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

An economic crisis situation, like the Covid19 one, has serious implications for financial institutions around the world. With the arrival of IFRS 9 ECL / CECL impairment standards, banks have to work now even harder to assess the potential financial impact of such crisis on their balance sheet & portfolios and take risk mitigating decisions accordingly.

These new standards and other keys banks’ processes are backed by models with assumptions that prevail in normal times however 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 Capital & Liquidity perspective banks have been well prepared for recession thanks to the to the capital buffer build-up initiatives we have seen after the 2008-2009 crisis and the excess liquidity funneled by the central banks into economy & financial system.

The following pandemic waves are putting these regulatory actions to test and will require banking risk managers to come with more pro-active forward-looking risk mitigating measures.

Furthermore, the emergence of Climate Change related Financial Risks and the related regulatory initiatives are creating yet another set of challenges for ERM professionals to address

Fortunately, there are couple of lessons learned from the pandemic developments that can help banks to better prepare for the upcoming Climate Change crisis.

Lesson Learned #1: Plan is nothing, but Planning is everything

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

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

With such insight at hand, banks can identify the optimal risk mitigating action and take impact-aware decisions in order to navigate through the volatile & uncertain times.

The Forward Looking What If perspective

From now on, the attention towards 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 the Unexpected Credit Losses

Both IFRS 9 ECL and US GAAP CECL forward-looking standards have been designed as a response to the 2008-2009 financial crisis with the objective to capture the risks on the horizon much earlier in the bank’s financial statements. And 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 & sensitivity embedded in these standards.

The leading global regulators like European Central Bank and Bank Of England published concerns about the potential pro-cyclical effect of these standards and asked the banks to apply their IFRS 9 methodologies & models with caution and do not let them run wildly.

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

Therefore, it is crucial for banks to fully understand & own their (C) ECL 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 (below)

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 & 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.

Lesson Learned #3: Keep your models at bay

The crisis times can expose the various models used by banks to new stressed data the models might not have been familiar with. As a result, the statistical soundness and relevancy of important models 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 can they take and how fast can they respond to ensure that their models do not push them into wrong business decisions.

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

The way forward to tackle the “Green Swan”

The recent regulatory climate risks regulations and climate risk stress testing initiatives are clear example of the attention given to the Climate Change by the 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

Similarly, to the pandemic experience, with climate change banks have to look forward to future but over much longer time horizons and with much broader range of risk drivers & scenario factors and involved uncertainty.

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

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

One of the key challenges for banks will be to establish a clear relation between climate change scenarios and their ECL methodologies that will be in line with the regulatory expectations. Learning from Covid 19 crisis, banks should be prepared to address & explain any unexpected volatility of their ECL and P&L caused by the 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 history data that could be used for training these news models. Therefore banks need to pay close attention to the risks arising from these new models and include them from the start into the scope of their MRM activities. 

Parting thoughts

It will be interesting to observe over the coming years how the banking industry will cope with the challenges arising from Climate Change.

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

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