14 Jan 2021 Ankit Chadha

The New Paradigm Of Risk Management For Banking Sector

Risk Management | TRC Corporate Consulting

The COVID-19 pandemic has substantially affected economic activities, businesses and individuals’ profits, and the value of assets in one go. The IMF has officially announced that the world is in a recession!

 The Bank of England described the situation as worse than the 2008 financial crisis. The magnitude of the economic effect is unparalleled and is projected to have far-reaching implications for the global economy.

Experts expect that the economic effect will permanently alter some sectors and that the transition to a new normal will take a few years. In particular, the banking sector is at the center of this crisis with elevated credit risk. It will need a major improvement in risk management processes and measures, loss calculation, and stress testing processes, frameworks, and models.

Depreciation In Value Of Financial Assets And Other Assets

Lockdown, recession, and downturn in national income have adversely affected people, companies, markets, and governments regarding revenue, income, earnings, tax collection, fiscal deficits, expenditure, capital flow, and demand for financial and other properties. This has depreciated financial and other asset prices and financial variables to varying degrees across goods in major countries except for gold.

The Rise In Credit Losses

The worst effect of the lock-up is the loss of profits and increasing unemployment. Businesses with high operating and financial debt are having a major effect. Many will file for bankruptcy, further accentuating demand, supply, and job pressures, resulting in an impact on collateral valuation.

Regulatory Measures To Deal With The Impact

Regulators, regulators, and setters of accounting standards are creating consistency in prudential and accounting standards.

Regulators, enterprise risk management experts, and governments have suggested a freeze on fees, reducing reporting obligations, and loan modification schemes to offer businesses relief. Regulatory authorities and policymakers embrace higher risk management processes for banks – a less prudent step – to keep borrowers afloat.

Limitations Of The Existing Credit Risk Management Framework

The existing credit/financial risk system is inadequate to assess and control credit risk under extreme pandemic stress conditions. In standard risk management processes, credit loss is determined by default likelihood (PD), default loss (LGD), and default exposure (EAD) as risk measures. Banks forecast Potential Credit Losses (ECLs) and Necessary Capital as a result of these risk measures. Commonly, banks use the following steps to come up with:

  1. Projection modeling on economic conditions
  2. Historical data and existing state conditions

When economic activity closes, it can be difficult to accurately estimate economic conditions, resulting in a significant portion of portfolio losses shifting to further levels. In order to avoid downward pressure in the midst of confusion, regulators have offered payment holidays in which the borrower profiles will not be transferred to Days Past Due (DPDs).

Limitations Of The Current ALM And Market Risk Management Framework

Depreciation of asset value is further exacerbated by a decline in market liquidity, especially in emerging market financial assets and lower-quality assets, suggests operational risk management experts.

There’s a quality flight in such risk management process implementation. This shifts the value, pattern, and relationship of financial risk variables that generate a need to rethink the treasury, asset-liability management (ALM), liquidity and market risk models, processes, and systems.

The New Normal In Credit Risk Management Landscape

Inability to quantify risk management processes or risk mitigation metrics correctly will be a big impact of the crisis, which means that banks will need to make substantial improvements to the credit/financial risk management and technology support process.

On the credit or financial risk process front, we expect improved focus from the credit/financial risk management team on:   

  1. Re-calibration of credit score and ranking models considering the U, L, and V recovery curve
  2. Review and calibrate the effects of agreements linked to accounting ratios and collateral valuations
  3. Adjustment of limit releases to end-customers on the basis of updated collateral valuations, with a clear alignment with the current working capital cycle.
  4. Adjustment of collection models by removing payments subject to a moratorium. As the concept of exclusion will change over a period of time, this will add more confusion.
  5. Expansion of stress assessments and ICAAP scenarios to include pandemic severity scenarios
  6. Adjustments to regulatory reporting as relaxed regulations would reflect higher capital, higher wages, greater liquidity, and lower credit losses for a particular period. Preparation of impact assessments and actual steps to strengthen policies
  7. Forward-looking view of losses continuously

The New Normal in ALM and Market Risk Management

With the depreciation of financial assets and non-payment of loans, banks are likely to face substantial short-term liquidity deficits due to deterioration in asset quality and the decline of collateral valuations. However, the central bank plans to compensate for the liquidity crunch by discounting and liquidity taps.

Changes in liquidity sources need re-calibration of ALM and liquidity behavioral models since existing models may not provide a historical baseline for evaluating current economic stress. Banks need to discover and change the yield curve seen in the operational risk market. The intended shift in the repo and reverse repo curves by central banks would take time to focus on the market.

In the recent period, exceptional market uncertainty has contributed to an increased degree of Value-at-Risk (VAR) back-testing of breaches across the sector. Regulators can enable the automatic application of a higher VAR multiplier temporarily through a proportionate reduction in non-VAR capital requirements to mitigate the possibility of creating pro-cyclical market danger.

The New Way Of Risk Management

Risk management strategies and technology at banks are entering a new era, and banks will need to rethink measurement metrics, processes, and technologies. This will require a significant revision of technologies and ideologies concerning different types of enterprise risk management functions such as operational risk, financial risk, and risk mitigation methods.

This is also an opportunity to simplify multi-point solutions, incorporate cloud technology, and update and improve model implementation technologies. This offers an opportunity to simplify and industrialize risk management, risk mitigation, and target-operating models at the end of the day.

How TRC Helps With Risk Management Process and Risk Mitigation?

At TRC Corporate Consulting, our risk management services help organizations deal with business governance’s wide-ranging problems, enterprise risk management, and effective compliance regulations.

Our risk management process involves specialized assistance for critical risk types such as operational risk, financial risk, risk reporting; besides providing services such as taxation, corporate consulting, and financial advisory services. For any queries, contact us!