Recalibrating Risk and Compliance Frameworksamid the COVID 19 Onslaught – A US Banking Perspective

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Banking & Financial Services

The COVID-19 crisis is having a huge impact on the US financial system. As with any other crisis, the pandemic too will give rise to new risks that banks will need to factor in by modifying their risk and compliance frameworks and processes. This white paper analyzes the impact of COVID-19 on risk management in the US financial services industry and suggests measures to mitigate the effects.

Abstract

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Sweeping Relief Measures by the US GovernmentThe US government has introduced a number of measures to counter the negative impacts of the pandemic-induced lockdowns. Noteworthy among these are the $2.2 trillion relief package including direct deposits to households with low to medium levels of income, increased payout benefits to the unemployed, and loans to the small business segment (SMB) to restart their businesses. On the repayment front, the Coronavirus Aid, Relief and Economic Security (CARES) Act has suspended student loan repayments and interest accruals until September 2020. In addition, the CARES Act has prohibited lenders and loan servicers from foreclosing loans for a 60-day period while allowing the borrowers financially impacted by the pandemic to request forbearance for up to 180 days.¹

The CARES Act and other relief measures will affect the US banking and financial services industry, specifically the risk management function. Add to this, the weaknesses in areas of compliance, internal controls, operational risk management, model risk management, and/or data and IT infrastructure highlighted by the Supervision and Regulation Report released by the Federal Reserve System in Nov 2019. The report assigned a satisfactory or less-than-satisfactory rating to more than half the large US banks.² This underscores the need for US banks to acquire the necessary business agility to quickly review and modify risk and compliance frameworks and policies to better manage emerging risks.

¹Consumer Financial Protection Bureau, Joint Statement on Supervisory and Enforcement Practices Regarding the Mortgage Servicing Rules in Response to the COVID-19 Emergency and the CARES Act, April 2020, accessed May 2020, https://www.federalreserve.gov/newsevents /pressreleases/files/bcreg20200403a1.pdf

²Federal Reserve Board, Supervision and Regulation Report, Nov 2019, accessed May 2020, https://www.federalreserve.gov/publications/files/201911-supervision-and-regulation-report.pdf

Impacts on Risk and ComplianceThe COVID-19 crisis will have varying degrees of impact on different risk types and will also give rise to new risks. Banks must adapt their business strategies suitably to manage these new forms of risk introduced by the pandemic and respond dynamically to evolving business scenarios. In addition, US banks will need to establish appropriate control measures in their risk management frameworks to infuse the resilience required to withstand the COVID-19 onslaught.

Credit riskContinued lockdowns and social distancing norms are likely to financially destabilize consumers as well as businesses and cause unanticipated levels of credit losses for US banks despite the short-term liquidity provided by relief measures.

In response, US banks must review their credit policies and factor the impact into the credit risk models used across probability of default and credit loss estimation processes as well as portfolio stress testing and economic capital calculation. US banks must also review the credit approval policies as a number of customers and corporations are going to see a downgrade in their FICO scores and credit ratings. Banks must suitably calibrate stress testing models to generate stressed risk parameters which must be further fed into the predictive models for more accurate credit loss calculations.

Market riskStock markets globally have taken a beating due to the COVID-19 outbreak and the uncertainty associated with the duration of the crisis has only worsened the situation. None of the stress testing or simulation models used by banks would have factored in the impact from an event such as this. Market risk managers will face challenges in accessing representative data to model scenarios that could potentially emerge from the COVID-19 crisis and assess impact.

Banks will need to simulate historical data for risk factors by building upon similar market events, possibly the 2008 financial crisis. The data from the 2008 crisis can be used as a foundation to gauge the COVID-19 specific impacts as the volatility and impact on financial systems from both crises are similar.

Liquidity risk The COVID-19 outbreak will impact cash flows and liquidity across multiple dimensions. For example, some of the regulatory relief programs could cause consumers and small businesses to hold back on their contractual payments. At the same time, a higher usage of credit cards and withdrawals from unused credit lines to meet basic personal and business needs are likely.

Thus, reviewing existing liquidity risk computation engines is key. Changes in liquidity driven by deposit run off rates, credit line withdrawals, and contingent liabilities, in addition to revisions in expected contractual cash flows must be factored into the computation engines to better assess liquidity risk.

Operational riskThe COVID-19 pandemic has changed the way the financial system operates. The disaster recovery and business continuity frameworks of banks are being sorely tested. In addition, operational disruptions across people, process, and systems may cause both monetary and reputational losses. For example, under the CARES act, the onus of determining the eligibility of borrowers and conducting their KYC is on the banks. Executing these additional tasks in a crunched timeframe may lead to errors. Further, there could be additional operational costs and/or losses on account of enabling work-from-home infrastructure for employees; this could also expose banks to data security breaches. Moreover, banks may be unable to render services on time, resulting in reputational losses and misconduct related penalties.

Banks will need to review their existing processes by carrying out risk control self-assessments to factor in the new risk that may have originated from internal operational changes as well as changes to the customer-facing processes.

Interest rate riskThe Federal Reserve has cut the interest rates to zero (0-0.25%), which will impact economic value and the net interest income of US banks.³ In addition, the ongoing LIBOR transition program has put interest rate risk in the spotlight.

US banks will need to reevaluate their existing positions on floating and fixed rates and enhance their ability to dynamically design interest rate hedging strategies to mitigate potential losses. Banks could build in multi-level early warning indicators of changing liquidity positions and implement a set of hedging responses and recommendations based on business rules for some of the lower thresholds of volatility in cash flow positions.

³Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement, Mar 2020, accessed May 2020, https://www.federalreserve.gov/newsevents/ pressreleases/monetary20200315a.html

Financial crime Social distancing is likely to cause a surge in correspondent banking needs globally, increasing the probability of money-laundering. With multiple new online vendors offering contactless and home delivery services, the likelihood of fraud also goes up exponentially. Customers will be vulnerable to identity thefts and social engineering.

Banks will need to review their existing anti-money laundering (AML) and fraud controls and introduce multi-factor authentication, wherever feasible, to combat financial crime. Cognitive and machine learning driven solutions can act as an additional optimization layer for prioritizing alerts and detecting anomalies in customer behavior to identify ’false’ negatives.

Conduct riskFinancial stress can result in default, and at times, such default may be willful. Banks must review repayment policies and other terms and conditions and ensure that they align with the prevailing economic scenario to cut down the probability of conduct risk. In addition, banks will need to monitor employee behavior and performance metrics to identify possible instances of misconduct. In addition, acute financial stress among customers has resulted in high call volumes and significantly longer wait times. Customers can misinterpret this as misconduct on the part of banks. US banks must offer technology backed self-service capabilities to address customer queries in a timely fashion.

Evolving Regulatory Scenario In response to the crisis, highly stressed macro-economic numbers to cover severely adverse scenarios are likely to be incorporated into the US Comprehensive Capital Analysis and Review (CCAR) regulation. The inclusion of a scenario to cover the possibility of an economic downturn due to a pandemic cannot be ruled out. In addition, regulators expect US banks to review the scenarios used to run the half-yearly and internal portfolio stress tests to align to the COVID-19 context. For instance, the Fed prescribed an unemployment rate of 10% for severely adverse scenarios for the 2020 CCAR tests.⁴ However, based on our interactions with business leaders, we believe that the unemployment rates are likely to be as high as 20% post the pandemic. Similarly, the current expected credit loss (CECL) estimates for the largest US banks are expected to be significantly higher if a severely adverse economic scenario, similar to the financial crisis of 2008-09, is factored into CECL calculations. Regulators have extended the deadline for estimating the impact of CECL on regulatory capital by two years.⁵

4Board of Governors of the Federal Reserve System, 2020 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule, Feb 2020, accessed May 2020, https://www.federalreserve.gov/newsevents/pressreleases /files/bcreg20200206a1.pdf,

5Federal Reserve System, Regulatory Capital Rule: Revised Transition of the Current Expected Credit Losses Methodology for Allowances, Mar 2020, accessed May 2020, https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200327a2.pdf

ConclusionThe extent of damage to the US economy, and eventually the US financial system, is yet to be fully ascertained due to the evolving nature of the COVID-19 pandemic. Banks, however, need to factor in multiple scenarios that might arise, estimate the likely loss, and proactively make provisions to absorb the losses. We concede that no bank could have anticipated and established controls and frameworks to deal with an event of this magnitude. Nevertheless, reviewing risk policies and frameworks and factoring in the impact of these events into ongoing stress testing and capital management processes are critical for banks to withstand the crisis and emerge stronger in the post COVID-19 era.

About the Author

Manoj Reddy is the Head of the Risk and Compliance Practice, Banking, Financial Services and Insurance, TCS-North America. With over 16 years of experience across financial services, IT, and business consulting, Manoj has led several consulting and implementation engagements for the risk functions of global financial firms. He has provided both regulatory and strategic solutions to TCS’ clients over the past decade, primarily in the areas of enterprise

risk transformations, CCAR and Basel compliance, liquidity risk and credit risk management. He is currently leading TCS’ efforts in providing cognitive solutions for risk and regulatory problems in North America. Manoj holds a Master’s degree in in Business Administration with specialization in Finance and Marketing from the St. Joseph’s College of Business Administration, Bangalore, India.

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