The evolution of post-Covid-19 bank credit risk

As banks and other market participants manage a return to some sense of normalcy after the Covid-19 pandemic, what are the likely long-term implications for data and credit risk management?

The banking sector entered the Covid-19 pandemic from a position of relative strength, especially from a capitalization perspective. Fitch’s initial analysis of the sector resulted in some degradation of notes, but government support during the pandemic helped the industry avoid much of the potential damage from this unprecedented event.

“The downside risks for banks have been offset by massive relief efforts by national authorities and central banks,” said Monsur Hussain, head of financial institutions research at Fitch Ratings. “Borrowers have benefited from significant government support programs through banks. Bank balance sheets have not swelled significantly and risk-weighted assets have remained fairly stable. “

While the mood remains positive for the future, there are downside risks, according to Hussain. This includes the continued potential for increased defaults, which would increase provisions on banks’ balance sheets, especially as government backing and forbearance moves.

“A strong data infrastructure is vital because it underpins a bank’s ability to understand the risks it faces… Data needs to be readily available and easily aggregated.

BCE press release published in May 2021

Regulators also took a more flexible approach to introducing new rules that entities expected to be implemented during the crisis, or in the months and years that followed. For example, the Basel Committee on Banking Supervision acted quickly to delay the implementation date of the Basel final III updated standards due to go into effect on January 1, 2023. In the early stages of the pandemic, he announced a one-year hiatus to account for Covid-related disruptions.

Banks have also benefited from some flexibility to pierce the capital cushions. This leniency was designed to allow banks to meet their immediate financial stability priorities and ensure they can continue to lend, Hussain explains. “What we found is that most banks didn’t, mainly because that would have meant they would have to suspend distributions, which includes payments on additional level one instruments.”

“Ultimately, the standardized approach is what will underpin how banks estimate their capital requirements… Gaining a complete understanding should be at the forefront for banks going forward.”

Monsur Hussain, Fitch Ratings

Digital transformation

One industry trend that has been supercharged by the pandemic is the digitalization of the financial services industry. For credit risk management systems and processes in particular, this has increased the amount of data that banks must integrate into their counterparty rating systems.

This is nothing new for banks, however. A number of regulatory changes have affected the use and management of data in recent years. This has included the shift from bilateral derivatives trading to over-the-counter and exchange-cleared transactions using a central clearing counterparty. Such changes have led to a general re-examination of data infrastructure and governance capacities.

More recently, in a study to examine the impact of Covid-19 on the way banks manage credit risk, the European Central Bank (BCE) stressed the need for banks to strengthen their systems in this area. “A strong data infrastructure is vital because it underpins a bank’s ability to understand the risks it faces,” the BCE said in a press release published in May 2021. “Data should be readily available and easily aggregated. ”

However, he expressed concerns about the ability of “some banks” to aggregate the data and the potential impact this could have on developing comprehensive credit risk assessments. “These weaknesses also translate into poor management information, which makes it difficult for leaders to make informed decisions,” he added. BCE noted.

All of this underscores the continuing nature of data-driven development in the financial services space. “The shortcomings identified by the BCE reflect the fact that change is happening in this area, ”says Hussain. “And, consistent with the impact of the pandemic on this larger digital megatrend, it’s clear that how banks use data is becoming even more important.”

“The downside risks for the banks have been offset by the massive relief efforts put in place by the national authorities and central banks”

Monsur Hussain, Fitch Ratings

Banks are likely to gain a better understanding of the strong and long-term requirements in this area as the final version of Basel III reforms are translated into legally binding national legislation by local regulators over the coming year. “It will be important for banks to fully understand the exact form of these rules and how the requirements will be fleshed out in legislation before they can refine their data disclosure and reporting systems,” Hussain adds.

The introduction of a more risk-sensitive approach to credit assessments under the new standards, as well as advanced calculations for risk-weighted assets, will undoubtedly have an impact on banks’ internal data infrastructure. . While these approaches will lead to a more precise risk assessment process, more detailed data will be required from a greater number of sources.

The standardized approach, in particular, should now feature on bank radars, especially as advanced models have historically received more attention. “Ultimately, the standardized approach is what will underpin how banks estimate their capital requirements,” Hussain said. “Gaining a full understanding should be a central concern for banks in the future. “