Risk Management in Uncertain Times: How to Prepare for Both the Expected and Unexpected
Four guiding principles for forward-looking processes and models.
Friday, April 30, 2021
By Peter Plochan
Facing super-low interest rates, an onslaught of regulatory developments and the emerging priority of climate risk, banks today are under tremendous pressure. However, despite current challenges, what institutions learn - and how they adapt as a result - may make them more resilient for the longer-term future.
Just how staggering are the impacts of COVID-19 and related financial losses on the banking industry? Banking profitability, already under immense scrutiny, has taken a significant hit since banks worldwide began publishing their experienced credit losses for 2020. Indeed, many have reported losses in the range of hundreds of millions to billions, with some larger banks surpassing the $10 billion mark.
The financial risk impacts are certainly being felt - and, once temporary COVID-19 regulatory reliefs and moratorium arrangements expire, every financial institution should brace for the real blow.
On the positive side, firms have learned some important lessons along the way. For starters, planning is key to later success.
Stress testing, forward-looking scenario analysis and risk modeling must be an integral part of the equation, with risk and finance closely aligned. Getting the organization on the same page is crucial to plan and prepare for the scenarios that may impact the organization.
Moreover, financial institutions must take into consideration the potentially explosive effects of IFRS 9 and CECL models (both severely impaired by the pandemic) on overall model risk management.
Embedding Stress into Business as Usual
The pandemic turned everything upside down. At the onset of COVID-19, banks' analytical models required quick redevelopment, recalibration and redeployment. As the pandemic progressed, stress testing of models in real life (and in real time), contingency planning, fallback plans and manual overrides all became essential.
However, there are ways to successfully manage forward-looking models and calculations. Banks should adhere to the following guiding principles in both certain and uncertain times:
Maintain an established definition of your models in your central model inventory, with clearly defined governance, responsibilities and procedures. This helps manage model risk, particularly covering the sensitive areas like manual overrides, ad hoc recalibrations and validations/revalidations.
Create robust and integrated model development and implementation processes and systems covering the entire end-to-end model lifecycle. These can expedite adaptation, response times and time-to-insight. They also help ensure the soundness of deployed models and their appropriateness and relevance in an ever-changing environment.
Embed fast and flexible forward-looking scenario simulation and a what-if analysis framework and system. This enables frequent and quick impact assessments that can be used for decision-making. The ability to explain and attribute the changes in the resulting key performance indicators (KPIs) and key risk indicators (KRIs) to the underlying drivers is particularly important.
Establish an environment that promotes alignment and integration among the various forward-looking teams, processes and systems. This helps ensure data, expertise and capabilities can be shared and leveraged in an efficient and governed manner.
One thing is certain in these uncertain times: financial institutions must plan and prepare for volatility. Testing, planning and models are all essential for banks to protect and prepare themselves for both the expected and unexpected, at least to the extent possible in these extraordinary times.
A Glimpse Ahead
Simply put, financial institutions must do more - of everything. To remain resilient during the crisis and beyond requires the following:
More forward-looking analysis using more alternative scenarios and ad hoc impact assessments, with focus on decisioning and strategic portfolio steering;
More sensitivity analysis and impact assessment of alternative modelling choices, assumptions and business plans;
More focus on cost-efficiency; and
More integration within risk and finance.
Doing more now means less pressure and less uncertainty. As an industry, by and large, we are becoming more forward-thinking out of necessity.
Exploring use cases for stress testing and scenario analysis capabilities will make us more resilient in the long run. For instance, banks must consider financial planning, risk appetite management, what-if and sensitivity analysis, emerging risk identification and reverse stress testing.
Each of these activities is important in its own right. Combined, they help banks make the most optimal decisions, in good and bad times.
Consider climate change, for example. Banks around the globe are currently assessing what this means for their regulatory compliance, models, scenarios, risk appetite, portfolio strategy and overall risk management.
These issues can't be addressed in isolation. In the end, to perform a climate risk stress test, firms need all these components to be in sync and tightly linked to their business-as-usual risk management processes.
There are also opportunities on the horizon to do more with modeling. Advanced analytics, ever-bigger data and cloud technologies are creating opportunities for completely new applications, products, services and business models.
Greater model complexity comes with inherent risk, but it is only through these advances that the industry can create a more sound and secure tomorrow. Banks can balance the risks and benefits by adopting a deliberate approach to managing models and their risks, based on the principles of soundness, accountability, fairness, ethics and transparency.
Enterprise risk management is only as efficient as the weakest link in the end-to-end risk and finance process chain. Adhering to this viewpoint, many organizations are already making great progress by bringing their forward-looking processes closer together.
Getting the organization aligned and in sync around preparedness for continued volatility is essential for the future - and achieving that end goal will require vigilance, forethought and preparation to ride out the storm.
Peter Plochan (FRM) is a principal risk management advisor at analytics firm SAS, which helps banking and insurance firms tackle their challenges around finance and risk regulations, enterprise risk management, risk governance, risk analysis and modeling. He has more than 15 years of experience in financial sector risk management, including oversight of large-scale risk management implementations.