The world as we knew it before the COVID-19 outbreak has fundamentally been affected by the virus and after the first wave of responses, as a society, we now seek a new equilibrium. It's human nature to want to hold on to what we know and to fear the unknown. At the same time, as in any crisis, the situation may force us to embrace a new reality.
COVID-19 has laid bare some critical vulnerabilities in our societal- and economic systems. A growing world population and globalized supply chains combined with an ever growing need from consumers worldwide for (cheap & 24/7) access to travel, seasonal produce, financial products, services and growth have resulted in a race to the bottom that has proven to be counterproductive in many ways.
Back to business as usual?
There seems to be consensus among economists that we will go into recession or even depression later this year. The main debate appears to focus on how long the recovery will take, which in all scenarios seems to rely on a return to business as usual at some point in time. This expectation, oddly does not seem to assume fundamental changes in behavior by consumers, businesses or governments. Even when we would assume that a vaccine would be developed and distributed in a short period from now, this seems an illogical assumption, as we now know from real experience how pandemics can disrupt life and businesses and people are likely to rethink (parts of) their behaviors.
COVID-19 is a new data point and one that should not easily be ignored. As we are slowly but steadily returning to a type of business as usual and as long as no vaccine has been developed, the re-emergence of covid-19 is now a scenario that is more likely than unlikely and as a society we need to prepare ourselves in the best possible way. If only, because our economic situation at such point in time might not permit a similar response as we have seen in the past 3 months.
Replenishing the capital base and liquidity buffers will be required after the dust settles
Worldwide, governments, regulators and supervisory authorities have deployed massive support programs to support businesses and consumers to deal with the economic impact of COVID-19. This was to a great extent possible as a result of the economic recovery we have experienced since the 2009 crisis. Government debt levels, in general, have fallen and in addition, banks had become more resilient with higher capital buffers and benefit from improved regulatory frameworks.
It is widely expected that increasing debt levels and unemployment will lead to higher government spending whilst rising defaults among SMEs and corporates will have a negative impact on banks' capital levels. We will need a period of economic recovery to over time be able to lower government debt levels and have banks replenish their capital base to be able to withstand other crises in future.
Compliance challenges continue, but banks do have a right to play
Since the previous financial crisis banks have been undergoing massive changes as a result of de-risking, regulatory- and accounting reforms and last but not least digital transformation. Significant progress has been made on issues like quantity and quality of capital buffers, asset quality, liquidity and improved digital services incl. open banking. However, challenges still remain with respect to compliance with complex AML legislation, growing sustainable lending, a reduced cost base and somehow a structural return on equity that outweighs the cost of capital.
On a positive note, although new entrants have made progress, often these new entrants focus on a particular niche and still don't offer a true alternative to the traditional banks with their one-stop shop offering. In that respect, Banks still have the resources, the economic function and the client base to continue to be a critical part of society for many years to come but they need to continue with the change process that they are in and in fact need to increase the pace. Considering the ever increasing cost of compliance and required technology investments that both benefit from scale, further consolidation might be on the menu again in banking.
The operational challenge in managing increasing credit risk is a pre-cursor to other topics
After securing the safety of their workforce, focus of banks shifted to ensuring business continuity and supporting their clients with measures such as payment holidays and facilitate the roll out of government lending programs. At the same time, banks have been assessing the potential financial consequences of credit deterioration in their portfolios. Obviously, we are still only at the beginning of this financial crisis and we will have to see how the financial crisis will develop, but it's very likely that the coming 12-24 months banks will be dealing with a significantly deteriorating credit portfolio (SMEs, corporate clients and retail clients). This will require significant attention from banks' management as they will have to navigate between protecting the bank's interests and public opinion that is still fragile as it relates to banking. At the beginning of this crisis, banks have been vocal re wanting to be part of the solution this time round and their first support measures certainly have been in line with that objective. As we will now likely go through a downturn cycle, it is important banks continue transparent, consistent and fair communication with their clients and stakeholders to avoid or mitigate reputational risk and by doing so preserve brand value.
It would be presumptuous to specifically predict what will dominate the agenda of banks but at an abstract level the following themes will likely require (continued) attention:
Capital replenishment & cost optimization
The current strong capital levels are likely to be eroded by increased credit losses going forward. We have already seen significant increases in loan loss provisions. It is unlikely that banks can attract fresh capital in sufficient quantities so retained earnings are likely to be the source for replenishment. Since the continued low interest rate environment and expected negative economic growth will hurt earnings and new business models are not fully emerging yet, focus on cost containment will be even more important going forward. Good insights into how the capital position will develop (scenario based) and how management needs to respond will be essential.
Banks' lending books will be affected and as we have seen in the previous crisis (which likely was far less widely spread in the economy than this one) and requires a program-like approach to managing the banks risk through this cycle. Because of the unprecedented nature of this crisis and the widespread impact it will have, strong analytical capacity in risk management is needed to assess and understand the impact Covid-19 on certain industries (supply chains) and sectors and how and when this will affect the portfolio, collateral and capital base but also new lending standards as old underwriting dogmas might no longer hold true. Developing and implementing an effective ESG framework is also essential to structurally improving the asset quality of banks. Improved end-to end processes in loan administration, risk-management and analytics are a must. Dynamic risk dashboards that can work with multiple scenarios will be essential in taking the right decisions at the right time in an ever more volatile environment. Banks had already begun to assess the requirements of risk management of the future before this crisis broke out but will have to speed up and move from analysis to implementation a lot sooner than they might have expected.
Digitize, digitize, digitize
One of the few positive aspects of this crisis has been the operational resilience banks have shown. Serious investments in technology by banks and focus on preserving business continuity in times of crisis situations have really paid off. Automation and digitizing end-to end processes in client facing activities, finance, risk and compliance processes were already put in motion by most banks before this crisis in order to address quality- and cost challenges but here too, acceleration is needed to make banks more customer centric and resilient going forward. Onboarding of clients or transaction monitoring are processes that would benefit enormously from a digitized approach and would make banks operations more nimble and responsive. Deploying platform technology to enable automation of complex risk- or financial control frameworks made even more complex as a result of agile- and remote working is another way to achieve efficiencies and improve quality.
In conclusion, banks will continue to be banks and a fundamental part of society. This reality has not changed because of COVID-19. However, some initiatives such as redesigning risk management-control or finance functions to make them future proof and digital transformation of the business will need speeding up.
For more information please contact Ferdinand Veenman.