Addressing modeling and scenario-analysis challenges as the pandemic impacts the economy
COVID-19 Impact on Modeling and Forecasting
The COVID-19 outbreak is foremost a human tragedy that affects millions of people and is reshaping industries. It has enormous impact on the economy and financial markets and therefore on almost all models used by financial institutions. Real GDP in the Euro area and UK is expected to decrease 5%-10% in 2020. Financial markets are driven by high volatility and diverse liquidity. Credit risks substantially increase for some sectors. At the same time a few sectors, such as healthcare, show virtually no risk impact.
Capital and liquidity models applied in ICAAP/ILAAP are challenged, and the newly introduced IFRS 9 standards may have undesired procyclical impact. Supervisory authorities for European implementation of Basel 3 / Solvency 2 (EBA, ESMA, EIOPA) therefore decided to take a variety of countercyclical measures for the longer term. At the same time they want to be adequately informed about most material risks and vulnerabilities driven by the crisis.
Protiviti's Model Risk Practice encompasses model governance and development, validation and audit. Given the changing regulatory requirements, we can help with developing economic scenarios for stress testing, forecasting and reserving. Our deep experience validating and auditing models, allows to anticipate where models will break and develop solutions to effectively forecast in these challenging times. We can assist adjusting SREP/ORSA, Recovery Plans, Exit Plans and Resolution Planning. For true foundation, a Model Contingency Plan can be developed.
As models are updated and changed, detailed documentation must be maintained to show appropriate model risk management controls and challenge by business leaders. Where models have been validated for a different purpose, we can use existing information to accelerate the validation process for new uses in a cost-efficient manner.
Model Risk Management experts from Protiviti across Europe have developed different services to evaluate and adjust your model landscape during these challenging times for the short and medium term.
Our model risk advisory offers you the following 4 model solutions:
Early view of how the global pandemic affects models
The pandemic has changed the way we look at a financial institution’s balance sheet temporarily, but from a risk perspective also in the longer term. Many mitigating countercyclical governmental and supervisory measures followed. This has created a totally different landscape. A priority should be: having a good overview of how business, risk, model governance and reporting is impacted. Key for this is the knowledge of which models are impacted due to changed parameters and changed regulatory requirements.
Models that fail due to the impacts of the pandemic
As extreme macroeconomic factors and financial market indicators become the actual data used for modeling and back-testing, models will need to be updated partly. For example, when looking at credit risk and IFRS 9, many macro variables, legal and collateral quality assumptions are now heavily tested. Depth and length forecasts of the pandemic and the volatility in those differ throughout the market. However, a recovery is expected in 2021. Present EC expectations are real GDP to drop between 5.4% and 9.7% in 2020 in the euro area and UK. Swiss government expects GDP to drop 1.3%. Further the EC expects several countries to experience deflation, and on average unemployment to increase by 2%. In their Coronavirus Downside Scenario Risk Heat Map, Fitch expects high impact for the oil & gas industry, airlines, and virtually no impact for healthcare & pharmaceuticals, utilities. Several sectors receive support, and relief measures are taken, such as moratoria on repayment of loans and partly loan guarantees. As shipments do not arrive, credit insurance policies may be triggered. The value of collateral may have depreciated substantially. The definition of default has changed, temporarily. Loan terms have been adjusted. All these can be inputs for a credit loss model, which needs to be recalibrated or even redeveloped.
Developing scenarios to support management information during the pandemic
As economic indicators fall, institutions will be challenged to forecast a deepening crisis and the impact of the lower trough on the eventual recovery. Assumptions used for budgeting, business risk and strategy scenarios no longer hold. Baseline, adverse and severely adverse COVID-19 scenarios must be considered for planning and budgeting, allowance estimation. Effective action plans can minimize credit losses, while maintaining liquidity and overall financial strength. The forward-looking component of IFRS 9 as well as the stress testing component of the regulatory framework will need to be adapted even under mitigating counter-measures by supervisory authorities.
The pandemic triggered risk measures defined in the model risk management (MRM) framework
As many requirements and warning indicators fail or are triggered, management action is required by policy. A response may be to recalibrate models, to replace or adjust by expert opinion, or to redevelop a model, to cope with the new environment, which old models did not cater for. This can lead to an unintended sliding scale of accepting more risk going forward. This necessitates the application of a solid control environment, with an independent view.
How We Can Help beyond Model Services
We are With You All the Way
As the financial services industry responds to the unprecedented level of disruption caused by COVID-19, Protiviti’s experienced team of lending, risk, compliance, technology and operations professionals are actively providing solutions that address our clients’ immediate and near-term challenges as well as future resilience efforts.
Our capabilities include:
How Protiviti Can Help
Want to know more about this topic or learn how Protiviti can help your organization overcome regulatory compliance challenges? Please contact one of European offices.