COVID-19 and financial institution stability: stress testing the Eastern Caribbean currency union

Abstract

Purpose This paper aims to simulate the potential impact of increasing non-performing loans (NPLs) on capital adequacy, interest income and firm value of banks and credit unions in the Eastern Caribbean Currency Union (ECCU) using stress tests. Design/methodology/approach A financial stress testing model was deployed at the levels of individual financial intermediary (FI), sectoral loan portfolio composition, individual member country, and the ECCU collectively, to investigate the impact of NPL shocks on FI stability. Findings The authors find that shocks impact the capital adequacy of banks less than that of credit unions, but that firm value of banks is more susceptible to increases in NPLs. Interest income responses to NPL shocks were linked to credit exposure from the tourism sector, which also reduced capital adequacy more than other economic sectors. Findings show that while the COVID-19 pandemic occasioned some increase in NPLs, the magnitude of impact was significantly mitigated by pro-stability policies including loan repayment moratoria and restructuring, guidance on the distribution of profits and deleveraging by financial institutions leading up to 2020. Originality/value The paper is among the first to use stress testing on the Caribbean in response to the COVID-19 pandemic. Past studies which have used stress test models in the region have not explicitly investigated the impact of credit shocks on risk-weighted assets or interest income as done herein, nor do they include credit unions in the modeling. The results offer novel evaluations as well as implications for FIs in other developing economies, especially those that share a comparable financial and economic architecture.