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