Supervisory forward guidance: the effectiveness of the 2020 euro area supervisory capital relief on the bank credit supply channel

We investigate the effectiveness of the euro area’s single supervisory mechanism’s capital relief measures in response to the outbreak of the coronavirus pandemic, in terms of large non-financial corporations’ lending outcomes. Using a granular borrower level dataset and controlling for the policies of other euro area authorities, bank characteristics and demand effects, we find that the lifting of the pillar 2 guidance (P2G) capital recommendation had a considerable statistically significant impact in supporting bank credit supply. The results are attributed to both, the capital made available and announcement effects. The latter are generated by the communication of supervisory plans and the fact the P2G was not designed to be ex ante “releasable”. The announcement of granted supervisory flexibility seems to have reduced uncertainty surrounding forthcoming regulatory responses in the beginning of the pandemic and acted as a de facto “supervisory forward guidance” in support of bank business decisions. Going forward we propose the creation of a formal supervisory forward guidance strategy, to complement the existing communication channels, to the benefit of banks’ and market participants’ decision making during both normal and crisis times. Our work therefore contributes to the literature threefold: (i) it introduces a novel granular supervisory dataset at the borrower level, (ii) it is one of the first papers to take a euro area supervisory perspective in analysing the effectiveness of capital relief measures at the onset of the Covid-19 pandemic, and (iii) it proposes a new supervisory policy instrument, the “supervisory forward guidance” with the goal of informing and steering banks’ and market participants’ expectations in order to prevent distress episodes.