Gearing up for a shock helps financial institutions ensure their risk management processes also perform optimally when calm prevails.
As the Covid-19 pandemic at last begins to abate, we have a chance to step back and consider the lessons it can provide on the risks we all face, and on how difficult it is to evaluate and quantify risks of all sorts. Not only are we surrounded by uncertainty, but the uncertainties are themselves uncertain. As 2020 began and bank risk managers pondered what dangers might be lurking, a virus that soon would engulf the world could not have been high, or maybe anywhere, on the list. Yet the pandemic became a source of myriad financial risks last year, particularly a sudden reduction of liquidity. While its effects may be growing less acute, they are likely to linger in various ways. A positive one could be a new appreciation of the complexities of risk that could lead to a better understanding of how to protect against it.
The pandemic may be a once-in-a-lifetime event, yet one lesson of history is that shocking, damaging, once- in-a-lifetime events happen quite often, at great cost to financial institutions. Their origins can be natural – a flood, earthquake or similar sudden disaster – or else a slow-motion threat like climate change with natural and man-made elements. Catastrophes that imperil the financial system also may arise from geopolitical instability or from self-inflicted wounds, as during the 2008 crisis.
When a crisis occurs, it can have a major impact on an institution’s liquidity and capital, either directly or through effects on firms it does business with, or on the economy and financial system. The correct response is to act before action is needed – to prepare for a black swan before it descends from out of the blue. That requires a strategy of maximum flexibility that allows trouble to be spotted as soon as it arrives, if not before; that facilitates a prompt, accurate assessment of the issue and its impact on liquidity and capital; and that generates a range of possible responses to the problem and to fresh demands imposed by regulators. It is a tall order, but, when filled, it will leave institutions better able to withstand a crisis, and to operate when conditions return to normal, too.
Liquidity during and after a shock
A lesson from previous shocks is that liquidity levels typically return to normal within a year or so, and that the year is an eventful one. There are shifting macroeconomic variables, cash flow challenges and changes to funding requirements due to central bank and government measures. The immediate impact on liquidity is tied mostly to how, and how quickly, market conditions deteriorate. A surprising tendency is that quality provides little refuge; investment-grade assets are affected almost as fast as riskier ones. Indeed, liquidity can vanish even for assets presumed to be risk free.
As the liquidity backdrop improves, the focus turns to credit risk and its anticipated effect on cash flows. It is essential to avoid understating short-term flows and overstating longer-term ones. Adopting a prudent view of the credit position, partially discounting the effect of government support programs, such as those that push institutions to allow postponement of loan payments, may offer a more realistic view of the situation.
The cash-flow disruption is likely to damage medium- and long-term liquidity balances, making it vital that a portfolio has the right mix of assets from a liquidity standpoint. History tells us that when choosing between excess liquidity with lower returns, and less liquidity with optimized returns, most institutions go for the latter, even during a crisis.
How to optimize liquidity management
An institution must monitor liquidity daily and produce ad hoc reports as events occur. After a significant external shock, such as a pandemic or natural disaster, tools are needed to assess the situation immediately and take appropriate measures to ensure business continuity.
Processes related to liquidity management must be run multiple times per day to monitor evolution of the liquidity position and analyze the effect of mitigation measures in response to the shock.
These processes must be combined with others. Liquidity must not be viewed as a standalone issue but holistically, in the context of risk management writ large. Institutions that have taken steps to integrate systems and operations, and that have embraced more stringent stress-testing regimes for compliance and business purposes, are well on their way to possessing the flexibility and skill to respond swiftly and effectively to a crisis. They stand the best chance of coping, while gaining an edge over less prepared rivals.
But they may not be where they need to be just yet. While shocks to the system arrive suddenly, they can persist and evolve, presenting fresh challenges. It is vital, then, that risk managers not let their guard down as the Covid-19 pandemic peters out. They should gear up for the next crisis – or for whatever the present one still has in store. One useful step is to ensure that they have automated processes as much as possible. Another is to expand stress- testing frameworks to incorporate a broader range of risk types in a coordinated fashion, assessing each risk in the context of others, not in isolation. Some chief risk officers acknowledged before the pandemic that their stress- testing capabilities were not as sophisticated as they would like, or were insufficiently integrated. These shortcomings no doubt have proved costly over the last year.
Benefiting every day by preparing for a once-in-a-lifetime event
The pandemic is a unique event for most of us, and we can only hope it stays that way. But it is also the latest example of a conundrum as old as humanity: how to factor into our thinking a development that is extremely unlikely but extremely harmful when it occurs. It may seem like a necessary evil – but an evil all the same – to devote significant resources to limit the impact of such a low- probability outcome. But weighing risks and rewards, and optimizing liquidity and capital positions, is no one-off for a financial institution. It is an everyday endeavor.
Risk managers may have spent the last year handling the pandemic chiefly as a matter of regulatory compliance, but they can apply the lessons they have learned, and the changes they have made, to running their operations more effectively as calm returns. Implementing holistic stress- testing capabilities is valuable in the ordinary course of business, not just in a crisis. It creates better control of an institution’s risk appetite and a better understanding of the behavior of its portfolio. Maintaining a holistic view, combined with pre-trade analytics that, for instance, allow comparisons of cash and derivative instruments, provides necessary insights to balance liquidity and returns to maximum advantage.
Leveraging available information gleaned from crisis management for use in less fraught circumstances can help set risk constraints and optimize portfolios on the asset and funding sides alike. One possible approach is to start the journey with a multitude of scenario analyses and narrow them down from a risk perspective to obtain the best balance-sheet composition. A bank also could run regulatory scenarios and content within the same holistic, enterprise-wide risk engines. The result would be a tool that determines the ideal portfolio, as well as the underlying risk strategy. Adopting such a comprehensive, multipurpose approach would allow an institution to prepare for the next shock to the system, while meeting business objectives during the much longer – if we are lucky – period of peace and quiet that we will enjoy in the meantime.