The economic slowdown as a result of COVID-19 places banks’ balance sheet under stress. With a proactive approach to risk and finance, banks can build resilience and strength as they navigate through the new normal.
While banks have the support of regulators most regulatory action has centered around liquidity injections, targeted loans, repayment moratorium, and policy rate cuts. These policy measures will help in the short run, but banks have to plan and design a long term response themselves. Banks must remain vigilant and re-plan capital positions proactively to navigate the challenges ahead.
Imminent Challenges in Managing Capital
Banks face multiple hurdles across retail credit, corporate credit, and market risk. Banks will experience delayed loan repayments and an increase in delinquency and default rates for retail customers. With corporate credit risk, banks should expect rating downgrades–at least for some industries, if not all in the coming quarters. The rating downgrade is expected to be more severe for speculative-grade corporates. This will result in a surge in the probability of default (PD) across the banking book, equaling an increase in risk-weighted assets (RWA). Similarly, as financial markets have witnessed increased volatility, RWA will rise for the trading book and the need to account for increased marked-to-market losses in the trading book. Overall, banks should expect a jump in total RWA to put a strain on the current capital adequacy ratio.
Liquidity Risk Yet to Ease
During an economic crisis, financial instruments start to lose liquidity in the market, especially those with junk status. Understanding real-time liquidity positions in such a period of stress requires a granular view across entities. This could span lines of business and geographies, and with a status check daily or even on an intra-day basis. The models that predict the liquidity levels depend on the assumption of cash flow during regular market movements. But these models may not be able to capture tail scenarios like COVID-19.
Banks must utilize accurate reporting to manage liquidity during a crisis. An enterprise-wide, robust, and comprehensive framework to manage data volume, computational complexity, along with speed and accuracy, all at the same time, is required to produce such reporting.
Banks should look for a liquidity risk management framework with pre-configured regulatory scenarios and runs. And must ensure that it has an extensive set of business assumptions available for behavior modeling and the granularity required is available to drill-through comprehensive reporting. An improved liquidity risk governance, which aids the process of contingency funding plans through multiple counterbalancing strategies, is needed. For quicker turnaround times and to avoid duplication of efforts, a repository of time bucket definitions and business assumptions should be defined and maintained. These criteria should be coupled with the ability to aggregate enterprise data on the cloud in real-time to manage liquidity positions better.
Increased Loan Loss Provisioning
IFRS 9 and CECL accounting standards mandate that banks set aside provisions for expected future credit losses. Banks are likely to experience a significant increase in credit risk in the banking book, resulting in higher provisioning. Under IFRS 9, there will be an increase in the reclassification of loans from Stage 1 (performing) to Stage 2 (under-performing). And banks will have to reassess defaults and Stage 2 triggers in the context of the COVID-19 crisis.
While modeling for COVID-19 scenarios, banks need to consider facets of the current economic and regulatory environment to establish a consistent and robust framework for loan loss forecasting & provisioning. The use of pre-built and easily configurable business rules and computations will alleviate compliance to IFRS 9 impairment guidelines. To effectively compute expected credit losses across multiple scenarios, banks will need to calculate interest adjustments to arrive at an effective interest rate. With sudden increases in the probability of default (PD), the solution must be easily customizable to suit your needs for PD and Loss Given Default (LGD) term structure based Expected Credit Loss (ECL) computation. The need to invest in granular data for analysis and forecasting is more apparent than ever for accurately estimating ECL and managing the volatility of earnings.
Capital Planning During Economic Uncertainty
Stress on liquidity, increase in provisions, and deterioration in asset quality and investment value ultimately places downward pressure on the current capital adequacy levels maintained by banks. Digging into capital buffers to meet the challenge is likely. However, banks also need to plan. The effect of the COVID-19 crisis on the balance sheets is going to remain for some time.
Banks’ focus should be on most critical models that require more considerable qualitative judgment, including adjustments or overlays. There will be a dire need for granular-level data and better system performance to handle the more frequent forecasts required. One must ensure that the capital planning solution can assess the impact of adverse scenarios on risk and return, improve capital management, and strategic planning.
With consistency in the capital planning process, projected profit and loss, income, balance sheet, and capital should be based on the same scenarios. It must be ensured that risk-weighted assets (RWA), unexpected loss (UL), and expected loss (EL) are calculated. This calculation occurs both on an overall basis and at an individual portfolio-level. The solution must define and maintain a shock definition and monitor RWA movements and rating migrations across different lines of business and jurisdictions. A multi-dimensional assessment of metrics across lines of business, risk categories, and product types help to highlight weaknesses in capital adequacy.
Looking Ahead to the New Normal
The COVID-19 crisis is no doubt a tail event for which the banking industry did not prepare itself. Even banking supervisors across the world did not anticipate such a scenario. The current situation is more severe than the stressed scenarios regulators assumed in their stress test exercises. The next few years will likely prove to be extremely challenging for banks. To safeguard the balance sheet, stepping up risk management and its integration with finance can help ensure better business outcomes.
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