How financial services can navigate through a real time stress test
25 September 2020
COVID-19 is causing incredible uncertainty across the financial services landscape, as well as headaches for those responsible for the financial planning and stress testing processes. But there are opportunities too. Here I share insights observed across challenger banks and building societies.
Challenges with financial projections: Firms currently performing their annual financial planning process are using dramatically shifting macroeconomic variables. This is a losing battle, as while firms perform their projections on a best-efforts basis, and clearly define their key assumptions as part of this process, those assumptions are invariably out of date before projections are finalised. Board members should use stress testing to understand the range of potential outcomes arising from COVID-19. This brings new challenges, such as how to calibrate a stress test when your base case is in stress. Also, how effective do you assume government intervention will be and how many customers requesting payment holidays are actually in financial distress?
Challenges with stress testing: Across challenger Banks and regional building societies, we have observed a considerable variety of operational issues relating to data management and modelling capabilities. Those who previously invested in modelling and data management were better placed when COVID-19 struck. Those who were reactive in their response to stress testing generally proceeded with outdated macroeconomic variables or resorted to simplified and higher-level scenario analysis, therefore less able to understand the live impact on higher-risk portfolios.
Regulatory support: In response to the stress, the Bank of England has clarified how banks should treat the volatility arising from COVID-19 in key financial processes such as IFRS9, Market Risk VaR and the nominal setting of Pillar 2a. While helpful, these clarifications have raised operational issues for banks and can make a simple process appear more complicated due to ‘another’ set of overlays and assumptions. Of interest to new and growing banks are the recent PRA consultation papers (CP9/20 + CP10/20) that proposes a more proportional approach to supervision.
Moving forward: Now the initial reactive phase of COVID-19 is over, we suggest firms consider the appropriateness and recalibration of their risk appetite. Will back-book portfolios ever fully recover? Were the early warning indicators set up appropriately? Has the quality of the front-book been impacted? Are new products appropriate and what underwriting criteria should now be applied to those products?
Potential opportunities: Every crisis is a good test of a firm’s business model and provides an opportunity to adjust the strategy. Debt and capital raising may be vital to ensure firms continue to support their customers at a time it is needed most. Private equity, venture capital and family offices will be closely following the valuations of existing holdings as well as new opportunities in the market and we expect a reasonable number of defaults, liquidation, mergers and acquisitions in the coming months and years.
Firms are seeking new opportunities, whether to develop new products, or grow or reduce their balance sheet inorganically. These strategic initiatives generally require significant investment in risk management frameworks. UK regulators will be keen to ensure any product development or deals are in the interests of financial stability and customer outcomes.
Effective management of the regulators through this transition will be key to its success.