A bank’s risk function can play a key role in addressing pandemic-related risks across the enterprise, including credit and liquidity.
The effects and implications of the pandemic and global crisis continue to evolve and grow. In addition to the human and broad impacts to the economy and society, the banking sector has been significantly affected.
The immediate economic downswing across many industries led to an increased need for debt offerings from financial services firms. In addition, government mandates, such as the Paycheck Protection Program, meant banks were put into unanticipated situations to help support the broader economy and therefore ramp up operationally to support remediation efforts. While uncertainty continues as the crisis precipitates, it is clear the risk function has a key role to play within a bank’s organization, and needs to think and address immediate, near term and long-term challenges across credit, liquidity and enterprise risk functions.
The current liquidity risk environment
Due to the pandemic and the related market shocks that occurred during March 2020, treasurers and risk managers have been tested in ways not seen since the 2008 financial crisis. We anticipate banks may experience additional stress in the coming months as disruptions persist, national borders remain closed and travel is restricted.
Firms saw shifts in their balance sheets as market participants reallocated their assets and struggled to repay outstanding debt. While some behavior mirrored impacts modeled off the 2008 crisis, given the worldwide demand shock (which is lasting for a prolonged period) firms saw shifts in product demand that were not expected, and which affect forecasting and existing stress models.
Customer actions and behavior changed in ways that were not predicted by previous stress events. These may have had unanticipated effects on liquidity ratios, leading to tighter management and monitoring of cash buffers. Additionally, banks were called to serve as the intermediaries for new government credit facilities established by recent legislation.
In this environment, risk management should be more vigilant than ever. First and second lines of defense should have adapted to new market conditions, and previous assumptions and limits should have been revisited to reflect new market realities.
Banks may not have the operational capacity to monitor the impact of these rapid changes. Management should ramp up operational capabilities and move towards more frequent reporting to track the situation closely and support better decision making. Enhancements should be made so that positional, cash and collateral information can be viewed daily or intra-daily, as well as at a more granular level to allow risk managers to effectively monitor liquidity product movements and regulatory ratios.
Firms should be more cognizant than ever of the impact of the crisis upon liquidity ratios and required cash buffers. Using the refreshed data, banks can run a tactical liquidity coverage ratio (LCR) several times per day to understand these changes. They can analyze changes in liquidity positions to improve ratios and build buffers against future shocks.
Ad hoc scenario generation can assist management in understanding potential market shifts. These scenarios should be developed to model the new realities of the financial markets and the bank’s financial and liquidity positions. As changes take place—for example, deposits are withdrawn or loans default—stress tests can be updated and recalibrated.
Treasurers and risk managers have been tested in ways not seen since the 2008 financial crisis.
The recalibration of assumptions and limits can be labor intensive and may require complex adjustments. It should also be controlled properly to provide data quality. Banks should review the accuracy and effectiveness of market and combined stress scenarios to see if the assessment of the impact on liquidity was conservative enough to account for recent shocks.
Finally, maintaining ongoing access to all liquidity sources is essential. Banks should regularly conduct exercises—such as raising unsecured funds across key counterparties or pulling small portions of credit lines across core currencies—to test these sources. If access to specific sources is lost, banks should reassess the potential drivers that may have led to the losses. Balance sheet forecasting and stressed assumptions should be recalibrated based on the findings.
In the longer term, banks should take the lessons learned from the demand shock and devise a strategy for improving liquidity risk management and monitoring. Banks should use this opportunity to make meaningful changes via the streamlining of treasury data, adding flexibility to modeling, enhancing stress testing and making upgrades to forecasting capabilities.
Please contact Fred or Jeff if you wish to discuss steps your bank can take in this crisis. You can also consult our COVID-19 hub, which features our latest thinking on a variety of subjects including a document on how banks can manage the business impact of the pandemic. Also of interest is a document titled “Solving for liquidity, profitability and enterprise value in uncertain times.”