Financial Risk Management: Practice and Governance in the COVID-19 Crisis

The COVID-19 pandemic surprised businesses and authorities around the world, and though banks were generally well capitalized before the crisis, they may be forced to tap into their capital and/or liquidity buffers at higher rates if the severity of the pandemic extends beyond current expectations. It is our view that once the crisis has passed, supervisory assessments of bank risk management will focus on whether bank management took action during the crisis that reflected strong risk management and governance approaches, and that considered the crisis’s impact on the firm’s business actions, risk appetite, and strategy. Supervisors are likely to focus on capital, loss provisioning, and liquidity processes — specifically on the quantitative and qualitative aspects of provisioning for the allowance for credit losses (ACL) or the allowance for loan and lease losses (ALLL), stress test results, and measures of capital and liquidity adequacy. These estimates are crucial to strategic and risk decisions critical for the future growth and risk profile of banking organizations.

Given the extraordinarily steep decline in economic activity, as well as the unique circumstances generating the shock to the economy, it’s our view that expert judgment will have an unusually large role in models affecting bank financials, business decisions, and risk assessments. It will be critical for organizations to have well-governed processes for generating financial estimates to properly manage risk, make sound strategic decisions, and maintain the confidence of investors and regulators. In this paper, we outline three particularly important actions that financial institutions should take when considering their current and future financial risk management activities:

Assess and qualitatively address the limitations of existing financial risk measures using expert judgment and tools such as sensitivity analysis and benchmarking
Develop stress tests and scenarios that are relevant and reflect the crisis
Ensure a robust governance approach adequate to address the unique challenges of the current crisis, including clear analysis of the sensitivity of estimates to key assumptions