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Managing the Impact of COVID-19 on Credit Risk Function

By Ajay Katara is a Domain Consultant with the Banking Industry Advisory Group at Tata Consultancy Services (TCS).

The world currently is reeling under the pressure of an unrelenting pandemic which is caused by COVID 19, the impact of this is already being felt across all sectors and has resulted in Global Lockdowns, increased joblessness and downward revised growth projections for countries globally. The impact on the Banking sector is no different either, with an economic lockdown enforced Banks are having to brace themselves for reduced interest rates, increased default rates and reduced recoveries.

A high-level view of the impact on the Banking system is provided below

Managing the Impact of COVID-19 on Credit Risk Function 2

A decade ago, Banking and Financial Industry witnessed a similar unprecedented Financial crisis and as an outcome of that there were a slew of regulations which were introduced by regulators worldwide to monitor and contain the impacts of such crisis. Regulations like stress testing have helped banks to brace up for such scenarios to some extent but given the nature of this pandemic the stress test scenarios and models will need to be enhanced to understand the impact of COVID19 scenario on the Banking Book. Global Regulators have been very proactive, and many have also announced a host of measures aimed at injecting the necessary liquidity and supporting the financial system from rate cuts, freeing up capital buffers and deferring stress testing exercises, all of which is aimed to avoid any breakdown in the Banking Sector.

Typically Banking Book captures a bigger pie of the overall exposures and hence the focus on credit Risk Management practices is more prominent in the ongoing crisis. Currently, the following initiatives are gaining momentum in most of the Financial Institutions for improved credit risk management:

  1. 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. Post the introduction of the new IFRS 9 standard the economy was stable until it was hit by Global Pandemic. In order to come up with forward-looking Expected credit losses (ECL) the existing “probability-weighted scenarios” will need to be enhanced to consider current economic scenario while computing ECLs.
  2. Customer Scoring Model Upgrades – The current pandemic has had a wide spread impact on the Corporate counterparty ratings and the current rating models do 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
  3. 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 the Banking Book portfolio. The major challenge here is that historical data is not present on such scenarios and Credit Risk teams are creating hypothetical scenarios to test the impacts. From a regulatory perspective Global Regulatory bodies are making concentrated efforts on coming up with Pandemic scenarios based on the characteristics of their respective geographies which will help in better understanding the impacts and bring in necessary interventions to manage their Banking Book.
  4. More focus on Proactive Credit Risk Management – Early warning solutions are being augmented with unstructured data especially in case of corporate customers which helps in the proactive assessment of riskiness of counterparties and be more alerted towards their counterparty’s Financial behaviour.
  5. On Demand Credit Risk Reviews – Generally, Credit Risk Reviews follows a standard calendar and the review frequencies range from monthly (high Risk) to annual (low Risk) depending on the customer type. Due to the ongoing pandemic where 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
  6. Credit Risk RWA optimization – Apart from Regulatory measures driven by Global bodies to inject liquidity in the system, the 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, Computational rules, Model Management and Collateral management approaches to name a few.
  7. Creating Digital Roadmaps – Cost optimization and efficiency is emerging as one of the focus areas and Banks are trying to have a relook at their Business processes, Systems and Data Management programs and understand touchpoints where Digital technologies can have a role to play for optimize the processes and reduce costs as well. For e.g. Business processes around Internal Credit Reporting are leveraging automation and Cognitive technologies to a faster generation of reports and to gain better insights from the Reports. 

While Global Banks, Financial Institutions and Regulators are better prepared this time and are taking necessary actions to absorb the economic shocks emanating due to the pandemic. However, they have to constantly work towards coming up with strategies and developing a robust approach covering short term to long term implications on the credit risk functions.