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Implications on risk management

  • Fabiano Gobbo, Author |

Banking is being hit hard by daily pivoting market conditions and deteriorating credit quality among others, marking unprecedented times for Chief Risk Officers (CRO), risk functions and the business.

By taking action now in six priority areas, risk leaders can help their organizations support the immediate crisis management, operational and financial disruption, but also aid in managing and stabilizing for how it will enter the post-COVID ‘new reality’.
 

  1. Credit risk
    Credit impacts will vary significantly by sector and business. From what I can see now, tourism, airlines, oil and gas, healthcare and automotive industries stand to be the most impacted industries due to disruption in their operational models. From a credit perspective, banks need to identify these sectors and understand how they can support. This will likely include an acceleration of credit review and approval processes for immediate liquidity and subsidized loans – deterioration of credit quality may result in an increased number of default cases, increased requests for forbearance measures and rising credit risk provisions – as well as intensifying monitoring and reporting of obligors. To help manage this increase on resourcing, banks should explore digitalization and D&A-based methodology, as well as standardized decision trees to increase efficiency.

    Looking at mid-to-long-term, banks need to develop a strategy on how to cope with recalibrations of rating models, as well as consider COVID-19 scenario analysis on credit portfolios and inclusion of pandemic scenarios. Finally, banks should thoroughly and regularly check all regulatory and governmental relief measures for their applicability and possible opportunities for stabilization.

  2. Liquidity and treasury risk
    Strong liquidity management has proven to be critical for banks to support significant drawdowns of facilities and changing customer borrowing needs. Throughout the month of March, banks operated under their crisis governance with contingency funding plans being activated by many institutions. While the spread of COVID has slowed, measures by central banks and governments are starting to support banks with liquidity, several banks have moved to business as usual governance in an unusual environment. Liquidity managers are also shifting the focus from ad-hoc short-term actions to navigating through the crisis.

    Among other things, banks may need to revise methods and models used for liquidity management. Liquidity stress models that were established based on experiences from the 2008 financial crisis do not provide meaningful insight on current liquidity development, so banks need to back test and revise certain models. Credit line models will likely require an additional layer of prudence and loan models will likely require additional flexibility to reflect changes in customer behavior. Several banks are assessing ways to increase the flexibility of liquidity models in order to allow for ad-hoc recalibration.

  3. Market risk
    Since March, an increased noise in market data, dispersion of spreads and high market volatility across all asset classes, has led to limit breaches, back-testing outliers and increased risk measures, thus also increasing market risk capital requirements. In response, banks need to focus on day-to-day market risk operations and closely monitor capital requirement implications and respective mitigating supervisory measures.

    The stressed market conditions, in combination with hedging challenges and increased price uncertainty, can also lead to financial losses from credit and funding valuation adjustments, and bid/offer fair value adjustments. In addition, an increase in regulatory prudent valuation figures impacts bank’s regulatory capital ratios. While supervisory measures to mitigate prudent valuation impacts are anticipated, a re-design of the frameworks in the light of overly cyclical methodologies is recommended.

  4. Enterprise risk and capital management
    The COVID-19 crisis will have a significant impact on banks’ capital ratios and overall capital adequacy. On the one hand, deteriorating credit quality may lead to a massive rise in credit impairments, and on the other, banks are expected to continue lending and supporting the economy – leading to higher exposures in the downturn of the credit cycle.

    In response, many regulators across the globe are allowing banks to use their capital buffers to cover the losses while continuing to lend. However, eventually banks will need to refill their capital buffers and return to a sustainable capital level.

    To navigate this crisis, banks need to make sure that their management instruments are fit for purpose – and having the recovery plan and the respective governance activated for a prolonged period of time might not be the best option. Once a viable 12-month strategy to navigate the crisis has been identified, banks should consider re-adjusting their risk appetite statement and recovery thresholds to support the plan – and return to business-as-usual governance to execute the plan.

    One thing’s for certain, no one can predict how this pandemic will evolve. Flexibility will be key. For ERM and capital management, this might mean to increase the capabilities to analyze new scenarios quickly, and to be able to do more frequent updates to forecasts, business, funding and capital plans. Lessons learned in this area will be key going forward.

  5. Operational resilience, compliance and non-financial risks
    Banks’ internal control systems are under extreme stress, leaving a margin for potential losses due to crisis-driven measures. Almost overnight, COVID-19 has become the single greatest threat to the continuity and existence of many businesses. Businesses are faced with crisis situations whether they’re cyber risks (such as fraud, remote working), IT risks, employees, project quality, scope and resources risks and reputational impacts. The CRO's central task will be to raise awareness of these risks for both customers and employees.

    Banks should further integrate specialized second line of defense functions in order to obtain a holistic view of the changing risk profile. They should also review the appropriateness of their operational risk scenarios and business continuity management scenarios and plans.

  6. Recovery and resolution planning (RRP)
    Currently underutilized in the management process of banks are RRP elements. COVID-19 causes triggering of recovery indicators due to macroeconomic developments and deterioration of the liquidity position, and therefore an activation of the escalation governance. Banks should review for usability and recalibrate their recovery options and the appropriateness of indicator thresholds. The current crisis also requires an adaptation of the recovery planning scenarios.

    Banks should also develop simulation facilities, specifically for funding and valuation in resolution, which can be flexibly adapted to the respective situation to enable short-notice measurement and reporting of liquidity positions. As well as systems, methods and processes to allow for a robust and short-term update of important balance sheet items in crisis situations. In addition, banks should incorporate lessons learned into their crisis governance and operational continuity in resolution framework.

    It’s a challenging time. The pressures for banks to transform risk holistically and sustainably will only increase – cost pressure will likely mount once capital reserves have to be replenished. And efficiency pressures may soon come into focus. I encourage CROs to consolidate lessons learned from the crisis, and take key first steps in this direction now to set a strong foundation for post-crisis transformation towards increased efficiency while maintaining the desired levels of effectiveness.