By Miles Elliott, Risk Management Advisory lead at SAS
From the very top of the house to the bottom, COVID-19 poses a comprehensive challenge to financial services firms. Every segment of the economy has been impacted and continues to be disrupted. This affects the full extent of the bank balance sheet, from determining liquidity strategies to maintain cash flow out to shoring up capital to protect against unexpected losses.
With more lockdowns and restrictions on the horizon, the road to recovery will be long and uncertain. Against this backdrop, executives and board members urgently need real-time, accurate insight into the financial health of their customers, their business and the broader economy. To provide this, banks need optimised and digitised risk modelling, risk decisioning and risk measurement capabilities to manage risk exposure across their operations and their portfolio.
Building analytical agility
From the Risk department’s perspective, determining which customers represent an underlying risk to the firm will be crucial. Yet so too will be determining the appropriate action and the timing of that action. In parallel, risk will also focus on model re-calibration, and re-development as traditional, stable characteristics of prediction and affordability become skewed. Identifying new early warning indicators and external market alerts is a priority.
This level of responsiveness requires analytical agility and the ability to change and deploy decisioning, measurement and scenario models rapidly. A scenario-based analysis allows firms to quickly and efficiently measure the impacts of multiple macroeconomic and business scenarios on their portfolios. When a particular asset suffers adversely during a likely scenario, it serves as an early warning indicator. Instead of suffering unnecessary losses if the event comes to pass, the bank now has the time and insight to act to mitigate losses.
Firms also need to pay special attention to model governance. Scenario and risk-based analysis can help plan for a myriad of potentials, but they’re underpinned by models that continually need to be reviewed, switched out and retired. When these models don’t undergo the necessary development and validation, there’s a danger that they can be applied incorrectly or generate inaccurate results. Therefore, risk teams must have strong review processes at every model development and deployment stage. This helps ensure that models are continuously updated and accurate, shielding the firm from unnecessary risks.
We also see that embedding stress tests as a constant process has additional benefits.
This year’s stress test results demonstrate that the UK Banking sector has responded well to the potential impact of unexpected losses, with all participating firms remaining above minimum hurdles and no bank required to strengthen its capital position. But there is still more that banks can do to align stress-testing capability with day-to-day business activities.
The exercise highlights the criticality for banks to have interconnected business processes that can react to external market pressures and integrate to the determination and stress of their key financial measures. This was evidenced by the resulting observations on the material increase in bad debt provisions and reductions in profitability observed under the stress scenario. This point further underlines the benefit of embedding the depth of capability required to execute a Regulatory Stress Test with the ability for a bank to undertake its own internal business planning activities.
Continuity in the face of crisis
Banks face a myriad of risks and operational challenges in the current climate. For example, with the extension of government aid schemes uncertain amid the Omicron variant, economic risk regarding customers’ ability to finance their borrowing remains in flux. Firms must therefore be vigilant to mitigate potential shortfalls.
In response to COVID 19, increased competition and emerging technology we see that banks are right in the midst of their Risk Management Transformation. As a result, banks are continually striving to strengthen their ability to execute and continuously challenged to enhance their ability to govern and control. Statements by the Bank of England reinforce this with their observation of an improving trajectory but with further advancement needed in the ability of banks to stress certain financial measures and integrate end to end business processes.
The positive reality is that banks already have the processes in place for regular stress tests and scenario-based analysis. However, in most cases, stress testing activity should be scaled up to cater for more scenarios over a longer time frame and become business-as-usual. That’s why banks should focus on streamlining and automating these processes as much as possible. In addition, the use of advanced analytics and AI solutions will help risk teams make sense of their data, leading to faster and more informed decision-making.
During a crisis, risk is the driver of a bank’s most crucial decisions. Uncertainty will be the only certainty for some time to come, but banks can meet the challenge through persistent analytics and a streamlined approach to model governance. Firms should operationalise what they’ve learnt over the past few months to define a strategy that will transform them going forward. Risk Management Transformation has to be at the centre of all activities involving customers, colleagues, companies and communities.