The COVID-19 pandemic has revealed unexpected flaws in the business models that banks rely upon. How can they best address this challenge?
The COVID-19 pandemic is taking a terrible toll in human life and in the livelihoods of millions the world over. As people and institutions struggle to contain the spread of the virus, the measures necessarily imposed have caused major economic disruptions. Every industry has been affected, and banking is no exception. Capital, profit-and-loss, and liquidity positions have been hit very hard. One consequence has been that banks’ models have broken down across their business. The flaws have put the reliability of these models in doubt and suggest that they cannot be trusted to help banks navigate through the crisis.
Few business leaders could have foreseen a global economic shutdown of this magnitude. The models that financial institutions depend on to run their businesses simply did not account for such a crisis. Most models are almost by necessity designed to predict a stable future. In truth, the real failure is not that banks used models which failed in this crisis but rather that they did not have fallback plans to manage when the crisis did come.
There are a number of reasons for the failures. First, model assumptions and boundaries defined at the design stage were developed in a pre-COVID-19 world. Second, most models draw on historical data, without the access to high-frequency data that would enable recalibration. Finally, while access to the needed alternative data is theoretically possible, models would not be able to integrate the new information in an agile manner, because the systems and infrastructure on which they are built lack the necessary flexibility.
Banks are experiencing ever more model failures, and further issues can be expected with time. Financial institutions must now urgently review their model strategies. They need to develop and apply both efficient short-term actions and a long-term plan to improve model resilience. Over two prioritized time horizons, banks can carry out coordinated model adjustments to enable business continuity in the short term while reviewing their model development and redevelopment needs and upgrading their model-risk-management (MRM) frameworks over the longer term.
COVID-19 has affected model reliability across all bank functions and operations
Model issues are not confined to one business or function but instead have emerged in every aspect of a bank’s operations. The effect on standard operations is widespread:
The short-term effects on regulatory models, including those for the IRB approach, IFRS 9, and stress testing, are expected to be partially neutralized by regulatory and supervisory flexibility.1 We do anticipate further guidance in the future. Inevitably, banks will have to adjust their data and methodologies to reflect the new normal.
Inevitably, banks will have to adjust their data and methodologies to reflect the new normal.
By contrast to the effects on regulatory models, the impact of the COVID-19 crisis on business models was immediate. Their failure has rendered them useless for supporting decision making in the crisis. Banks must urgently address the model failures and make needed adjustments to avoid having to rely only on the analysis and judgment of experts.
The speed of banks’ reaction to the crisis has triggered new risks
Like companies in other sectors, financial institutions were unprepared for a locked-down economy and have scrambled to adjust. Rapidly, they are taking model-mitigation actions, often in an uncoordinated way. The rushed actions include the following:
These mitigation actions have been hampered by short implementation timelines, a lack of access to alternative data sources (such as high-frequency data), and the absence of an underlying agile operating model. This last obstacle prevents banks from addressing arising changes with timely adjustments on an ongoing basis. The result is that the mitigation actions themselves are generating a host of new risks:
Banks need to do more than act efficiently in the short term to manage the crisis. They must also prevent short-term solutions from becoming long-term problems by taking a step back and developing a coherent and resilient model strategy.
What strategies should financial institutions now be putting in place?
To address the challenges thrown up by COVID-19 and the risks of quick-fix solutions, banks should develop their two-phase strategy. The first phase is a short-term crisis-operating mode for MRM, and the second is longer-term comprehensive enhancement of the MRM strategy to increase resilience and enable proactive adjustments to arising changes.
Phase one: Moving to a crisis-operating mode for model-risk management
In the first phase, banks focus on effectively adjusting models to make them fit for purpose and mitigate the risks of poor business decisions. The adjustments should be made quickly but also efficiently and consistently to avoid undue redevelopment or readjustment costs.
We recommend that a dedicated taskforce be created to lead banks in crisis-operating mode. To run the MRM crisis response effectively in a highly disruptive situation, the team should have clear governance, a disciplined operating model, and useful MRM tools. It will lead a rebalancing effort away from business-as-usual activities to crisis activities. Taking an agile approach, the team should perform a quick and effective MRM review. Using clear methodologies and its MRM tools, including model inventory and an MRM crisis-response dashboard, it can then develop and implement a well-organized crisis-response plan. We recommend that this consist of four parts:
Phase two: Moving to the next level of the model-risk-management journey
Banks need to use MRM in a more strategic and fundamental role, as banks move proactively to manage their portfolios of models. The purpose of MRM will be to enhance business efficiency and management decision making while increasing the resilience of the model landscape.
To enhance their MRM, banks should develop solid framework elements to inform business and strategic decisions. While MRM will add value in a number of ways in the current situation and the overall model strategy, the following core elements can be considered essential: