Managing COVID-19’s impact on credit risk functions

The 2008-09 global financial crisis led to stress testing and other regulations worldwide to identify and contain the impacts of such events, but given the nature of the coronavirus pandemic, the stress test scenarios and models will need to be enhanced to understand the impacts on the banking book.

Global regulators have been very proactive, with many announcing a host of measures aimed at injecting the necessary liquidity and  supporting the financial system. These measures include rate cuts and freeing up capital buffers.

The focus on credit risk management practices are also more prominent in the ongoing crisis. Currently the following initiatives are gaining momentum in most of the financial institutions for improved credit risk management.

• International Financial Reporting Standard (IFRS 9) impact: One of the major focus areas for banks is to provide a forward-looking approach for recognizing impairment loss in a more timely manner under IFRS 9. The standard was bought in to play to overcome the delay in recognition of losses. In order to come up with forward looking expected credit losses (ECL), the existing “probability-weighted scenarios” should be enhanced to consider current economic scenario while computing ECLs.

• Customer scoring model upgrades: The pandemic has had a widespread impact on corporate counterparty ratings. The current rating models may not provide an accurate assessment of counterparties’ current business position, as they are currently prioritizing expenses such as salaries and commitments to keep their businesses running. The traditional models may actually downgrade them and reduce their access to credit. Most banks are aware of this change and are trying to upgrade their rating models to gain a realistic picture of the counterparties current financial position.

• Upgrading current credit risk stress testing models: The current credit risk models are being upgraded and newer scenarios around pandemic are being introduced to understand the impact on bank portfolios. The major challenge here is that historical data is not present on such scenarios, so credit risk teams are creating hypothetical scenarios to test the impacts. Global regulatory bodies are making concentrated efforts to come up with pandemic scenarios, based on the characteristics of their respective geographies, that will help in better understanding the impacts and bring in necessary interventions.

• More focus on proactive credit risk management: Early-warning solutions are being augmented with unstructured data, especially in case of corporate customers . This helps in proactive assessment of riskiness of counterparties and being more alerted toward their counterparty’s financial behavior.

• On-demand credit risk reviews: Credit risk reviews generally follow a standard calendar, with the review frequencies ranging from monthly (high risk) to annual (low risk), depending on the customer type. Due to the ongoing pandemic, within which the banks are operating in a volatile environment, a strong need emerges for doing on-demand credit reviews of their counterparties so that they can take adequate steps to identify potential defaults and come up with mitigation strategies.

• Credit risk RWA optimization: Apart from regulatory measures driven by global bodies to inject liquidity in the system, banks also are trying to refine their RWA numbers to free up capital where possible. RWA optimization roadmaps are being drawn to solve legacy issues from data management, model management and collateral management approaches, just to name a few.

• Creating digital roadmaps: Cost optimization and efficiency is emerging as one of the focus areas, so banks are trying to have another look at their business processes, systems and data management programs to try to understand touchpoints where digital technologies can play a role in optimizing the processes and reducing costs. For example, business processes around internal credit reporting are leveraging automation and cognitive technologies in order to generate reports faster and to gain better insights from the reports.

Banks, other financial institutions and regulators are now better prepared for a global disruption than they were more than a decade ago, and they are taking necessary actions to absorb the economic shocks emanating due to the pandemic. However, they have to constantly work toward coming up with strategies and developing a robust approach that covers the short-term to long-term implications on the credit risk functions.

Ajay Katara is a domain consultant with the banking risk management practice at Tata Consultancy Services.

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