The changing shape of bank credit risk post-Covid‑19

As banks and fellow market participants manage a return to some sense of normality following 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 in a position of relative strength, particularly from a capitalisation standpoint. Fitch’s initial analysis of the sector resulted in some ratings downgrades, but government support during the pandemic helped the industry sidestep much of the potential harm from this unprecedented event.

“The downside risks for banks were counterbalanced by the massive relief efforts instituted by national authorities and central banks,” explains Monsur Hussain, head of financial institutions research at Fitch Ratings. “Borrowers benefited, through the banks, from substantial government support programmes. Bank balance sheets did not materially inflate and risk-weighted assets remained fairly stable.”

While the mood remains positive going forward, there are some downside risks, according to Hussain. This includes the continued potential for rising defaults, which would increase provisions on banks’ balance sheets, particularly as government support and forbearance measures unwind.

“A strong data infrastructure is vital as it underpins a bank’s ability to understand the risks it is facing … Data should be readily available and easily aggregated”

ECB statement published in May 2021

Regulators have also taken a more flexible approach to the introduction of new rules that entities had expected to be implemented during the crisis, or in the months and years afterwards. For example, the Basel Committee on Banking Supervision moved quickly to delay the implementation date of the final Basel III updated standards due to come into force on January 1, 2023. In the relatively early stages of the pandemic, it announced a year-long pause to account for Covid-related disruption. 

Banks were also provided with some flexibility to pierce capital buffers. This leniency was designed to allow banks to respond to their immediate financial stability priorities and ensure they can continue to lend, Hussain explains. “What we have found is that most banks haven’t done this, mostly because doing so would have meant they would have to suspend distributions, which includes payments on additional tier one instruments.” 

“Ultimately, the standardised approach is what’s going to underpin how banks estimate their capital requirements … Gaining a full understanding should be front and centre for banks going forward”

Monsur Hussain, Fitch Ratings

Digital transformation 

An industry trend that has been supercharged by the pandemic is the digitalisation of the financial services sector. For credit risk management systems and processes in particular, this has boosted the amount of data that banks need to incorporate into their systems for counterparty assessment. 

This is nothing new for banks, however. There have been a number of regulatory changes that have affected data use and management 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 capabilities. 

More recently, in a review designed to examine the impact of Covid‑19 on how banks are managing credit risk, the European Central Bank (ECB) highlighted the need for banks to strengthen their systems in this area. “A strong data infrastructure is vital as it underpins a bank’s ability to understand the risks it is facing,” the ECB said in a statement published in May 2021. “Data should be readily available and easily aggregated.” 

However, it voiced concerns about the ability of “some banks” to aggregate data and the potential impact that could have on developing comprehensive credit risk assessments. “These weaknesses also result in poor management information, which in turn makes it difficult for executives to make informed decisions,” the ECB said. 

All of this underlines the ongoing nature of data-related development in the financial services space. “The shortcomings identified by the ECB reflect the fact that change is ongoing in this area,” Hussain says. “And, in line with the impact of the pandemic on this wider digitalisaton megatrend, it is clear that how banks use data is becoming even more important.”

“The downside risks for banks were counterbalanced by the massive relief efforts instituted by national authorities and central banks”

Monsur Hussain, Fitch Ratings

Banks are likely to gain more insight into solid, long-term requirements in this area as the final Basel III reforms are translated into legally binding national legislation by local regulators in the coming year. “It will be important for banks to fully understand the exact shape of those rules and how the requirements will be fleshed out in the legislation before they can fine-tune 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 impact banks’ internal data infrastructure. Although these approaches will lead to a more accurate risk assessment process, more detailed data will be required from a greater range of sources.

The standardised approach, in particular, should now be firmly on banks’ radars, particularly since advanced models have historically received more attention. “Ultimately, the standardised approach is what’s going to underpin how banks estimate their capital requirements,” Hussain says. “Gaining a full understanding should be front and centre for banks going forward.”

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