COVID-19 has set the wheels off of the global economy and derailed it, and the global economy is experiencing high risks. The financial institutions are, however, adapting to the new normal by redefining financial risk management practices and frameworks.
Impact of COVID-19 on the Global Economy
The ongoing COVID-19 pandemic has severely impacted the economy of almost all the countries of the world. According to the data released by The Ministry of Statistics and Program Implementation, the economic effects of Covid-19 resulted in India suffering the maximum GDP contraction in the quarter from April to June 2020 of 23.9%, while Spain reported a contraction of 22.1%, the United Kingdom of 21.7%, and the United States a GDP contraction of 9.1%.
The devastating consequences of the coronavirus pandemic on the global economy have sent the policymakers thinking. They are redefining the financial management processes to save and boost up the economy, including lowering the interest rates, injecting liquidity, and managing risks. Investors are also rebalancing their portfolios to increase asset diversification and reduce risks.
The pandemic and its effects have underlined the changes that need to be undertaken in financial risk management to keep up with the challenging times. The existing financial risk management frameworks lacked in terms of agility and effectiveness. They had to be revisited in response to high volatility, poor credit quality, and other challenges brought about by COVID-19.
The challenges faced by financial institutions cover varied categories of financial risks. All these segments have been impacted by COVID-19 and undergoing redefinition by the financial institutions, policymakers, and regulators.
Credit Risk
Many banks and financial institutions even pawn loans have offered credit extensions and payment deferrals in response to the coronavirus pandemic. The businesses of all sizes are left threatened and financial markets are highly volatile. As a result, credit risks have increased manifold, with higher chances of default, drawing down of credit facilities, and downgrading credit.
Even after the pandemic has passed, the volatility and credit risk are here to stay. Therefore, credit financial risk management needs to be redefined and for good. The credit rating models will require complete recalibration to imbibe the new risk factors related to impacted industries and products. Early warning signals and quantitative information will be needed to test the stress of portfolios across all risk levels. Additionally, the process of credit risk analysis, impact of surroundings on the creditworthiness, and review and response are to become rapid, timely, real-time, and dynamic. The quick response and adjustments will help gauge the gaps faster and fill them before they cause significant repercussions.
Market Risk
The coronavirus pandemic has impacted the stock markets significantly and increased market risk multiple times. The financial markets have plunged, and volatility has shot up across all asset classes, including equities, foreign exchange, and commodities. The S&P 500 index witnessed a drop of more than 7% compared to its previous levels, the treasury rates fell substantially, credit default spreads widened, and interest rates became highly volatile.
Due to the increased risks, higher uncertainty, and greater concerns of corporate defaults, the fair values of assets and liabilities have also undergone significant changes. Therefore, the stressed market risk environment called for better risk measures and limiting of breaches. The financial institutions are reworking their market financial risk management protocols with respect to the reallocation of limits, fair value adjustments, scenario analysis, and closer monitoring of CVA movements. The banks are expected to follow supervisory measures to reduce the impact of prudent valuation and redesign of the entire framework to overcome the cyclical methodologies.
Operational Risk
COVID-19 and the resulting lockdown have pushed many organizations to ask their employees to work from home. The arrangement seems to be the only alternative in the current scenario, but it has led to new sets of operational risks, related frauds, lack of regulatory compliance, and the need for distinctive processes, systems, and regulations.
As a result, most of the sectors, including financial institutions, are looking to enhance their operational resilience framework. The redefined framework should bring about a balance between cost-cutting and carrying on smooth business operations. The financial institutions need to revamp their capabilities to manage technology risks, cyber risks, human capital risks, and risks related to organizational reputation. The organizations are working towards making their operational environment more immune to economic and other uncertainties and remain able to continue business as usual.
Liquidity Risk
The coronavirus pandemic has impacted employment gravely. Over 649,000 people lost their jobs between March and June in the UK itself, with unemployment expected to reach 2.5 million after the COVID-19 slump. Additionally, thousands of workers in the UK are on furlough. The government has introduced multiple support schemes and programs. Yet, the financial institutions are facing severe liquidity financial risk management issues due to deferred loan repayments, massive drawdowns, and high margin calls.
Therefore, the liquidity financial risk management framework needs to be redefined during these uncertain times to make the systems more robust. The financial institutions must revisit their liquidity assessment procedures and stress-testing models and modify them according to the new reality. Moreover, the financial institutions should keep a liquidity buffer and contingency plans for unforeseen situations and improve the timeliness and readability of their crisis reporting.
Regulatory Risk
With the rapid and continuing spread of the coronavirus pandemic, the older regulations have almost lost their meaning and efficacy. Most of the industries, including technology, logistics, pharmaceutical, and entertainment, are experiencing regulatory risks; however, banking and financial services are at the helm of it. The financial institutions function under stringent regulations and are suffering the most of compliance and regulatory concerns.
Financial Institutions in countries like the UK are undertaking regulatory changes in response to COVID-19. The regulators, including the FCA, have laid down the revised guidelines to ensure that the companies continue to meet their regulatory requirements and operate efficiently. The FCA, HM Treasury, and Bank of England have declared that they will review the contingency plans of the financial institutions to ensure that the companies are dealing with regulatory risks effectively.
Thus, the financial institutions are bearing the direct brunt of these unprecedented times. However, the industry is evolving quickly in response to the pandemic as a second wave hits other countries. Multiple measures have been implemented for immediate financial risk management and to support the way forward even after the shock of disaster has passed.
