While governments’ responses to the COVID-19 pandemic are turning our world ‘upside down’, banks urgently need to adjust their risk management practices, to make them much more flexible and adaptable. Current methodologies and models do not capture risk levels correctly, nor do they allow for adequate forecast of potential future losses. So, what can banks do to manage this situation?
COVID-19 and its countermeasures are having a profound impact on our lives, with our wellbeing, our economy and our jobs (short-, mid- and long-term) all under pressure. Whilst it is far from certain how successful countries will be in stabilizing their economies, it is clear that everyone must deal with the consequences in the long run: supply and demand effects, huge GDP shortcuts, deteriorating creditworthiness and disinvestments due to uncertainty, to name a few.
NEW EXPECTATIONS FROM BANKS
In response to the pandemic, many countries have established support and remediation programs, including state-backed loans, which target primarily freelance workers and small to medium-size enterprises (SMEs) in the worst-hit industry sectors. The aim of the loan programs is to provide additional liquidity early to ensure that healthy businesses do not face insolvency or even bankruptcy due to the temporary supply- or demand-driven liquidity problems.
These necessary and highly beneficial programs have led to a significant increase in the loan books of some banks. The loan programs were set up under a huge time pressure and therefore we expect to see new concentration risks arising, as rating and scoring methods have not yet been adapted for the ‘new normal’. Critics have raised doubts about the risk management systems ability to fully reflect the unprecedented new risks. Banks must now address these concerns.
THE REAL STATE OF RISK MANAGEMENT
Banks urgently need to revise their internal risk management approaches and procedures in response to COVID-19. They need to be able to understand the pandemic’s impact on their risk profile, profitability, liquidity management and capital in the short run but also the medium- and long-term perspective. This is necessary for banks’ own risk management and risk mitigation procedures, and also for all key stakeholders - shareholders, investors, clients, rating agencies and regulators.
Risk management needs to become much more responsive and flexible, as banks must now deal with high uncertainty due to the current pandemic and anticipate the next pandemic or crisis and the respective countermeasures. The classical model-based approaches to risk management need to be supplemented by a highly flexible ad hoc risk management. This will in turn require adaptions to business and IT architectures as well as to data management for risk.
As stated earlier, the current methodologies and models do not capture risk levels correctly and do not allow for adequate forecast of potential future losses. Historic calibration of models, for example, reflects neither the current level of risk nor the newly relevant risk drivers. In addition, correlations within risk types and between different risk types are strongly increasing, while exogenous factors, such as government support, are affecting defaults and risk provisions and profitability.
MEASURES AND IMPROVEMENTS REQUIRED
To understand and manage the situation, banks need to undertake the following actions:
1. First, banks need to understand the overall impact on their profitability, liquidity, and capital situation from a short- and medium-term perspective. A scenario-based approach will aid the initial impact analysis. Existing risk modeling approaches need to be extended with the COVID-19 effects. The mechanics of these approaches need to be revised and extended to reflect various aspects such as industry specific impacts, governmental mitigation measures, specific risk concentrations, collapsing inter- and intra-risk diversifications, secondary effects etc. Approaches based on historical data are not sufficiently meaningful in the current situation.
2. The above aspects also need to be considered in the internal comprehensive, multi-year stress-testing approach. This significantly revised stress-testing approach needs to be based on a revised risk modeling approach and capture multi-year effects not only on credit risk but also on other risk types (e.g. market risk, liquidity risk, operational risk). It needs to provide the complete view of the overall impact on the bottom-line of a specific institution.
3. Looking ahead, banks will need to adjust their risk strategies. On a short-term basis, management decisions on the overall acceptable risk-taking in specific products or industries should be translated into an adjusted risk appetite and specific risk limits. From a medium- and long-term perspective, the risk strategy needs to reflect the required overall adjustments to risk management for the ‘new normal’, e.g. the necessary changes to risk processes, risk management tools and data management to improve the flexibility and speed in risk management and modeling.
4. Further, banks need to revise their rating/scoring systems as well as their pricing models. We expect that for example the impact of flexibility of clients’ cost base as well as the availability of alternative sales channels for clients will be reflected much stronger in rating and scoring as well as pricing models.
5. Also, early warning systems for existing credit portfolio revisions might become necessary. New early warning signals, such as the speed and intensity or the lack of furlough measures, clarity of communications between firms and their clients around the COVID-19 measures, press and media alerts, etc., would require improved timeliness and quality of the early warning processes, to trigger better and more appropriate measures by the bank upon detection.
6. Finally, banks need to extend their existing internal risk reporting with a specific section on a potential pandemic impact – both the current pandemic as well as the overall resilience to future pandemics - covering all above-mentioned aspects. Banks need to assess whether and what communications on the risk management measures are required - to the banking supervisor and potentially to the public.
Summarizing the challenges, we see how the coronavirus is driving the necessary evolution and digitization of the risk management approaches in the financial industry. Implementing a highly flexible, data- and scenario-driven approach to risk management will address the described challenges - and not only in the short run. In the long run, this approach will contribute to the competitiveness of individual institutions: revised risk management architectures and processes will strongly increase insight into risk-return profiles and allow for much better understanding of business opportunities.
We support our clients on their journey to a modern, flexible and data-driven risk management through modernization of models, methodology and architecture as well as target operating models for risk management teams and divisions. As a first step, a bespoke and focused check-up can provide input for risk management, aid the creation of a roadmap for this journey and highlight measures required to stabilize risk, profit, capital, and liquidity from a short-term perspective.
Contact us to learn more.
Dr. Olaf Clemens, Partner
M +49 172 746 7502
Dr. Martin Rehker, Managing Principal
M +49 174 334 6440