ERM lessons learned from the pandemic crisis for addressing the climate change risks - by Peter Plochan

ERM lessons learned from the pandemic crisis for addressing the climate change risks

by Peter Plochan

An economic crisis situation, like the current COVID-19 one, has serious implications for financial institutions around the world. With the arrival of IFRS 9 ECL / CECL1 impairment standards, banks have to work even harder now to assess the potential financial impact of such a crisis on their balance sheet and portfolios and take risk mitigation decisions accordingly.

These new standards and other key bank processes are backed by models with assumptions that prevail in normal times but may prove impaired in the context of extraordinary uncertainty. As a result, these institutions and their decisions are increasingly exposed to model risk during the crisis times.

From a capital and liquidity perspective, banks are well prepared for recession thanks to the capital buffer buildup initiatives implemented after the 2008-2009 crisis and the excess liquidity funneled by central banks into the economy and financial system.

The 2nd pandemic wave is going to put these regulatory actions to the test and will require banking risk managers to develop more pro-active, forward-looking risk mitigation measures.

Furthermore, the emergence of climate change-related financial risks and related regulatory initiatives are creating yet another set of challenges for ERM professionals to address (See Figure 1).

Fortunately, there are a couple of lessons learned from the recent pandemic developments that can help banks to better prepare for the upcoming climate change crisis.

Figure 1- Arrival of Climate Change

1 / Expected Credit Loss / Current Expected Credit Loss

lesson learned #1: plan is nothing, but planning is everything

In order to identify the best course of action, banks have had to analyze the financial impact coming from alternative future evolution paths on both macro and micro levels. In crisis times, new insights arrive almost on a daily basis, and so the need increases for banks to reassess the impact of these changing alternative future scenarios on the economy, their loan portfolios and their bottom line, frequently and in automated fashion

As banks go through a forward-looking analysis exercise, the focus should not be just on the resulting numbers, but rather on better understanding the risk sensitivities, concentrations and dependencies embedded in banks’ portfolios, and assess the effectiveness of any potential actions.

With such insights at hand, banks can identify optimal risk mitigation actions and take impact-aware decisions in order to navigate through volatile and uncertain times.

Figure 2: Forward looking what if perspective

From now on, attention on the forward-looking “What If” perspective suddenly makes a lot of sense to the relevant business stakeholders, and banks will, and should continue to, work on improving the timeliness and efficiency of their forward-looking analytical processes.

lesson learned #2: expect unexpected credit losses

Both IFRS 9 ECL and US GAAP CECL forward-looking standards were designed as a response to the 2008-2009 financial crisis, with the objective of capturing the risks on the horizon much earlier in banks’ financial statements. Now they are being stress-tested in reality for the first time by a live crisis, and the recently posted skyrocketing credit losses of leading global banks are clear proof of the volatility and sensitivity embedded in these standards.

Leading global regulators like European Central Bank2 and Bank Of England3 have published concerns about the potential pro-cyclical effect of these standards and asked banks to apply their IFRS 9 methodologies and scenarios with caution, and not to let them run wild.

Credit Losses are the single most important factor impacting bank’s performance in times of stress, expressed both in P&L and capital adequacy terms. The changes introduced by these new standards have made impairment calculations much more complex and calculation-heavy, which makes their forecasting a very resource and time-consuming process.

Therefore, it is crucial for banks to fully understand and own their credit loss calculations, so they can be more in control of their Balance Sheet and P&L, and create a better perspective on their potential future evolution. Examples of banks taking active measures here include explicit objectives to limit ECL volatility embedded in their risk appetite statement (Figure 3)

Figure 3: Risk Appetite metrics of a global bank with explicit ECL targets

Thanks to the current crisis, both banks and regulators now better understand the volatility and sensitivities embedded in their ECL estimates, and they can better work on addressing the identified gaps and improve the efficiency and explainability of the underlying processes and systems.

2 / ECB’s Letter: IFRS 9 in the context of the coronavirus (COVID-19) pandemic 3 / BoE’s Dear CEO letter: Covid-19: IFRS 9, capital requirements and loan covenants

lesson learned #3: keep your models at bay

Crisis times can expose models used by banks to new stressed data which the models might not have been “ familiar with. As a result, the statistical soundness and relevancy of important models can get impacted. “The real failure is not that banks used models which failed in this crisis, but rather that they did not have fallback plans to manage when the crisis did come.” Source: McKinsey, Banking models after COVID-19: Taking model-risk management to the next level

What matters is how banks respond to situations when performance of their key models drastically deteriorates, what corrective action they can take, and how fast they can respond to ensure that the models do not push them into wrong business decisions.

The recent pandemic experience has exposed the burning points within banks’ modelling ecosystems. At the same time, these developments have reiterated the need for sound model governance and model risk management (MRM) processes, as well as flexibility of the underlying infrastructure which are both crucial for banks to respond optimally when their models are exposed to the unexpected.

the way forward to tackle the “green swan”

“Recent regulatory climate risks regulations and climate risk stress testing initiatives are clear examples of the attention given to climate change by leading global regulators, despite the pandemic setback. “Climate change could lead to “green swan” events and be the cause of the next systemic financial crisis.” Source: Bank for International Settlement The Green Swan - Central banking and financial stability in the age of climate change

Similar to the pandemic experience, with climate change banks have to look forwards but over a much longer time horizon and with a much broader range of risk drivers, scenario factors and uncertainty.

Banks have to work with scenario pathways which depict the relationship between carbon footprint and resulting temperature increase (Figure 4). These then have to be translated into traditional financial risk drivers (e.g. GDP growth), risk factors (e.g. PDs) and, in the end, into risk KPIs (e.g. ECL).

Figure 4: Global Green House Emission Pathways Scenarios4

One of the key challenges for banks will be to establish a clear relationship between climate change scenarios and their ECL methodologies that will be in line with regulatory expectations5. Learning from the COVID-19 crisis, banks should be prepared to address and explain any unexpected volatility of their ECL and P&L measures caused by climate risk factors.

To address all the above, banks will have develop lot of new models and adjust their existing ones in a situation where there is lot of uncertainty and lack of historical data that can be used for training these new models. Banks therefore need to pay close attention to the risks arising from these new models and include them from the start in the scope of their MRM activities.

parting thoughts

It will be interesting to observe over the coming years how the banking industry copes with the challenges arising from climate change.

However, one thing is sure, that going through an experience like the current pandemic crisis makes it easier to have discussions with internal stakeholders about the importance of simulations and what-if analysis backed by sound MRM processes. An opportunity now emerges for banking risk managers to work on the efficiency, effectiveness and timeliness of their forward looking ERM and MRM processes, which will be much needed in the years to come for tackling the risks that come either from climate change or from the next pandemic.

4 / Source: Bank of Canada, Scenario Analysis and the Economic and Financial Risks from Climate Change

5 / Source: IFRS.ORG, IFRS® Standards and climate-related disclosures

author

Peter Plochan

Peter Plochan is the Principal Risk Solutions Manager at SAS. As a global domain expert, he helps organizations leverage the latest analytic technologies to solve their challenges around finance and risk regulations, enterprise risk management, risk governance, risk analysis and modelling.

Plochan has a Master’s degree in banking and is a certified Financial Risk Manager (FRM) with more than a dozen years of experience in financial sector risk management. Before joining SAS in 2014, he assisted various banking and insurance institutions with large-scale risk management implementations, including working internally and externally as a risk management advisor at PwC.

Peter is also a Risk Management trainer for PRMIA where he develops and delivers training on Model Risk Management and ERM & Stress Testing for the global risk community.

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