The COVID-19 pandemic has impacted economic activities, income of firms and individuals, and valuation of assets in one go. 

IMF has officially declared the world is in recession! Bank of England has described the situation as being worse than the financial crisis in 2008. The scale of economic impact is unprecedented and is expected to have far-reaching consequences on the world economy.

Experts predict that the economic impact may change several industries permanently and the transition to a new normal may take a few years. The banking industry, in particular, is at the core of this crisis with increased credit risk, and will need a significant change in the processes, systems and models for risk measurement, loss estimation, and stress testing.

Depreciation in value of financial assets and other assets 

Lockdown, recession and decline in the national income has adversely affected individuals, corporates, economies, and governments in terms of revenue, incomes, profits, tax collection, fiscal deficits, spend, flow of capital and demand for financial and other assets. Except gold, this has depreciated financial and other asset values and financial variables to a varying degree across products and countries.  

Increase in credit losses 

The worst impact of the lockdown is loss of income and rising unemployment. Businesses with high operational and financial leverage are getting hugely impacted and many will file for bankruptcy, further accentuating the demand, supply and employment conditions, with a resultant impact on value of collaterals. 

Regulatory measures to tackle the impact 

Regulators, supervisors and accounting standard setters are creating flexibility in prudential and accounting standards.

Regulators and governments have proposed moratorium on payments, relaxation in reporting obligations, and loan modification programs to provide relief to the firms. Regulatory authorities and governments are accepting higher level of risk at banks – which is lesser prudent measure – to keep borrowers afloat.

Limitation of the existing Credit Risk Management Framework

Existing credit risk framework is insufficient to measure and manage credit risk under severe stress conditions created by the pandemic.

In common practices, credit loss is computed through probability of default (PD), loss given default (LGD), and exposure at default (EAD) as risk measures. Banks estimate Expected Credit Losses (ECLs) and Required Capital from these risk measures. To come up with these measures, banks use 1) Forecast modeling on economic conditions; 2) Historical data and current state conditions.

In the state of closure of economic activity, it might be difficult to correctly forecast economic conditions, resulting in a large chunk of portfolio losses moving to further stages. To avoid the downward push amidst the uncertainty, regulators have offered payment holidays, within which borrower profiles will not be moved to further Days Past Due (DPDs).

Limitation of existing ALM and Market Risk Management Framework

Depreciation in asset value is further amplified by reduction in the market liquidity especially of emerging market financial assets and assets of lower quality. There is flight to quality.  This changes the value, trend and relationship of financial variables creating a need to revisit treasury, asset liability management (ALM), liquidity and market risk models, processes and systems.

New Normal in Credit Risk Management 

Inability to measure risk accurately is going to be a major impact of the crisis, which means banks will need to adopt significant changes to credit risk management process and supporting technologies.

On credit risk process front, we expect increased focus from credit risk management team on:   

• Re-calibration of credit scoring and rating models considering impact of U, L and V recovery curve
• Review and calibrate impact of covenants linked to accounting ratios and collateral valuations
• Adjustment of limits release to end clients based on revised valuations of collateral, with strong alignment to the new working capital cycle
• Adjustment of collection models by excluding payments covered by moratorium. Since the definition of exclusion will evolve over a period, this will create further complexity 
• Expansion of stress testing and ICAAP scenarios to include pandemic level severity scenarios
• Adjustments to regulatory reports as relaxed rules will reflect higher capital, higher income, better liquidity and lower credit losses for a specific period. Preparation of reports on the impact and actual measures to improve upon policies
• Forward looking view of the losses on a continual basis

On technology front, we will expect the credit risk management team to make important changes to the systems covering:

• Core banking systems to cover identification and segregation of Day Past Due loan
• Credit scoring and rating models to be recalibrated with different recovery scenarios
• Stress testing models and ICAAP to include new scenarios for severe stress events
• Re-calibration models for collateral valuation and allocation approach
• Modification of Early Warning Signal for financial covenants 

New Normal in ALM and Market Risk Management 

• With the depreciation in values of financial assets and non-payment of credit due, banks are expected to face significant short-term liquidity gap due to deterioration in asset quality and loss in valuation of collaterals. However, central bank is planning to offset liquidity crunch through discounting and liquidity tap.
• Change in sources of liquidity requires re-calibration of ALM and liquidity behavioral models as the existing models have no historic benchmark to evaluate the current economic stress.
• Banks need to discover and adjust yield curve seen in the market as intended shift in the curve on both repo and reverse repo side by the central banks will take time to get reflected in the market.
• Exceptional market volatility in the recent period led to an elevated level of Value-at-Risk (VAR) back-testing breaches across the industry. Regulators may allow automatic application of a higher VAR multiplier temporarily through a commensurate reduction in risks-not-in-VAR capital requirements to mitigate the possibility of creating pro-cyclicality in market risk.

On technology and measurement front, we expect the ALM and Market Risk Management teams to make significant changes in Liquidity Risk and Market Risk Models and Regulatory Reporting.  

The new normal of risk management

Risk management practices and technologies at banks are entering a new era and banks would need to reinvent measurement metrices, processes and technologies. This will involve a major overhaul of risk technologies. This is also an opportunity to consolidate multiple point solutions, adopt cloud technologies, and revamp and strengthen model implementation technology.  Ultimately, this provides an opportunity to automate and industrialize target-operating model for risk management.

Harpreet Arora is Vice President and Head of Consulting at Wipro

Mohan Bhatia is DMTS Fellow and Head of Risk and Compliance Consulting at Wipro