandon payouts). In the economic support phase, there have been frustrations, as banks have sometimes been seen as too slow in delivering funds to struggling clients, but overall the commonality of interest has dominated. It seems likely that the public authorities and the banks will be condemned to work closely together for some time. Whether that results in a form of rehabilitation for the banks in the long run, or in more political coercion on them to support interventionist policies, remains to be seen.

There are some promising signs that those banks that have invested time and effort in describing their social purpose, as RBS and Lloyds have done in the United Kingdom, have begun to be seen as more responsible citizens and as constructive crisis responders.

I have categorized the accelerated growth of digital banking as a certainty. Alongside that, I would now judge it probable that the central banks will quite quickly launch digital currencies.

The BIS reported last year (Borondini and Holden 2019) that 70 percent of the major central banks were exploring the issue of a central bank digital currency (CBDC). Though that interest predated the launch by Facebook of Libra, a new asset-backed so-called stablecoin, the Facebook initiative certainly accelerated those developments. Regulators did not like the look of a Facebook-promoted alternative to the traditional payments systems, which could at the limit take money creation and control of the money supply out of the hands of central banks. The Swedish Riksbank is well advanced in its e-krona initiative. The People’s Bank of China’s initiative is mature too. It is probable that some of these CBDCs will come to fruition soon (Richemont 2020).

The crisis has given a further stimulus to the decline of cash as a payment mechanism. That is in part because of generally ill-founded concerns about the potential transmission of the virus on banknotes and coins. The Bank for International Settlements (Auer, Cornelli, and Frost 2020) have found little or no evidence to suggest that is true. Indeed, the virus may survive longer on a plastic card than on a banknote. But the truth or otherwise is beside the point, and more and more retail outlets have decided to bias contactless card over cash. The trends are somewhat different from place to place. In the United States, the volume of cash in issue has continued to grow, and New York State has legislated, on social exclusion grounds, to prevent retail outlets from refusing cash, but in Europe, cash is declining almost everywhere.

Central banks see a further argument for a CBDC. Offering digital accounts makes it potentially easier for them to implement negative interest rates. There can be no negative interest rate on a €100 note, so while large cash holdings are possible, negative interest rates for retail customers in particular are hard to impose.

For all these reasons, CBDCs are probable. They are also problematic for banks. Would they supplement bank accounts or replace them? In a zero interest rate environment, why not use central bank money to settle your transactions? If they become attractive to corporates and even individuals, deposits will be drawn away from the commercial banks and into the central bank. That will reduce commercial banks’ capacity to lend. Will the central bank step in and replace their credit creation? Could a central bank sensibly manage accounts for millions of consumers? Could it develop credit appraisal expertise? Are there privacy concerns if a public authority has access to data on every transaction in the economy? These are questions that need quite urgent answers if, as I expect, we are soon faced with a CBDC (Chen and Desouza 2019).

Last in my probability list, I fear that the crisis will make international collaboration between regulators rather harder in the future than it has been in the recent past.

It is clear that relations between the United States and China have been severely damaged, even if we discount some of President Trump’s more inflammatory rhetoric. Both the WHO and the WTO have come in for strong criticism. So far the central banks have managed to maintain their links and, in spite of some criticism, the Fed has continued to provide other central banks with dollar facilities through their swap lines. Chairman Bernanke was roundly abused in Congress for doing so during the last crisis. But although the central bank network has continued to function effectively, there is little sign at the political level of the coming together in the face of a common problem that was observable after the GFC.

A hint of divergence came in the attitude to bank dividend payments at the end of March. The original intention was a common statement by the Fed, the ECB, the Bank of England, and possibly others to the effect that banks should halt all payouts, whether in the form of share buybacks or dividends. But in the end, separate statements were made, and the Fed did not support the view taken in Europe that ordinary dividends should be suspended. It concluded that while share buybacks should be suspended, US banks were well capitalized enough to support a regular dividend, and that continuing to pay would assist in future capital raising should that prove necessary (Powell 2020).

It is quite likely that we have passed the high-water mark of international regulatory cooperation. I do not expect a Basel IV accord to come into view on any near horizon. Governments will be heavily focused on supporting credit creation in their own jurisdictions. They will be in survival mode. International agreements can wait.

There are manifest tensions in Europe, too, especially in relation to the powers of the ECB, following the German constitutional court ruling of May 12 this year that cast serious doubt on the legality of the Bundesbank’s participation in the ECB’s bond-buying program (Wolf 2020). Can the ECB find a way around the ruling to maintain its program? Should it do so if the court rules against, or should the German court be clearly subordinated to the European Court of Justice, as most nonlawyers always thought it was? One answer would be the creation of a form of common bond, backed collectively by EU member states, as President Macron of France and others have proposed. Will the crisis unblock that proposal? That question goes more broadly than my focus on the future of the financial system, but there is a risk that if the ECB’s ability to buy bonds where necessary to constrain spreads and maintain the integrity of the euro is restricted, that may create a debt crisis in Italy or elsewhere with incalculable consequences for the Italian and European banking systems. To return to my language of probabilities, I would judge it probable that this problem will somehow be resolved, as the alternative is unpleasant to contemplate. But the route to a solution is not self-evident, and there will be painful bumps on the road.

## 3. Big Unknowns

### A. The public debt overhang: Inflation or financial repression?

Apart from the obvious uncertainty about the depth and length of the recession, the biggest unknown is what the longer-term consequences of the debt overhang in both the public and the private sectors will be.

Looking first at public debt, it is likely that governments will emerge from the recession with debt-to-GDP levels unknown since the end of the Second World War and an order of magnitude bigger than those experienced after the GFC. Those debts will be held in a different way, as we can expect a large proportion to be on the balance sheets of the central banks, but they are nonetheless real, and large enough to threaten both financial stability and, indeed, political stability if they severely constrain governments’ freedom to maneuver.

Economic history suggests that, generically, there are four ways in which debt-to-GDP levels can be reduced. A government may do so by running a primary surplus. The Greeks and Italians have done that in recent years. The coalition government in the United Kingdom adopted a tight public expenditure policy after 2010, holding down public-sector pay and benefits—a policy dubbed “austerity” by its opponents. The second route, the most positive one, is if the growth rate of the economy is appreciably above the nominal interest rate. That was achieved for a lengthy period in the 1950s and ’60s, on both sides of the Atlantic and in Japan, and it was the principal factor behind the steady reduction in the debt-to-GDP ratio that had exploded as a result of World War II.

The third option, whether pursued deliberately, or more often simply tolerated, is a sustained rate of inflation that reduces the real value of outstanding debt repayments. The fourth, which may have a similar effect, is some form of financial repression, where interest rates are held down to such a low rate that, even if inflation remains relatively subdued, savers are effectively penalized.

It is very hard to judge which of these routes will be followed. And they have very different consequences for the financial system.

The politics of austerity will be very difficult to handle if unemployment reaches the rates that many forecasters now envisage. There will surely be some adverse consequences for public spending. The prospects for pay raises in the public sector look poor. Public-sector workers are currently largely insulated from the layoffs and pay cuts that are the fate of many private-sector workers, so while health service employees and other emergency services that sustained the social fabric in the lockdown will see some return for their endeavors, other public-sector workers may be less fortunate. But a sustained policy of spending cuts and tax increases looks remote on both sides of the Atlantic. It is possible that wealth and property taxes could be considered by politicians who have set their faces against them in the past. But experience in France suggests that the politically feasible yield is not very high, and Macron scrapped the tax in 2017. So large primary surpluses as a route out of excessive debt seem unlikely.

A higher growth rate would clearly be a very welcome development, but it is hard to see why we should expect that, after—perhaps—a year or two of above-trend postcrisis catch-up recovery. Productivity growth has slowed in almost all developed economies in recent years and has come to a halt in the United Kingdom. There are competing explanations of that new trend (Gordon 2018), but few economists forecast a sustained upturn in the near term. So it is unlikely that growth will in itself relieve governments of their newly created debt burden.

That leaves either a rise in inflation, or a sustained period of financial repression, if public debt levels are to be stabilized or reduced. On that point, opinion is currently very divided.

After the last crisis, and the large volume of quantitative easing (QE), many monetary economists forecast a rise in inflation. For the most part, that did not happen, except in isolated cases like the United Kingdom, where the sharp decline in sterling resulted in imported inflation that the Bank of England chose not to seek to offset with interest rate increases, at a time when the economy was operating well below capacity and the output costs of holding inflation down were deemed to be unacceptably high. In the last few years, inflation-targeting central banks have struggled to lift the inflation rate up to the central target rate. The price level in the eurozone would be around 19 percent higher today had the ECB met its declared objective of an inflation rate of just below 2 percent (Whelan 2019).

So even though the huge increases in public deficits would typically result in higher inflation after a year or two, economists are divided on the consequences. In the inflation camp, we find, for example, Charles Goodhart of the LSE. He argues (Goodhart and Pradhan 2020) that a combination of “massive fiscal and monetary expansion,” on the one hand, and “a self-imposed supply shock of immense magnitude,” on the other, will result in “a surge in inflation, quite likely more than 5% and even in the order of 10% in 2021.” “Today’s policy measures are injecting cash flows that will directly raise the broader measures of money.” That, combined with an increase in the bargaining power of workers as migration slows and barriers to trade are erected, will be a powerful combination. So “inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate” and “the excessive debt amongst non-financial corporates and governments will get inflated away.” There will be negative real interest rates, and “only when indebtedness has been restored to viable levels can an assault on inflation be mounted.”

There are, however, powerful counterarguments. The supply-side shock is accompanied by a demand shock of even greater magnitude. McKinsey & Company estimate that private-sector discretionary spending has fallen by 40 to 50 percent (Smit et al. 2020). That is a difficult environment in which to raise prices, even as demand begins to recover. So Miles and Scott (2020) see little risk of a resurgence of inflation. A further point is that if much of the new debt ends up on the balance sheets of the central banks, that may change the dynamic. Is central bank–held debt as inflationary? Miles and Scott believe that “the value of financial assets held by the private sector will be much lower after the pandemic… [and] … the total value of the wealth of the private sector is likely much more significant for consumption—and that wealth will very likely have gone down.” So they consider a significant rise in inflation to be unlikely.

And is Goodhart right to assume that independent central banks would effectively suspend their inflation targets? Gertjan Vlieghe, an external member of the Bank of England’s monetary policy committee, recently addressed that question (Vlieghe 2020). He argues that there is “good” and “bad” monetary financing of deficits, and that the current version is very different from the policies followed by the Weimar Republic or Zimbabwe.

Vlieghe points out that the inflation worries after the last crisis were greatly overdone. “Some thought that [QE] would turn out to be excessively inflationary. Instead the post-crisis recovery was generally characterised by inflation being too weak, rather than too strong. Central banks that did QE earlier ended up with inflation closer to target. Those that waited longer to act undershot their inflation target by more, some persistently so.” (He is clearly referring to the ECB.) The key difference is that the central bank will, unless its independence is removed, continue “rigorously to frame its monetary policy actions in terms of its monetary policy remit.” He explicitly rejects Goodhart’s view that there may be circumstances in which it is politically impossible to raise rates to the level needed to meet the target.

The dispute is, then, as much about politics and institutional arrangements as it is about the implications of rapid growth in the monetary aggregates. That is why I categorize it as a great unknown.

But whether or not it is on a scale that leads to rapid inflation, it does seem likely that some form of financial repression will be with us for some time. Central banks now actively manage the yield curve out to very long durations—with considerable skill, one might add. They seem likely to do that for a considerable period.

How far can financial repression go? Central bankers are somewhat divided on the imposition of negative rates. Some, like the Swiss National Bank, have been content to impose them. The Fed and the Bank of England have been more reticent. The new governor, Andrew Bailey, has said that the Bank negative rates are “not something we are currently planning or contemplating” (Bailey 2020). But the Bank’s chief economist, Andy Haldane, has taken a different line, saying that negative rates are “something we’ll need to look at—are looking at—with greater immediacy” (Haldane 2020).

Others believe that rates could go strongly negative and that that would be the way out of the crisis. Rogoff argues that central banks should be bold and push negative rates to minus 3 percent or lower: “negative rates would operate similarly to normal monetary policy, boosting aggregate demand and raising employment.” Furthermore, “a policy of deeply negative rates in advanced economies would also be a huge boon to emerging and developing economies.” He believes that central banks and governments [should] give the idea a long, hard and urgent look" (Rogoff 2020).

Even if rates do not go negative, as they have already done in some parts of the world, very low or zero rates have a significant impact on the financial system. Bank profitability will remain depressed. That will, over time, raise their cost of capital, through ratings downgrades and a very high cost of equity, if indeed equity is available at all. That in turn will constrain bank balance sheets and make bank credit less available. The impact on banks, especially in Europe, has already been very striking. Bank share prices have fallen by around 50 percent in 2020 so far. The price-to-book ratios are now remarkably low for some very large European institutions. At the end of April, BNP and RBS were trading at around 35 percent of tangible net asset value. Lloyds Bank was at around 50 percent, while Deutsche Bank and Société Générale in France were at 26 and 21 percent respectively (author’s calculations). Those figures suggest that the franchise value of major banks is now negative, and even taking account of the heavy discounts to be expected on a fire sale of loan portfolios, their shareholders may be better off were they to be resolved. Such an outcome, of course, is scarcely conceivable as the consequences for the broader economy would be immensely damaging.

Insurance companies and asset managers will earn lower returns on their bond portfolios. In the general insurance market, that will have the effect of raising premiums. In life insurance, returns to savers will fall, making institutional saving less attractive. These effects will take time to work through, but they will be profound. The market prices of insurers and asset managers, except those with a strong presence in growing emerging markets, have therefore also been marked down sharply.

The position of these large institutions is, arguably, not sustainable if the prospect is for further financial repression for a long period. The US market is less badly affected. US banks have benefited from a more rapidly growing and dynamic economy. They coexist with a more flexible and receptive capital market, which allows them to securitize loans to free up their balance sheets for new and more profitable opportunities. The returns on their capital market activities are structurally higher in North America than in Europe. One important consequence is that US banks have systematically gained share in EU capital markets over the last decade. From 2005 to 2015, the market share of US investment banks in European capital markets rose from 37.2 percent to 44.6 percent. The share of European banks during the same period fell from 54.7 percent to 46 percent (Goodhart and Pradhan 2020). The trend has continued since then and is now likely to accelerate. A number of European banks are reducing their capacity, and the scale of the assets they devote to this activity, at present. Few have managed to establish a profitable presence in the United States (Noonan 2020).

The combination of zero interest rates, cross-subsidized US competition in capital markets, low cost fintechs, and BigTech entry into payments systems is a powerful set of headwinds that may reshape European banking in the next decade.

### B. The corporate debt overhang

As I explained at the start of the paper, the exponential growth in public-sector debt as a result of the crisis will be matched by ballooning private-sector debt, especially in the corporate sector. How will that problem be resolved? It is hard to imagine that all the companies borrowing extensively today to carry them through the worst of the demand shortfall will be viable with a debt-laden balance sheet when some form of normality returns. Many were only marginally profitable beforehand, with more lowly geared balance sheets.

For a period, this instability will be hidden, as many of the loan support packages in place incorporate interest holidays and subsidized rates. But they will have to come to an end at some point. The early output from an EY review of the potential recapitalization need in the UK corporate sector suggests that “the level of unsustainable debt held by UK private non-financial corporations could be up to £90 to £105 billion” (Montague 2020). How will that gap be filled?

One element could be the creation of some kind of “bad bank” with government backing. Currently the banks are energetically pumping funds into companies to help them to survive the deepest trough of the downturn and to avoid permanent scarring of the economy, which would reduce its productive capacity in the longer term. The analogy is of building a bridge over the COVID chasm. That makes sense, especially if the recession is V-shaped. But even in those circumstances, and certainly if any other letter of the alphabet turns out better to describe the shape, there will be unrecoverable loans at the end of the process. The banks will seek to recover, even where 100 percent of the loan is government guaranteed, but will not always succeed. Where the company is insolvent, there will be a write-off, shared between the government and the banks, depending on the precise terms of the scheme. But there will be a category of loans, possibly quite a large one, where the companies are solvent, and trading profitably without the additional interest payments, but where they cannot afford to remunerate the additional debt, at least in the recovery phase, when the need for working capital is often the greatest. Those assets might find their way into an institution able to hold equity or quasi-equity stakes in companies, which banks currently cannot do given the heavy capital requirements. Before the GFC, banks often owned private equity arms that managed principal investments, but almost all of that activity has now been pushed off bank balance sheets by regulation, for good reasons at the time.

The type of mechanism that would help is fairly clear, but who would own and manage it, and what would its relationship be with the principal bankers to the entity in which the “bad bank” held a stake? That is still highly uncertain. But it is increasingly urgent to resolve. Becker et al. (2020) point out that “the coronavirus crisis arrives against a backdrop of private sector indebtedness…corporate leverage is at an all-time high…current policies will leave parts of the corporate sector with even larger debt burdens. These will delay a recovery.” They argue for schemes that “attach options to the bailout funds in the form of stock warrants or convertibles that can ensure that the public benefits from future gains in corporate valuations.” These are sensible suggestions but are more relevant to the larger corporates. They also argue for accelerated insolvency procedures, which would be of more general application.

In the European Union, discussions are underway on the establishment of a recovery fund that could provide needed equity support for struggling companies. There is a case for strong involvement of the banking sector, to avoid politicians “deciding unilaterally which companies to help” (Anderson and Wolff 2020). As their Bruegel paper argues, “the local knowledge and analytical capabilities of commercial banks is already extensively used to distribute state guarantees and subsidised loans to firms and individuals. Further partnerships will be required for equity-based instruments, especially for the more arduous assessments of the viability of smaller companies.”

But will this recapitalization exercise be so extensive as to lead to a different long-term relationship between the state, the financial sector, and nonfinancial companies? Decisions on support taken in haste may lead to very different outcomes.

### C. The global financial system

Most of the policy interventions we have discussed have been national in scope. Just as we saw in the last financial crisis, countries are thrown back on themselves when times are tough. As Mervyn King observed in relation to bank bailouts, banks may be global in life, but they are national in death. So the major economies may be global when all goes well, but when life support mechanisms are needed, the national government is the relevant actor.

But we may nonetheless ask ourselves what implications the crisis may have for the global financial system in the longer run. I have suggested that a reduction in the intensity of international collaboration is a probable consequence. Will that be a temporary phenomenon, or can we expect a prolonged return to some form of financial autarchy?

Researchers at the Institute for Advanced Sustainability Studies (IASS 2020) have developed four possible scenarios for the global financial system. They are not, perhaps, mutually exclusive and collectively exhaustive, but they are suggestive of potential directions of change.

The Federal Reserve still acts as the central underpinning of the global system in important ways. Just as it did in the GFC, the Fed has created and fueled swap lines with other central banks, to allow the provision of dollar funding to non-US entities that need it, given the continued dominance of the dollar in international trade and finance. Though its founders hoped it would, the euro has not gained market share in the denomination of international trade in the last two decades (Papadia and Efstathiou 2018). Over the last decade, the share of EU exports denominated in euros has declined from around 70 percent to 57 percent. But will the Fed, and US administrations, be prepared to continue to play this central role in the longer term? Indeed, as the IASS paper observes, “the Federal Reserve’s rescue efforts run counter to the policies of the Trump administration, which has probably not yet grasped the scope of these interventions.”

In the longer term—they look out to 2040—the IASS researchers see four possible scenarios:

• a continuation of the current dollar hegemony

• the co-existence of competing monetary blocks

• the emergence of an international monetary federation; or

• international monetary anarchy (IASS 2020)

The implications of these scenarios are not difficult to imagine. Under the first, the Federal Reserve continues to act as the world’s central bank. In the second, we see the emergence of at least two rival currency poles of attraction: the euro and the RMB. The first would require stabilization of the eurozone through treaty change, and almost certainly a greater degree of common fiscal policy. The second would be predicated on full convertibility of the RMB, which the Chinese government has not yet been prepared to accept, but in spite of that, the international role of the currency has continued to grow, with implicit official blessing. The RMB is likely to continue to play a greater role in international trade and finance in the coming decade.

The third scenario would depend on united action by the G20, at least, to introduce structured provision of liquidity on a global scale, while the fourth assumes that the Fed retreats from global dollar supply and that neither Europe nor China, nor a combination of the two, is willing or able to fill the gap.

The authors do not attempt to handicap these options today. They are all conceivable, and the odds on option four have shortened somewhat in the course of this crisis. It is evident that any move away from the first scenario will have immense consequences for the financial sector.

## Conclusions

The terms of debate about the future of the financial system are rapidly changing. The questions that seemed central as recently as February of this year—whether Basel III should be amended to increase the amount of capital in their trading books—seem now to belong in the history faculty rather than in finance ministries, central banks, or the boardrooms of major banks.

The new crisis will not change everything, but I have suggested that some previous certainties have been thrown into question, and in other areas, history has been speeded up. I have tried to sketch out some probabilities and have posed an inordinate number of questions. Predictions are hazardous. To adapt and update J. K. Galbraith’s bon mot, economic and financial forecasts are designed to make epidemiologists (Galbraith chose weather forecasters) look good. If I have succeeded in that, it would be quite an achievement.

### Competing Interests

Royal Bank of Scotland will be affected by the trends identified.

### Author Biography

Howard Davies was appointed Chairman of the Royal Bank of Scotland on 1 September 2015. Previously, Howard was Chairman of the Phoenix Group between October 2012 and August 2015. He chaired the UK Airports Commission from 2012-15 and was the Director of the London School of Economics and Political Science from 2003 until May 2011. Prior to that appointment Howard chaired the UK Financial Services Authority, then the single regulator for the UK financial services sector, from 1997 to 2003.

Howard was the Deputy Governor of the Bank of England from 1995-97, after three years as the Director General of the Confederation of British Industry. Earlier in his career he worked in the Foreign and Commonwealth Office, including two years as Private Secretary to the British Ambassador in Paris, the Treasury, McKinsey and Co, and as Controller of the Audit Commission.

Howard has been a Professor of Practice at the French School of Political Science in Paris (Sciences Po) since 2011. He teaches courses in financial regulation, and central banking to masters students.

He is a member of the Regulatory and Compliance Advisory Board of Millennium Management LLC, a New York-based hedge fund. He has been a member of the International Advisory Council of the China Banking Regulatory Commission since 2003 and in 2012, was appointed Chairman of the International Advisory Council of the China Securities Regulatory Commission.

Previously Howard chaired the Risk Committee at Prudential plc from 2010 to 2020. He was an independent Director of Morgan Stanley Inc. for 11 years, from 2004 to 2015 and earlier in his career was a Non-Executive Director of GKN plc from 1989-95.

He was a Trustee of the Tate Gallery from 2002-2010 and Chair from 2009-10. He was a director of the Royal National Theatre from 2011 to 2015, when he left to chair the London Library. He is also the patron of Working Families, a charity which promotes family-friendly working practices.

Howard has published five books focused on the financial markets and regularly writes for The Financial Times, Times Higher Education, Prospect, The Literary Review, Project Syndicate and Management Today.

He was educated at Manchester Grammar School, Merton College, Oxford and Stanford Graduate School of Business.

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