FRANKFURT — It was supposed to be a drill. Government overseers would test whether European banks could survive a hypothetical perfect storm that included a steep economic downturn, plunging stock prices and a collapse in consumer spending.
But before bank regulators could begin their planned stress test this year, they were confronted with the real thing. The financial impact of the coronavirus — visible in shuttered factories, empty airports and desolate downtowns — makes their worst-case scenario, a 4.3 decline in European Union economic output by the end of 2022, seem mild by comparison.
Some economists expect the European economy to decline by more than 10 percent in the first half of this year because of the pandemic, threatening an explosion of bad loans, deteriorating assets and plummeting share prices.
The question that regulators and central bankers are asking themselves now is whether the measures they took in recent years to crisis-proof the banking system will be enough to prevent a credit crunch, bank failures and a financial meltdown with global ramifications.
Andrea Enria, who oversees bank regulation at the European Central Bank, said that the damage has been manageable so far. But, he said from his home office in Frankfurt, “We still have to understand how long this will last and how deep it will become.”
Banks are under pressure anywhere on the planet that the virus has spread, which is virtually everywhere. The problem is particularly acute in Europe because many banks there never really recovered from the last financial crisis, which began in 2008 with toxic real estate debt, spread to eurozone government debt and took at least seven years to tame. Lenders like Deutsche Bank in Frankfurt are plagued by meager profitability, inefficient operations and the continuing cost of cleaning up old messes.
More than the United States, the European economy depends on banks to function. European companies get more than two-thirds of their credit in the form of bank loans, while American firms get less than one third directly from banks. They raise the rest by selling corporate bonds or shares.
There is no sign yet of bank failures, in part because the European Central Bank quickly flooded the financial system with cash.
“There may be some smaller banks that have to be bailed out, but I don’t think any of the big ones,” said Richard Portes, professor of economics at London Business School.
But Mr. Portes, who is also chairman of a committee that advises the European Central Bank and European regulators on financial risk, cautioned that things are happening so fast it’s impossible to say what the future may bring.
“In a worst-case scenario, it could trigger another financial crisis,” Marcel Fratzscher, president of the German Institute for Economic Research in Berlin, told reporters on Thursday. “The banking system in Europe and in Germany is not as robust and resilient as one would wish.”
When it’s all over, European banks could be even more diminished on the global stage than they already are. After the 2008 financial crisis, American giants like JPMorgan Chase and Goldman Sachs bounced back more quickly than their European rivals and pushed them to the sidelines. Deutsche Bank is the last eurozone lender among the top 10 investment banks globally, based on revenue. (Outside the European Union, Barclays in Britain and Credit Suisse in Switzerland also belong to the top 10.)
As European citizens retreat indoors, and restaurants, hair salons and airport lobbies stand empty, the sudden halt of economic activity will expose banks’ hidden weaknesses.
Regulators are worried, for example, about how much banks are vulnerable to debt rated just above junk. If, as expected, the crisis leads to widespread downgrades of this debt by rating agencies, investment funds run by banks would be forced to dump the assets at fire sale prices because they are not allowed to own junk bonds.
Banks are also struggling to serve big corporate customers like airlines or carmakers that are suddenly drawing down existing lines of credit to compensate for plunging sales. Lenders are required to devote a certain amount of capital to every loan they make. The sudden demand for credit eats away at their reserves.
“Losses from big corporate borrowers are the big concern at the moment,” said Nicolas Véron, a senior fellow at Bruegel, a research organization in Brussels.
Banks that have lent heavily to the aviation industry, like Natixis in France, or to the oil and gas industry, like ING in the Netherlands, could be particularly exposed, according to analysts at Berenberg Bank. A spokesman for ING said that only about 4 billion euros, or $4.3 billion, of the 38 billion euros the bank has lent to oil and gas companies is at risk because of recent declines in energy prices. Natixis declined to comment.
The crisis has been especially harsh for Italian banks. Italy has the highest death toll from the virus in Europe, and its economy was already on the verge of recession.
Germany and other northern European countries have balked at proposals to share the financial burden of the crisis. That could fuel political resentment in Italy if any of its banks need government bailouts. The country’s debt is already dangerously high.
“If you want to have this crisis followed by populist governments, right-wing governments,” Mr. Portes said, “that’s one way of getting it.”
German banks are also weak, even though the country’s economy is much healthier.
The country has more banks than it needs, and many are barely profitable. In late March, the ratings agency Fitch revised its assessments of numerous German lenders downward, including the two biggest, Deutsche Bank and Commerzbank.
Banks also face a threat that no one thought of before. Call it the work-from-home risk. With so many traders, loan officers and technology specialists working remotely, there is greater danger of data breaches or cyberattacks.
There are some grounds for optimism. Major policymakers like Christine Lagarde, the president of the European Central Bank, are veterans of the debt crisis that began in 2010 and nearly destroyed the eurozone. Philip Lane, the central bank’s chief economist, was previously governor of the Central Bank of Ireland, and witnessed firsthand the meltdown of Irish banks that followed the collapse of the investment bank Lehman Brothers in 2008.
With those bitter experiences in mind, European leaders moved quickly to head off a financial crisis that would multiply the economic damage caused by shutdowns and quarantines.
The European Central Bank will buy up to 1 trillion euros, or $1.1 trillion, of government and corporate bonds, which helps hold down interest rates and makes it easier for banks to extend loans. The central bank’s regulatory arm has allowed banks to deploy capital they had set aside for just such an emergency. Countries including Italy and Germany are providing credit guarantees so that struggling businesses can still get loans.
Mr. Enria, the top regulator, has eased some of the regulatory requirements on banks. The stress test scheduled to be completed by the end of July, a major administrative burden for banks, was postponed. In return, Mr. Enria insisted that banks put a hold on dividends and cap bonuses to managers.
“At this moment the key point is to preserve capital,” Mr. Enria said.
The European financial system is stronger than it was during the last crisis. Political leaders centralized oversight of lenders at the European Central Bank. That has helped prevent the bickering and political jockeying among national bank supervisors that hampered crisis management in the past.
New rules forced banks to reduce their reliance on borrowed money and build up their capital reserves. Now, Mr. Enria said, “they have quite a lot of resources to burn before they hit the wire.”
But the longer the crisis lasts, the greater the risk that those resources will run low.
“We can hold out at least for some time,” said Wim Mijs, chief executive of the European Banking Federation, an industry group. “If you bring the whole economy to a stop for six months, well, then we will have to see.”
Melissa Eddy in Berlin contributed reporting.