COVID-19 – Credit Risk Management

COVID-19 – Credit Risk Management

The world is exposed.

The coronavirus outbreak has draped the world in uncertainty and has greatly increased the risk of most organisations on the planet. COVID-19 is delivering two economic shocks – demand, supply – and a financial one, in one big blow.

Government responses, including the confinement of entire populations, are protecting the people from infection, but are simultaneously dragging the economy to its knees. Businesses are now pulling on credit lines to support them through the crisis, and consumers are deferring payments or even refinancing their existing loans to help them pull through.

This has some major implications for financial institutions across the globe as they try to adjust their strategies and risk assessments to the situation at hand. Risk managers are currently seeing the returns on their portfolios deteriorate and are bracing themselves for the blow to liquidity, knowing that they might not see next month’s returns.

It’s imperative to not go into panic mode. 

There are ways to take back control of the situation. But this entails the production and implementation of new models that incorporate COVID-related changes, and the utilisation of alternative data that can reveal the economic situation of a client.

In other words, banks must take a proactive stance instead of waiting for the risks to reveal themselves.

Debt Moratoria

With businesses closing and workers being laid off or having their hours cut back, it seems highly unlikely that many will be able to repay their mortgages and loans. Across the world, major banks are offering payment deferrals in order to relieve customers of the economic burden and prevent them from going into default.

The EBA has released a set of guidelines to clarify what criteria the payment moratoria have to fulfil to not trigger forbearance classification in light of the legislative and non-legislative moratoria on loan repayments adopted by financial institutions.

In order to align current strategies and adapt them to these circumstances, financial institutions must be able to predict how many clients will have to rely on the moratorium.

Luckily, financial institutions already have a tool to extract such information – PSD2.

Thanks to the revised payments services directive, third parties are allowed, with customer consent, to access account information. As we’ve already mentioned in our previous post on PSD2 use cases, a bank can request this access to determine a client’s financial status.

There are several, actionable insights that one can extract from this open banking data.

Though there are multiple factors to consider when predicting which client will request a deferment and when, there’s one piece of information that rarely deceives – the account balance.

If a client’s balance looks bare, that client will likely take advantage of the moratorium on offer.

Clients who are financially in trouble share some common characteristics that may help the bank make predictions at the portfolio level. In order to understand where the risk is coming from, a financial institution must “slice and dice” the portfolio to examine it first in detail, at the individual level.

This view from above will give banks an overview that can be inserted into the overall risk of the institution.

Determining Eligibility

If clients do end up requesting a moratorium, the financial institution must determine their eligibility.

In Italy, mortgage payment holidays are offered to those whose hours were suspended or reduced for thirty days. In addition, self-employed workers can request a holiday if they have seen a 33% reduction in income for the trimester.

By accessing the client’s account information and identifying the earned income among the transactions, banks may calculate the average losses associated with the coronavirus outbreak.

Understanding COVID-related risk

The outbreak has hit some sectors more than others. Travel, for example, has received a substantial blow while demand for digital communication tools has risen sharply.

To determine which clients require the most relief and where to pour the most resources, they have to be categorised. There are a number of factors to consider when trying to forecast the risk of an unprecedented event such as this.

  • Demand

Has the demand for the client’s products or services declined or has it risen? Those sectors that are seeing a plunge in demand are the sectors that will require the most attention. It is improbable that these areas will be able to return to normal after the dust has settled.

  • Supply Chain Disruption

With the fact that China is the western world’s factory for phones and accessories, the outbreak in the orient has disrupted the supply chain worldwide.

But this is not limited to that side of the world. Supply chains around the globe are feeling the effects of the pandemic and a financial institution must make the appropriate plans.

Risk committees must prepare scenarios spanning over 10-12 months covering the hardest-hit sectors, like hospitality and manufacturing, and include this in their risk assessments. Then, working with credit committees, they must determine what kind of impact these could have on revenue and take steps to mitigate the predicted damage. 

  • Customer Behaviour

Has the customer requested a holiday? Have your forecasts predicted that he or she will? Knowing that a client is financially unstable is usually enough to predict the short-term. But, in a pandemic situation, this will help you understand what the long-term effects will be.

Banks should keep a keen eye on anomalous behaviour, whether it be requesting a deferment or withdrawing large amounts of money in one go. These behaviours could point to the client knowing that harder times are still to come.

All of these factors should be considered as early warning indicators that will help credit officers make portfolio decisions proactively. 

Future risk

Even when the world starts nudging back into the usual routine, risk will NOT find its balance.

In fact, scientists fear that the rushed return to our normal lives will lead to an inevitable second wave of infection. This means that, even after lockdowns start to ease, financial institutions need to be prepared.

Think of The Spanish Flu and The Plague – pandemics come in waves. This is why financial institutions must be prepared to make effective and accurate forecasts.

In this day and age, a risk manager should be able to

  1. Visualise a portfolio – segmented and whole
  2. Make accurate predictions at a portfolio and individual level
  3. Share findings with colleagues using a format that they can understand
  4. Determine the next steps to be taken based on these predictions

All of this cannot be done with outdated tools. Financial institutions must adopt modern technologies for modern problems in order to keep the surfacing risks of the new age under control.

Looking so far ahead in a decipherable way requires certain types of techniques that can only be adopted when the whole institution is forward-looking.

But we must face the facts – some banks are not ready. 

Some financial institutions are not prepared to expose their APIs and adopt cloud solutions and, even if they were, they should do it slowly. This is not to say that it cannot be done, rather, the process changes greatly in the hands of an institution that is not yet technologically ready.

It requires serious forethought on behalf of all employees – both decision-makers and the employees who use the tools directly – and must spark a dedicated internal dialogue.

Furthermore, a cross-functional virus response team must be created to keep an eye on all COVID-related risks posed to the institution.

More inconspicuous risks should be taken into account.

For example, when the world is looking the other way, the criminal undergrowth starts rustling. 

Since the start of the outbreak, cybercriminals have been preying on unaware websurfers with scams, fraudulent websites and misinformation. Recently, they have also managed to shut down the Italian social security website, leaving vulnerable Italians without the money they’re entitled to.

One must think ahead and protect one’s systems from such attacks. Reaction speed is a priority and one successful attack could leave the bank and its clients in deep waters.

After the negative public opinion for the wrongdoings of 2008/09, it seems that COVID-19 is offering banks an opportunity for redemption combined with a golden chance to innovate. Banks should not miss out.