A very quick look back at 2020
Whilst this year has largely been one to forget, we think there are still some important positive lessons to take from this annus horribilis.
The response of regulators, in the 12 years since the financial crisis, has enabled banks to weather the extreme turbulence seen in 2020. This can reasonably be seen as a triumph for the current regulatory regime implemented over the last decade and the financial services industry’s response to them.
With banks being well capitalised going into the crisis, stress testing by regulators and banks themselves has provided positive outcomes with no significant stories of financial losses, yet. The reactivity and adaptability of models have passed a severe test, with regulators and central banks playing a leading role in stabilising the economy and their swift interventions have been crucial. In fact, the stress testing regime of the last 5-10 years has demonstrated the flipside of truth behind the old adage “fail to plan, plan to fail”. Whilst the nature and magnitude of the crisis hadn’t been predicted by most, the planning and systems put in place by the existing regime came into their own.
This has also been true of financial services operational resilience measures with markets functioning well and firms making the transition to remote working under lockdown remarkably smoothly and quickly….at least when looked at in the round and once the worst turbulence had passed. The lessons learned from this experience must be factored into future play books and business continuity plans.
However, that doesn’t mean to say everything is now perfect:
The current position of the health crisis, as viewed through the lens of financial services, is much like the pregnant pause associated with an impending tsunami. The earthquake has happened way out at sea, the water has rushed off the beach and people have run for higher ground. Now they sit and wait to see the damage the sea will do.
With 2 global crises in 12 years, it is clear globalisation has led to greater incidence of disruption and contagion than has occurred in the past.
There is a retreat from global governance (Brexit anyone…?) and a rise in populist politics from both ends of the spectrum, generating greater instability[MP1]
The Basel III regulatory regime is not complete and may need some tweaking in light of its first proper test, particularly regarding the cyclical buffer, leverage ratio and regulatory guidance on distributions
Negative and low interest rates are squeezing profitability
High public and private debt, with zombie firms in the real and financial economy propped up by government funding that will have to be withdrawn in 2021
As we move into 2021, there is still plenty to keep the boards and CROs of financial services firms awake at night.
The Covid-19 health crisis is far from over with new waves and strains of the virus still hitting globally, even in the East-Asian and Australasian economies who seem to have weathered the storm better than Europe and the Americas.
In an effort to keep economies from crashing, governments and central banks have pumped huge quantities of liquidity into the system. As a result, the unprecedented level of debt could drive up sovereign risks; a number of speakers at the recent Risk Minds speculated it will be the driver behind the next major crisis.
The increase in liquidity has, beyond its purpose of keeping viable business afloat, reduced the rate of corporate defaults relative to recent trends. As a result, Zombie businesses, and the jobs they provide, are being kept on life support.[MP2] This can’t last forever, and as governments remove this support in 2021, a social crisis is likely to follow with increased defaults across retail and corporate lending. Economists’ forecasts vary wildly but median expectations seem to hover around a UK unemployment peak in Q2-21 at 6% and a slower return to growth than hoped for in late summer. What is certain is that the crisis has caused a deep scarring of the labour market, has acted as a catalyst to structural changes to the economy (retail, work life, travel) and collateral damage whose[MP3] impact will have a long tail (such as the impact of closing schools and cancelling exams).
Brexit, the other big story of 2020 – at least in Europe – will also have a structural impact on the UK economy. Despite the government’s deal, the changes will initially be bumpy with short run disruption for goods. The negative impact is expected to be strongest in London and SE due to strength of financial services industry (for whom a deal has not yet been reached) and regional pockets that export to EU (West Midlands, North West):
New supply chains will be required
There will be a reduction in skilled labour
The government will have less fiscal room for manoeuvre
There will be lower investment as businesses who are likely to wait and see before committing resources
Lower growth as the economy transitions
More, optimistically, the move away from European governance will enable the UK to be more agile in its law making and regulation with the government stating it wishes to use this freedom and the necessity of recovering from Covid-19 to reset economy on a greener path. Ultimately, success will depend on consumer and business confidence. The long run is less predictable but to succeed outside EU this and leading in the provision of higher value services, where productivity can be increased, will be the key.
In 2020, there has still been GDP growth worldwide, but this is mostly driven by China, East Asia and Australasia. Whilst there has been a rebound in Q3-20, further lockdowns in Europe are driving a W or possibly worse a zig-zag recovery. A full recovery (back to 2019 levels) is not expected for most western regions until mid-2022 and possibly late 2023 for the UK as a result of Brexit.
The biggest, longest run story for the next decade will be the growing frostiness of a Sino-American cold war. China has abandoned its collaborative, open door policies of prior decades and replaced them with aggressive triumphalism under President Xi. Both the Democrats and Republicans see China as a malevolent power and the Democrats (traditionally a protectionist party) are likely to be even more hawkish given China’s appropriation of other countries’ IP and undercutting of its manufacturing base.
The Covid-19 crisis has been a case in point. China's fast economic recovery, following draconian lockdowns, is seen by President Xi as justification of the model of communism over western democracy. The US (and most of the west) sees China as being wilfully negligent on the crisis, allowing the virus to fester and spread and manipulating global agencies to prevent rapid action in Dec-19 and Jan-20.
China has already returned to growth, albeit slower than last year, allowing it to steal a march on the rest of the world. Whilst the cold war is real, it will not be a repeat of the Russian-American cold war of the previous century due to the integration of the Chinese economy with the west and well as the need for a global response to global challenges such as climate change. America is likely to take a two-track approach, talking tough on trade yet working with China on Environmental, Social and Governance (ESG) issues.
In Europe, Greece, Spain and Italy are in deflation. OECD worst case scenario has debt to GDP ratio of southern states and France between 150-230%. The ECB has already bought up large portions of these countries’ debts and continues to do so. A €750bn Covid-19 fund has been earmarked but not, as yet, delivered. Recipient countries continue to haggle over whether the money is distributed as loans or grants. Given what happened to Greece and the potential debt burden of France and the southern states, most recipients are resisting loans out of fear of the dreaded Troika. Given that the money has been already too slow to be distributed and the structure of distributions such that they are spread out over time, there are also strong question marks over whether it will prove to be effective. This cannot possibly be sustainable and the risk of another Sovereign crisis in the EU continues to build.
It’s not all doom and gloom, however. There are plenty of upsides going into 2021:
A Biden presidency is expected improve US trade relations with the rest of the world, with
The US will also re-join the Paris accord which is crucial to make real progress on Climate Change
Asia, having handled Covid-19 better that the West, is booming
The political strength of the European project continues to trump economic reality and is likely to keep the wheels on, even if they become a little shaky
Brexit is finally over and, with its completion (for the most part), the uncertainty that it wrought will fade away in 2021
The 4th industrial revolution – the use of modern smart technology, machine-to-machine communication and the internet of things to drive production without the need for human intervention – is creating a competitive landscape increasing in its ferocity. The challenges posed are not unique to any industry and provide as much instability to financial services firms as it will to their clients.
The biggest challengers to financial services firms will not be the start-ups, although these will erode market share, but the big tech firms who will seek to disintermediate the incumbents, hollowing out the lucrative income streams. However, chasing big tech (Google, Facebook, Apple) brings considerable cyber risks for which the insurgents are better equipped to handle.
For western banks this couldn’t come at a worse time, with structural challenges (low interest rates, high liquidity) hampering profitability. Many banks, unable to earn their way back to profitability, can only continue to cut costs all-the-while still having to invest heavily in technology and regulatory programmes.
Financial services also have to balance the provision of frictionless service to clients with a robust control environment (cyber, credit, know-your-client, fraud, anti-money laundering, treating customers fairly, data protection etc) to be competitive without breaching regulatory and legal obligations. Finding this balance will necessitates looking for solutions beyond the financial services industry. The 2020s will be a decade where innovative solutions are required and without bringing in new blood firms will lose the freshness of thought required to succeed in the long term.
Climate change, and the financial service industry’s driving of the agenda, will change the face of how it sees its clients, the support it provides and who it is willing to provide services to. See separate section on Climate Change below.
Given the status of the current global economy, it will be little surprise that the “traditional” risks (credit and sovereign risks) are back on top of the CRO agenda. Whilst sovereign risk is discussed above, credit risk warrants more discussion.
Whilst UK and European stress testing of banks has provided comfort that they can withstand much more severe downturns than that already experienced, capital depletion was mostly affected by credit losses.
As the crisis abates and the furlough and lending schemes are wound down, bankruptcies, whose rates are currently depressed, will be significantly larger than in 2020. There will also be greater clarity on the scale of fraud and cyber-related crime with the crisis lending schemes and the level of true forbearance the moratoria schemes are hiding.
As we move into 2021, non-performing loans (NPLs) will be the number one strategic challenge and will take 2-3 years to work through the problem. However, forecasting where the damage will be is a lot trickier:
There has been no comparable crises on such a global scale - you have to go back 100 years to the Spanish Flu
The current crisis is different to Great Financial Crash (GFC) in 2008. It is not initially financial driven, severity of the impacts come from lockdowns and the logistical consequences of social distancing, many of the impacts are largely unseen as yet and the magnitude is way beyond GFC.
The governments’ fiscal, monetary and macroeconomic policy responses have been unprecedented and so looking back to past crises will not be particularly useful as templates for what will occur in 2021 and beyond.
This is a truly global crisis, world trade (both internal and external) has taken a knock, there are sector specific hits with transport, leisure and tourism particularly bad.
There is huge uncertainty in exit back to “normal”. There is uncertainty in the outcome of a potential cure, the transmission of economic stress from one industry to another and wide-ranging debate on the recovery shape (U, V, W, K).
Common consensus is that, with continued waves of the virus forcing new lock downs, further downturns will continue until the vaccines have been rolled out. Leisure, tourism and transport will continue to struggle. Leisure that managed to survive the summer by providing outdoors options (e.g., restaurants), is finding trading much more challenging in winter. They will need the late spring and summer business unencumbered to stand any chance of making 2022.
There is early evidence is that there will be lower demand for office space (particularly in city centres) and residential property in densely populated areas and so there will be increase pressure on the infrastructure (shops and services) that supports office workers. Conversely, products and services that support working from home (tech firms, residential property market outside cities like London) are likely to do well, as are pharmaceuticals.
Many banks are likely to have limited room for manoeuvre with respect to capital and liquidity and continued volatility in impairment calculations courtesy of IFRS9. The CFO and CRO will have to work ever more closely together to optimise capital and manage NPLs and will need to upgrade their analytical capabilities to improve forecasting and stress testing.
A common theme when talking to CROs has been their concern that whilst 2020 has forced them to focus a lot of attention on financial risks, there are still significant challenges in the non-financial, where, in recent history, the largest individual losses have emanated. Issues around conduct, resilience, financial crime and cyber-security are ever present, not to mention the new and emerging “digital risks” surrounding the use of AI and cloud technologies.
The response to the current health crisis, most notably working from home, poses significant risks to a strong risk culture. With staff working remotely from each other and mainly interacting through email and conference calls, the little everyday processes and controls that shape how the culture is embedded in the organisation are broken up. This can undermine the psychological safety that the culture provides, especially for less experienced or new staff, and thus impacts on customer experience.
The environment created by the current crisis (which is expected to continue into 2021) also means that existing staff fear for the stability of their jobs. They will be less likely to rock the boat and call out inappropriate behaviour or, where appropriate, whistleblow.
Furthermore, if staff attrition is 10% per annum, then by early next year it's possible that 10% of your staff have never been in your offices. How does culture get instilled in them? How clear is your vision and expectations to new staff? What culture and conduct risks are you running as a result? Now, more than ever, risk leaders need to dedicate more time to the clear communication and leadership needed to keep teams focussed, motivated and confident enough to be innovative.
Capital and Liquidity in a post Covid world
So, let’s start with the good news….at the Risk Minds conference in early December, regulators indicated a substantial pause following the final implementation of the remaining Basel III rules (aka Basel IV). To be clear, no Basel V in the foreseeable future.
That said, the remaining Basel IV reforms are still substantial and will require model rebuilds across all capital models. It will be a challenge to complete, as:
The timetable to complete the program is tight for both the firms and the regulators
There is a lack of sufficiently qualified resource in high demand
Credit model validation will be a challenge due to lack of historic data to compare to Covid-19 environment
Market risk regulatory models are increasing in complexity. Standardised itself is a model (unlike credit where it is more formulaic) and the build cost and ongoing demands placed on regulatory IMA questions its value for all but the very largest firms
In addition, whilst there may not be the desire to launch a Basel V, the crisis has highlighted a number of tweaks to the regime, for which financial services firms and regulators have acknowledged:
There is a need to look again at the forward-looking provisions for IFRS 9 and their implementation.
There needs to be a better balance of capital buffers and distributions. Many would argue that the headroom above the capital buffer should belong to shareholders, subject to stress testing determining what is reasonable.
Pro-cyclicality effects on capital (especially for market risk) seen as a result of regulator capital calculations.
The leverage ratio, meant for curbing exuberance in plentiful times, is not helpful when regulators want financial firms to rapidly expand lending.
With the global health crisis requiring industry and regulators to work together to keep the financial markets functioning, 2020 has seen a shift in mindset in some firms, working more positively with regulators through crisis. It is imperative this level of dialogue will need to be maintained and developed as only by working closely with the regulator, will the challenges be met in a sustainable, constructive fashion.
This topic has been on the agenda for firms for several years. The primary reason is that it is something regulators focused on – the PRA in particular – and so the industry followed. For now, the regulators are focussing on financial stability and management of risk but once that is mastered, expectations are that they will use their influence to facilitate and incentivise a transition to a more sustainable economy.
The challenge presented by climate change is driven by many factors, not least:
The time horizons are longer than we are accustomed to thinking about – especially banks.
There are huge uncertainties on the risks we are facing – the climate and the range of political and economic responses to it are so complex, even the most sophisticated models cannot predict the multitude of possible outcomes
The impacts are non-linear on socio-economic outcomes, with huge cliff edge effects e.g. a small increase in the level of flood water can change a small loss into a huge one.
The transition to a low carbon economy is going to be hard to manage. Financial institutions will need to balance supporting and nurturing green clients with a strong financial future whilst not abandoning existing clients who may be swept away by transition or not just on the path as yet. This will require balancing the risks and opportunities presented by both types of client.
Many feel that the financial services industry must take a leadership role, that it has a responsibility to society, even more so since the financial crash. Banks, insurers and asset managers can offer more green products and promote green culture. How they behave and products they roll out can influence and change society in a significant way. However, firms must not fall into the cynical trap of “green-washing”. Firms need to take people with them but to do this successfully there must be authenticity behind their decision making and the governance and frameworks that support it.
Some insurers are well placed to provide this leadership role. The industry has a long history of weather-related risk management and have more sophisticated tools to do so than their banking counterparts. They also, particularly in their life businesses, have longer duration credit portfolios that are increasing in size due to the Solvency 2 benefit these accrue.
The regulators are continuing to churn out new regulation, all looking to see improvements in firms’ governance, risk monitoring and disclosure. However, the regulators are moving at a different pace to each other and there is a need for firms to manage the differing expectations:
The PRA are seeking to lead the agenda, requiring firms to assess themselves against supervisory statements and providing feedback on where the firms need to do more work. They are expecting embedding of plans into day-to-day governance by the end of 2021
The ECB (and the US regulators) are more focussed on managing and monitoring the climate change risk but still aligned with PRA guidance, for now.
Current expectations are that the board has an informed business strategy, linked to the firm’s strategic objectives and dedicated senior manager responsibility. The business plans that are developed from this must be global in nature (for multinational firms) and not just for the location of the parent company. After all, this is a global issue.
The risks posed by climate change should be considered a mainstream financial risk, albeit one that cuts across all other risk types. The risks posed by climate change can be subdivided into transition risk (the financial risks which could result from the process of adjustment towards a lower-carbon economy) and physical risk (event driven or longer-term shifts in climate patterns creating financial implications such as direct damage to assets and indirect impacts on, e.g., supply chain disruption). It is incumbent on firms identify and monitor these risks to ensure financial resilience.
To get themselves ready to lead the way in climate risk management, firms will need to embed climate considerations into their strategic thinking and by using levers such as pricing and risk appetite to ensure incentives and actions provide the right outcomes. It requires a lot of effort in particular with regard to governance:
Who will be responsible for assessing the climate change risk?
How is climate change risk measured and converted into risk appetite?
How do we monitor against risk appetite?
How do we reflect these in our disclosures through financial reporting?
Climate risk will also have to be incorporated into the already complex macroeconomic stress testing process. This is hard enough and imprecise as it is, and climate change modelling will be even more so, but this doesn’t mean it should be ducked. In fact, stress testing needs to be more dynamic in order to manage the increasingly likely cliff effect – e.g., sudden changes in government policy. To achieve this, firms must be developing tools to identify, measure and monitor the risks and their links to business strategy and stress testing will need to include scenarios related to climate change for both physical and transitional risks in the short term (3-5 years) and long term (decades).
Looking ahead to 2021 there is a huge amount of work to do for those tasked with delivering on the above agenda, not least the PRA stress testing, analytical development, enhancing governance and increasing disclosure to meet investor demands.
Measurement, Data and Modelling
As technological capabilities continue to develop at a rapid pace, there is an expectation that models built on big data and machine learning become increasingly used within credit risk management. Historically, the slow response from regulators has been seen as something of a blocker to progress as has some of the transparency of the machine learning models themselves.
Financial services firms need to catch up in this space. Internet firms such as Google and Facebook are light-years ahead in the exploitation of the technology and, given their existing access to information from news flows and social media, they present a real threat to the distribution channels of financial services firms. In China, for example, tech firms are using social media data to score its users’ suitability for a personal loan without requiring any banking history. There is a real possibility banks become disintermediated as a result of failure to respond.
This shouldn’t be the outcome if they begin to more aggressively use the abundance of data they do have from customer activity and the additional data they can now access through open banking in addition to news flows. With the current Covid crisis, the ability to see trends that only machine learning uncovers is even more vital (see “spotting the next crisis” below).
To do this, banks need to be more data driven, even mirroring the strategies of the big IT companies. This may seem like something of an extreme statement but banks’ reliance on IT is huge: for risk management alone stress testing, risk appetite, pricing, reporting and risk models are all tightly interwoven and impact each other and demand vast quantities of data and processing.
This is not to say that the banks don’t face significant headwinds in adopting machine learning. Bank databases are of varied data quality, fragmented and are a struggle to use and the older and larger the bank, the more so. Additionally, regulators are not yet ready for capital, impairment and stress testing models to be built through machine learning algorithms (albeit, they can provide a useful benchmark to existing models) and so both the incentives to spend on development and the resources to perform the work are held back for the existing model suite.
This shouldn’t stop firms moving forward. Understanding the ecology of data systems and building use cases through small scale trials of the technologies available, whilst actively engaging the regulator to move faster, will help to shape a viable strategy for the future.[MP4]
Using machine learning to spot the next crisis
What excites people most about the positive potential of machine learning and artificial intelligence (AI) is that it can spot trends that are much harder to uncover through traditional means and it can be done in a fraction of the time.
This capability needs to be turned towards predicting potential future crises. Whilst humans are still needed to make quick decisions with myriad consequences and outcomes in a crisis, AI will be better at spotting one coming in advance. The models can then direct humans towards value added work in planning and preparing for turbulence through scenario and stress testing and updating and expanding playbooks.
There are 3 themes behind risk events that AI can provide greater insight on, and for which data is readily available:
Polarity: spotting the extremes in societies provides forewarning that a correction is likely to occur as they are rarely sustainable – e.g. low/negative interest rates, high income inequalities, high borrowing relative to income
Rhythm - business and credit cycles are a fact of economic life and are broadly predictable if somewhat harder to pinpoint the timing
Cause and Effect – significant changes to fiscal and monetary policy, work patterns, paradigm shifts from technology, trade relationships will all have knock on effects. Often, we look at these in the short to medium term (3-5 years) but climate risk will require us to assess risks in the longer term.
By applying AI to these themes, likely stress scenarios can be generated and fed through the stress testing process allowing firms to plan ahead, adjust business strategy (if appropriate) and update their playbook for such a scenario.