Volume 14 (2021)

Each volume of Journal of Risk Management in Financial Institutions consists of four 100-page issues, published both in print and online.

The papers and case studies confirmed for Volume 14 are listed below:

Volume 14 Number 4

Editorial
Julie Kerry, Publisher
Papers
Fixed-Income ETFs: A liquidity illusion?
Anando Maitra, Head of Systematic Fixed-Income Research and Credit Portfolio Manager, Lombard-Odier Investment Managers and Stephen Satchell, Trinity College, Cambridge

Exchange-traded funds (ETFs) have revolutionised the asset-management industry with high liquidity and low bid-asks allowing investors to access a diversified portfolio cheaply. The desirable liquidity characteristics of ETFs are, however, in contrast with their behaviour in crisis periods. This paper studies the breakdown in the fixed-income ETFs (FIETFs) market, during the peak of the COVID-19-driven liquidity shock of March 2020. We argue that FIETFs provide an illusion of liquidity and the liquidity mismatch between the ETF and the underlying manifests itself in terms of very significant differences between the price and the net asset value (NAV). We run a further analysis on the dislocation by comparing it with equity ETFs. Comparisons suggest that the cost of liquidity is very high for fixed-income ETFs with significant tracking errors during volatile periods in contrast with the better-behaved equity ETFs. Further analysis on the performance patterns of FIETFs indicates that both the price and NAV might have deviated from fundamentals with an overreaction in the ETF price accompanying an underreaction in the NAV. We also study the phenomena of ‘dealer inventory management’. FIETFs are uniquely different from equity ETFs in that the authorised participant (arbitrageurs) tend to be the large banks that are also market-makers in the underlying securities. Therefore, we show that the incentives of the arbitrageurs may not always be aligned towards arbitraging the price-NAV differential. In a novel empirical study using trading volumes and position changes for the largest corporate bond ETF (LQD), we suggest that inventory management by the larger broker-dealers may have exacerbated the dislocation. We believe that the conflicting objectives of dealers have further increased due to high balance-sheet costs imposed upon them post the global financial crisis. Finally, we propose the use of derivatives, in particular credit derivatives, for the risk management of liquidity shocks. We show that the drawdown from rapid liquidity shocks can be reduced significantly through exposure to credit convexity.
Keywords: liquidity shocks, dealer inventory management, risk management, credit convexity, exchange-traded funds
COVID-19 government support reinforces zombification
John Lorié, Chief Economist and Iulian Ciobica, Economist, Atradius

We investigate the effect of government support on firm zombification during the COVID-19 crisis for Belgium, Germany, Spain, France, United Kingdom, the Netherlands and the United States. For this purpose, we use a simple model that links insolvency developments at the macro level to GDP developments. We first observe from the data that insolvencies have declined during the crisis despite economic contraction. We then use the model to calculate the total firms saved from insolvency by government intervention and the fraction of which are not healthy, the zombies. It appears that government intervention has been effective in saving firms during the height of the crisis in Q2 of 2020. The impact is smaller in Q3 when the recovery set in. But it comes at a cost of efficiency as it causes significantly higher zombification in the economy. The effect can be seen in both quarters, most notably in Belgium. In Germany and the Netherlands, zombification was low in Q2 but soared in Q3. The reverse effect was visible in Spain as the number of insolvencies picked up in Q3. Therefore, government intervention during the crisis has reinforced the existing trend of zombification there. With government support only gradually withdrawing in the recovery phase of the crisis and probably further pushing up the number of zombie firms, risk management faces the challenging task of detecting them. We offer a few suggestions. These are based on the classification of zombies, including ICR and Tobin’s q, as well as research on underlying drivers. Compared to the sector median, zombies appear smaller, less productive, slower growing, with lower investments and higher leverage despite higher equity issues and implied interest rate subsidies. Complementary to this market-based information, more proprietary, higher frequency data such as payment behaviours, revenue growth pace change, credit sourcing, bank covenant compliance and management competencies can be monitored using scorecards. Finally, we recommend a high level of vigilance and an additional provisioning to anticipate any delayed effects of the crisis.
Keywords: zombie firms, COVID-19 crisis, modelling insolvencies, government support, risk management
Shifting paradigms: Regionalisation and the post-COVID-19 risk matrix
Guillaume Barthe-Dejean, Director of the Chairman’s Office, SK Group

The COVID-19 pandemic has exacerbated long-standing tensions in our international system and thrown globalisation into existential doubt. This paper argues that we are unlikely to return to the precrisis status quo and that our emerging global order will instead be hammered into shape by rising state interventionism, systemic rivalry and a growing momentum towards regionalisation. It then argues that regionalism will see a shift from ambitious free-trade and market integration efforts towards the formation of flexible regional arrangements that are more geostrategic and defensive in nature. Going forward, the above geopolitical transitions will disrupt supply chains, generating significant economic instability and systemic risk. This is a particular concern for the financial industry given its higher degree of integration globally. The paper then finally considers how supervisory authorities and financial institutions can prepare for the new normal and mitigate the expected surge in postcrisis regulation. This paper will be of interest to policymakers, risk management professionals and anyone interested in exploring global transitions in the post-COVID-19 landscape.
Keywords: paradigm shift, deglobalisation, state interventionism, systemic rivalry, regionalisation, COVID-19 pandemic, supervisory authorities, financial institutions
CECL and IFRS9 expected credit loss estimation in uncertain economic environments
Jorge R. Sobehart, Managing Director of Credit and Obligor Risk Analytics, Risk Modelling & Analytics, Citi

This paper introduces a multiple-scenario expected credit loss framework for capturing uncertainty in economic environments. The framework leverages default likelihood and severity information and their relation to economic activity and provides a more robust approach to the estimation of portfolio losses during periods of significant market uncertainty.
Keywords: expected credit loss (ECL), CECL, IFRS9, economic uncertainty, credit reserves
Digital transformation in treasury, risk and finance: COVID-19 to accelerate establishment of smart analytical centres in these departments
Johan von Solms, PhD Computer Science student, Josef Langerman, Professor of Practice and Carl Marnewick, Professor, University of Johannesburg

Digital transformation has been a growing focus in the banking industry for several years, with the introduction of digital technologies of the Fourth Industrial Revolution. The recent COVID-19 outbreak had a significant impact on banking, one being that its aftershock might lead to an acceleration of digitalisation efforts in core bank management departments. The reason is that the COVID-19 is dangerously unique. It differs from the 2008 financial crisis in that it is an exogenous risk that is not the result of the unravelling of previous financial imbalances. It is truly an uncertain event, with a wide range of outcomes that depends on unpredictable noneconomic factors. Therefore, the challenges facing banks and the course of action required are divergent from the situation post-2008. The purpose of the paper is to identify a few of the effects COVID-19 had on banks, but particularly focus on its impact on the responsibilities of internal management departments such as treasury, risk and finance. The reason is that the crisis highlighted some of the pressure points that exist in traditional approaches and technology solutions. The paper postulates that the pandemic might be the catalyst that speeds up the pre-COVID trend of adopting digital technology in treasury, risk and finance and thereby drive establishment of smart analytical centres. The advantage of smart analytical centres is bank management departments that will be better prepared, not just to handle future crises through intelligent and rapid decision-making, but also better equipped to enhance day-to-day operations in business-as-usual times. An implication emphasised in this paper is that to establish smart analytical centres, it is vital to study the applicability and benefits of digital technologies, as well as recognise the importance of putting a well-defined digital transformation plan in place.
Keywords: smart analytical centres; digital technology; digital transformation; COVID-19; Treasury Risk and Finance departments
Achieving operational resilience in the financial industry: Insights from complex adaptive systems theory and implications for risk management
Tom Butler, Professor, University College Cork and Robert Brooks, MD, Accenture

Financial institutions face a perfect storm of nonfinancial risks: Climate change, COVID-19, Brexit, digital transformation and cyberattacks generate new threats and exacerbate the impact to existing systemic and organisational vulnerabilities. Regulators recognise the magnitude of the risks that institutions face and are demanding that they become resilient — that is, they are able to absorb, adapt or recover from threats, stressors or shocks. This, however, is more easily said than done. The objective of this paper is to inform senior risk professionals on how resilience might be achieved by providing a much-needed frame of reference for those planning to transform their complex and chaotic organisations to resilient complex adaptive systems. Inter alia we delineate a logical model, based on conceptualising firms as resilient complex adaptive systems (RCASs), which elaborates the necessary and sufficient conditions for resilience in organisations. This general model can be applied to substantive areas of operations within financial enterprises to make them resilient in the face of endogenous and exogenous risk events, while meeting regulatory requirements.
Keywords: operational risk, resilience, complex adaptive systems, operational capabilities, organisational learning, digital transformation
Operational resilience as a new concept and extension of operational risk management
Udo Milkau, Digital Counsellor

In March 2021, the Basel Committee on Banking Supervision published new ‘Principles for Operational Resilience’, which define resilience as a bank’s ability to respond to and recover from disruptions, and the Bank of England published a ‘Statement of Policy on Operational Resilience’ that financial services firms should be able to prevent disruption occurring to the extent practicable, adapt systems and processes to continue to provide services and functions in the event of an incident, return to normal running promptly when a disruption is over and learn and evolve from both incidents and near misses. Both publications use the concept of a ‘disruption’ for a rare/plausible/severe event, which can be viewed through the prism of Frank Knight’s distinction between ‘known’ risk and ‘unknown’ uncertainty. We know that a pandemic, a financial crisis or even a global cyberattack can happen within a lifetime, but we do not know the probability and cannot estimate a frequency by number. A more general approach for risk — as applied in risk-sensitive industries — extended the traditional view of risk in ‘repeated games’ to rare events with catastrophic impact and includes our ‘strength of knowledge’ as a crucial factor in determining how much the past can be forecasted into the future. This approach and best practices from risk-sensitive industries such as power grids can help to integrate operational resilience into existing operational risk management in the financial services industry. Nonetheless, any precautionary measure of redundancy, flexibility and adaptivity requires additional investments and is antagonistic to the paradigm of economies of scale with minimisation of buffers. Therefore, the governance of operational resilience will require a fundamental and new understanding about rare ‘severe but plausible scenarios’, which might happen beyond typical timescales of management in a bank and require an intertemporal investment, which transcends usual economic reporting timescales.
Keywords: operational resilience, operational risk management, risk-sensitive industries, strength of knowledge, power law distribution
Assessing the impact of hurricane frequency and intensity on mortgage delinquency
Clifford V. Rossi, PhD, Professor-of-the-Practice, Finance Department, Robert H. Smith School of Business, University of Maryland

Considerable meteorological research suggests that the frequency and intensity of North Atlantic hurricanes are rising. This analysis focuses on estimating the impacts of hurricane intensity and frequency on mortgage delinquency. Based upon a large loan-level dataset of mortgages purchased by Freddie Mac between 1999 and 2015, loans with an average lifetime Saffir–Simpson hurricane rating of 3 or more were found to be 88 per cent more likely to become delinquent than other loans in the same locations, controlling for all other risk factors. This result has important implications for mortgage and insurance markets and homeowners. First, if long-term hurricane trends bear out, mortgage default risk in areas with a higher incidence of major hurricanes will likely rise significantly over time. Secondly, investors in mortgage credit risk from these locations will face higher default losses in the future. Thirdly, private investors in mortgage credit-risk transfer (CRT) securities could experience higher credit losses of loans from hurricane-prone areas. Investors in lower-rated tranches would be particularly impacted given the nature of their exposure to losses earlier than more highly rated tranches. Catastrophe bonds could be used to diversify hurricane risks to investors that may be in a better position to assess and hold this risk.
Keywords: hurricane risk, mortgage default, risk management, reinsurance
Book review
The Moorad Choudhry Anthology: Past, Present and Future Principles of Banking and Finance
Reviewed by Krzysztof Jajuga, Department of Financial Investments and Risk Management, Wroclaw University of Economics and Business

Volume 14 Number 3

Editorial: The Global Core Indicators: A sustainability risk management and reporting framework
Madelyn Antoncic, PhD, Senior Advisor to UNCTAD on SDG Reporting
Practice papers
Predicting sovereign credit ratings for portfolio stress testing
Jonas de Oliveira Campino, Lead Strategic Risk Management Specialist in the Office of Risk Management, Federico Galizia, Chief Risk Officer, Daniela Serrano, Economist and Frank Sperling, Unit Chief, The Inter-American Development Bank

This paper analysis the relationship between macroeconomic and credit cycles. It is not a straightforward relationship, particularly in sovereign credit assessment. Modelling such a relationship requires blending scenario analysis and stress testing, together with dynamic modelling of macroeconomic and credit variables. The novelty of the presented approach is its ability to cross-pollinate machine learning and Monte Carlo (MC) simulation as part of a process that overcomes the challenges faced by risk managers. The result is a probabilistic forward-looking view of credit risk scenarios that can guide action. Sovereign credit ratings are expert opinions based on relevant macroeconomic, financial and policy information. We introduce a predictive machine learning model of sovereign credit ratings that lends itself naturally to MC simulations and stress testing. The Least Absolute Shrinkage and Selection Operator (LASSO) allows considering many variables simultaneously in a nonlinear fashion as candidates for predicting sovereign ratings. The portfolio stress testing capability comes in by augmenting the set of variables used in the MC simulations to include external shock variables common to the sovereigns in the portfolio, for example, relevant global commodity prices. The resulting rating distribution can be used to calculate different relevant risk metrics, including credit-sensitive measures of risk-weighted assets.
Keywords: capital adequacy, sovereign risk, credit rating, stress testing, machine learning, LASSO, Monte Carlo simulation
Developing practical mitigations for reputational risks: A case study from the UK insurance sector
Matthew Connell, Director of Policy and Public Affairs, Chartered Insurance Institute

This paper examines a new method for measuring reputational risk developed by the Customer Services Institute in 2018 for UK insurance markets. It sets out the way in which the model was constructed through in-depth qualitative work followed by detailed opinion surveys, and uses two case studies to compare the results from the research with perceptions about how the sector has performed through the lens of different stakeholders, including regulators. It finds that the index correctly identifies two areas where public trust in insurers has been reduced. These areas are renewal charging practices in retail insurance and payment of business interruption insurance claims for SMEs. The paper also concludes that the index gives strong practical guidance about how these reputational issues can be addressed. Two limitations of the model are as follows: first, because it is set up to express issues in consumer terms, it can be difficult to then draw lessons for different organisations within the value chain, and secondly, the survey approach can obscure the experiences of very small minorities, unless the survey is carefully focused on those groups. For very small groups, a more qualitative approach may be more effective.
Keywords: reputation, risk, trust, consumer, SME, insurance
Eliminating the negative impacts of the Basel IV output floor by adjusting a bank’s business model
Martin Neisen, Partner, PricewaterhouseCoopers and Hermann Schulte-Mattler, Professor, Dortmund University of Applied Sciences and Arts, Germany

The purpose of this paper is to show the interaction between the Basel IV output floor and business model management. Specifically, the paper analyses how banks can optimise the output floor by moderately adjusting the composition of their portfolio. The individual topics are explained based on simplified exemplary cases. The presented capital floor analysis may help a bank’s top management to allocate the available capital better, formulate a coherent internal risk appetite, including the cost of capital in their pricing models, and set explicit targets for key performance drivers directly linked to the desired shareholder returns. With a target business model in mind, our approach can therefore be used to determine target levels for the individual risk positions that contribute to the output floor. The paper presents a procedure for overall bank management, particularly for business model planning in the presence of the Basel IV floor. Managers, analysts and regulators can apply our approach to analyse the business model of an individual bank, as well as the output floor of the banking sector as a whole. To our knowledge, our paper is the first academic contribution on the impact of the new prudential floor approach on the banks’ business model.
Keywords: Basel III finalisation, Basel IV, business model planning, output floor, risk-weighted assets
Evolution of risk management from risk compliance to strategic risk management Part II: Evolution of the risk executive and the boards — the changing paradigm — an analysis on the Canadian banking and insurance sectors
Bogie Ozdemir, Risk Vision Consulting

Part I of this paper examined the risk function’s evolution in response to (i) financial disclosures becoming increasingly risk-based, (ii) an increasing need to optimise capital management and business mix to enhance Return on Equity (ROE). The optimisation frameworks to determine the optimal ‘risk strategies’ need to be established by the risk function, which is now at the core of financial disclosure, technology and strategy. Part II examines the necessary competencies for the risk executives, in particular Chief Risk Officers (CROs), to be effective and lead the evolution. These are analytical, digital and strategic competencies. For the leadership roles in well-established finance, accounting, actuarial functions, and in engineering, it is recognised that professional qualifications, advanced content knowledge and experience are required for the leaders to be effective. We observe that this is often not the case for bank risk executives. It is not uncommon to see a leader without specific risk expertise and experience holding senior risk executive, even CRO, roles. CRO roles also have limited upwards mobility and can be the last stop, bridging the executive to retirement. We examine the potential causes, including the historical reasons, insiders’ bias, cognitive biases, pigeon-holed career paths and misuse of power. We make suggestions for improvements and opening the path for the next generation of risk professionals to fill the executive and board roles and lead the necessary evolution.
Keywords: CRO selection, executive selection, board effectiveness, unconscious biases, insider bias, strategic risk management, Basel, Solvency II, A-IRB, IFRS-9, risk governance, capital optimisation, provisions, impairment estimation, expected credit losses
Explainable artificial intelligence: A global fast approach
Daniel Mayenberger, Executive Director Digital Products and Artificial Intelligence, JPMorgan Chase

Decisions in the financial industry place ever-increasing reliance on artificial intelligence and machine learning (AI/ML) algorithms. These decisions span entire business lines and value chains, including customer marketing, credit underwriting, financial and capital planning, algorithmic trading and automated interaction with customers, particularly chatbots and robo-advice. The most advanced algorithms, however, are complex and inherent opaque, as they require up to hundreds of inputs, which then undergo several layers of processing that are not transparent. Such complexity and opacity raise the need for explainable AI (XAI) to understand how these algorithms produce a specific output and how they work in general. Local explain capability identifies the key determinants of a specific output while global explain capability identifies the inputs that have the highest impact on the output for the algorithm as a whole. In particular, global explain capability such as the Shapley value with computational complexity of N! is prohibitively expensive with currently available approaches. This paper presents model-agnostic approaches that provide local explain capability through counterfactuals and, most importantly, global fast explanation capability.
Keywords: artificial intelligence, black box explanation, counterfactuals, explainable artificial intelligence, machine learning
Research paper
The culture of risk governance in financial institutions
Paolo Agnese, Associate Professor of Banking and Finance, UNINETTUNO — International Telematic University and Paolo Capuano, Adjunct Professor of Management and Finance of Insurances, Sapienza University of Rome

Financial institutions increasingly need an integral and widespread culture, especially in terms of risks and relations with stakeholders, which guides corporate behaviour and organisation. When constructing this positive risk culture, financial institutions must be protagonists and not spectators. This means that risk governance necessarily need to be involved in the process. In this paper, the importance of risk management in the organisational structure of financial institutions is analysed, taking into consideration the logical transition from risk culture to risk governance. The paper then examines how the main aspects of risk governance have been analysed in the recent literature in order to understand the possible relationship between bank profitability and risk. The paper finds that the governance literature has considerably developed since the outbreak of the global financial crisis, leading to the implementation of not only theoretical paradigms but also empirical analysis. Quantitative research generally makes use of multiple regression models — with or without fixed effects — but some innovative analysis techniques are also used for specific aspects of analysis such as the estimation of certain variables. The results of the literature review show a general trend towards greater attention by financial institutions to risk governance which tends to be linked to a better performance, although studies on the subject do not always agree. The importance of a well-structured, efficient and effective bank risk governance emerges as a key conclusion, although research into further risk governance analysis models is expected to continue, particularly in light of the recent international economic and financial context.
Keywords: financial institutions, risk governance, enterprise risk management, risk culture

Volume 14 Number 2

Editorial: Managing the risk of climate change
Til Schuermann, Editorial Board Member & Partner, Oliver Wyman
Opinion pieces
A spotlight on boards’ response to the new risk environment: How boards are changing the way they think about risk in strategic decision making
Celia Huber, Senior Partner, Michael May, Associate Partner and Olivia White, McKinsey & Co

While most financial institutions have significantly enhanced their traditional risk management capabilities over the past decade, these organisations — and their boards of directors — are often less prepared when facing extreme and multi-faceted uncertainty. Preparing for uncertainty, particularly over long time horizons, is much more complex than preparing for particular risk events, as it means taking account of unknown unknowns. To help their organisations navigate extreme uncertainty, boards report that they are focusing on one topic above all: resilience. Leveraging insights from interviews with nearly 1,000 board members, this paper outlines the forms of resilience that should be bolstered and recommends three actions boards should take to build resilience. Specifically, boards should consider and promote operational resilience, organisational resilience, reputational resilience and business-model resilience, in addition to the more familiar financial resilience. To build resilience and prepare for uncertainty, this paper proposes that boards of financial institutions should take three key steps: first, they must understand the main drivers of uncertainty that will impact their operating environment. Secondly, based on these drivers of uncertainty, they should look at the specific financial and operational implications for the company and consider scenario and contingency planning. Thirdly, boards should set clear expectations for management — including setting an appropriate risk appetite, detecting risks and control weaknesses, developing responses, and setting clear metrics — and hold management accountable for strong performance and stewardship of risk.
Keywords: board of directors, risk committee, resilience, enterprise risk management, emerging risks, scenario planning, risk identification and risk appetite
Climate change uncertainty and central bank risk management
Dirk Broeders, Senior Risk Manager and Marleen Schlooz, Risk Manager, Financial Markets Division, De Nederlandsche Bank

The drastic change in the Earth’s climate is a key concern for central bank risk managers. The consequences of climate change for the economy are harmful and potentially far-reaching. Central banks are exposed to climate change through their asset purchase programmes and credit operations and via the impact of climate change on the economy in general. Risk management in this case is challenging and complex because climate change is surrounded by fundamental uncertainty. Given this fundamental uncertainty, risk managers can however rely on the precautionary principle for practical purposes. This principle aims to anticipate and minimise the potential impact of serious or irreversible events under conditions of uncertainty. Stronger risk mitigating measures taken at an early stage serve as a hedge against the cost of enduring temporary catastrophes or draconian interventions at a later stage. This paper discusses the fundamental uncertainty of climate change and offers some recommendations for the identification, assessment, mitigation and disclosure of climate change uncertainty in central bank risk management. These recommendations are however equally relevant for commercial banks and institutional investors.
Keywords: central banks, climate change, fundamental uncertainty, risk management, tail risks
Financial institutions and developing countries’ debt cancellations: How to get rid of moral hazard?
Michel-Henry Bouchet, Professor Emeritus, Skema Business School, Université Côte d’Azur, Paris-Sophia-Antipolis, Suzhou, Raleigh, Belo, France

The purpose of the paper is to shed light on the looming risk of developing country debt defaults for financial institutions in the wake of the pandemic crisis. There are mounting calls to delink debt relief and conditions on developing countries so that debt cancellations should be delivered immediately without performance criteria or record of accomplishment. To date, however, debt cancellations have not sufficiently distinguished developing country beneficiaries according to their performance in sustainable development policies, neither have cancellations taken into account commitments towards improved governance trajectories, despite the requirements of poverty reduction programmes involving civil society. International financial institutions thus face the risk of large write-offs at a time of portfolio fragility due to an environment of low interest rates, meager profitability and weak economic growth. This paper argues that much of the resistance of private creditors comes from deeply rooted skepticism as to whether debt relief and write-offs lead to sustained improvement in creditworthiness. Accordingly, prudent risk management requires resisting calls for blanket debt relief when there is little scope for improved governance. Financial institutions should insist on strict criteria regarding inclusive development policies. As new legislation to facilitate debt-restructuring agreements, likely at the expense of private financial institutions, is currently being discussed, the insistence on ‘fair burden sharing’ between official and private creditors should be a wake-up call for banks. A range of financial risk management instruments could link debt relief with enhanced governance commitments, including debt swaps, recapture clauses and the monitored recycling of debt-servicing relief into high-priority projects. The pandemic crisis provides financial institutions with an opportunity to transform debt relief into a leverage for improving sustainable development prospects, hence better creditworthiness.
Keywords: financial crisis, debt cancellations, governance, corruption, developing countries, capital flight (JEL Cl.: F34, F35 F63, H63, 055)
Practice papers
Did prudent risk management practices or weak customer demand reduce PPP lending by the largest banks?
Paul H. Kupiec, Resident Scholar, The American Enterprise Institute

Regulatory data shows large differences between large and small banks’ response to the Paycheck Protection Program (PPP). Large bank loan originations are smaller than predicted based on operational characteristics and historical lending patterns. One possible explanation is that large banks put greater emphasis on the legal and reputational risks associated with PPP loans because of their prior experience with similar government programmes. A second possibility is that there were systematic differences in large and small bank PPP loan demand. While bank-specific PPP loan demand is unobserved, indirect evidence is inconsistent with the customer demand explanation. On balance, circumstantial evidence favours the hypothesis that large banks took a more cautious approach to PPP lending to minimise the legal and reputational risks that have been endemic to past government loan guarantee programmes.
Keywords: Paycheck Protection Program, legal and reputational risks
How should risk professionals think about the rise in corporate indebtedness?
Dr Colin Ellis, Moody’s Investors Service

The COVID-19 pandemic has led to significant disruptions to economic activity, accompanied by a substantial increase in companies’ debt loads. The unique nature of this crisis and the quantities of debt accumulated pose challenges for assessing the risk implications. It is important to start with a clear macroeconomic perspective and benchmark; importantly, while lockdown measures have led to significant economic disruption, the medium-term impact is likely to be smaller than the 2007/2008 Global Financial Crisis. At the same time, financial market access for issuers was robust last year, with issuance surpassing pre-COVID-19 averages. Similarly, current refinancing profiles indicate that near-term liquidity risks are not pervasive across the business sector as a whole. Given that past corporate deleveraging across advanced economies (AEs) has typically been driven by profit growth, it may take several years for debt metrics to unwind after the pandemic has been brought under control. Against this broad backdrop, there are significant differences visible across sectors: one important differentiator is the rise in gross versus net debt, and the relative evolution of these metrics will provide a useful indicator as the pandemic continues. Finally, there is little sign that the extraordinary fiscal support provided by AEs has led to heightened concerns about sovereign risk among forward-looking investors, with investors not demanding higher yields despite the unexpected higher debt loads. This means that simply assuming support will remain in place until the pandemic has subsided should be sufficient, at least until investor perceptions change significantly.
Keywords: COVID-19, debt burdens, gross and net debt, sovereign-borrowing costs
Research papers
A test of the inherent predictiveness of the RU, a new metric to express all forms of operational risk in banks
Peter Hughes, Durham University Business School and Mahmoud Marzouk, University of Leicester

In 2016 Allan D. Grody and Peter J. Hughes proposed a method and system termed ‘Risk Accounting’, an integrated financial and risk accounting framework. Risk Accounting incorporates a novel operational risk exposure quantification technique based on the Risk Unit (RU), a new common additive metric designed to express all forms of operational risk in banks. In this paper, we report on initial tests of the inherent predictiveness of the RU. The test focused on the period leading up to the global financial crisis of 2007-8 and involved the restatement into RUs of publicly available accounting data in the United States relative to a subset of large US banks. We contend that the RU’s inherent predictiveness could be concluded if it is demonstrated that an accelerated increase in trended operational risk RUs and subsequent material unexpected losses are positively correlated. We further describe how a monetary value can be stochastically derived and assigned to the RU over time. The inclusion of valued RUs in accounting systems will potentially enable the systematic adjustment of financial performance and condition relative to accepted nonfinancial risks to complement the accounting treatment already applied to financial (credit and market) risks. The resulting harmonisation of the accounting treatment applied to both financial and nonfinancial risks based on stochastic modelling will enable risk-adjusted economic profit to be adopted as the primary business performance metric and economic capital as the primary method of determining both operating and regulatory capital requirements. The real-time or near-real-time production of portfolio views of operational risk exposures based on the RU adds analytical rigour to their management and causes risk mitigation to become both a risk reduction and a profit optimisation initiative. The more effective management, oversight and governance of exposures to operational risks is the anticipated outcome.
Keywords: operational risk, risk accounting, risk quantification, expected loss, unexpected loss
Time-varying autoregressive distributed lag model with changing volatility for stress test
Leilei Zhou, Quantitative Researcher, Department of Applied Mathematics and Statistics and Wei Zhu, Professor and Graduate Programme Director, Department of Applied Mathematics and Statistics, Center for Finance, State University of New York at Stony Brook

We present a novel time-varying autoregressive distributed lag (TV-ADL) model that allows for changes in both transmission mechanisms and innovation volatilities. The forecasting performance of the TV-ADL model has been substantially improved by removing the unrealistic traditional assumptions of constant volatility and constant inter-variable relationship. Our model is further adapted to stress tests mandated by the US Federal Reserve to generate conditional forecasts of the pre-provision net revenue of financial holding companies with large assets. The improvement of forecasting performance is demonstrated by the significant reduction of out-of-sample forecast errors at different horizons.
Keywords: financial supervision, stress tests, time-varying parameter, forecast, volatilities
The Fundamental Review of Trading Book: New standard approach and risk management impacts
Pasqualina Porretta, Associate Professor of ‘Banking and Finance’, Faculty of Economics, Sapienza University and Paolo Agnes, Associate Professor of ‘Banking and Finance’, Faculty of Economics, International Telematic University UNINETTUNO

With the aim of reducing the excessive variability of risk-weighted assets (RWA) and improving the comparability and transparency of banks’ risk-based capital ratios, the European Banking Authority restructured the regulatory market risk framework. The long-awaited final version of the FRTB Market Risk Framework was published by the Basel Committee on Banking Supervision (BCBS) in January 2019. This paper aims to analyse the main reasons that led the regulators to formulate the new Market Risk Framework named Fundamental Review of Trading Book (FRTB) and the consequent risk management impacts. The first FRTB impact assessments conducted by the same European authorities suggest important increases in capital charges for banks that use either the standardised or internal models approach. Beyond the impact on capital charges, the FRTB framework will have a deep impact on market risk management activity, analytics, data collection, market risk limits, control systems, market risk procedures and policies. From this perspective, the FRTB represents a great change in the market risk management paradigms. It requires not only new measurement, management and control tools but also new financial skills and knowledge for the European banking sector. This is for all banks and those that, in the current regulatory context, use the standardised approach for the calculation of the capital requirement.
Keywords: market risk management, market risk, trading book, Fundamental Review of Trading Book (FRTB)

Volume 14 Number 1

Special Issue: Impact of COVID-19 on risk management in financial institutions

Guest Editors: Thomas C. Wilson, CEO, Allianz Ayudhya and Christian S. Pedersen, Head, Risk & Compliance, Growth Markets, Accenture

Editorial
Guest Editors: Thomas C. Wilson, CEO, Allianz Ayudhya and Christian S. Pedersen, Head, Risk & Compliance, Growth Markets, Accenture
Practice papers
Banking system stress testing and COVID-19: A first summary appraisal
Jérôme Henry, Principal Adviser, European Central Bank

This paper discusses the special banking system stress tests which central banks for the USA, the UK and the euro area published shortly after the outbreak of COVID-19. Based on the limited quantitative information available on a comparable basis, this paper discusses how the results seem broadly consistent across institutions as well as with previously conducted exercises, once accounting for the respective differences in scenario severity. The paper also discusses how central banks identified specific design features characterising these COVID-19 exercises, employing the typology put forward in the Bank for International Settlements’ (BIS) Financial Stability Institute (FSI) insights #12 — considering three building blocks: governance, implementation and outcomes. In particular, these special exercises set a new, more demanding benchmark for scenario adversity. Top-down modelling was also used to a larger extent to deal with uncertainty via alternative scenarios and to assess the impact of policies. Moreover, only aggregate results were published, with limited information on the results across banks. Finally, the connection with supervisory decisions appeared loose at most. The latter two features are not expected to remain in subsequent regular supervisory system-wide exercises. At the same time, the granularity of information collected, the banks in scope or the treatment of spillovers and feedbacks largely remained in line with standard supervisory stress-testing practices. This admittedly came short of what could be needed to get a more complete assessment of the impact of this specific crisis, from both a microprudential or macroprudential perspective. In particular, sector-specific information was sparse and banks’ credit deleveraging explored only for the UK. Looking ahead, it appeared that stress-testing models can represent a valuable forecasting and monitoring tool, especially when baseline conditions are adverse enough and uncertainty prevails. The review also suggests that bottom-up and top-down system-wide supervisory stress-test results could coexist, thereby giving further concrete relevance to recent proposals on the future of European Union area-wide stress tests.
Keywords: stress test, COVID-19, macroprudential, microprudential, scenario, banks
Adjusting loss forecasts for the impacts of government assistance and loan forbearance during the COVID-19 recession
Joseph L. Breeden, CEO, Prescient Models LLC

Since the onset of the COVID-19 recession, loss forecasting and stress testing models have dramatically overpredicted losses. As all models are pattern recognisers trained on past events, such an unprecedented event inevitably leads to model errors. Rather than, however, view the models as broken, they are useful in providing an upper bound of what could have happened if government assistance and loan forbearance had not been provided. The present work develops an approach for quantifying the short- and long-term impacts of these government and lender policies in order to create quantitative model overlays. These overlays express the problem via a set of key parameters that can be set via management judgment or simulation studies. Examples of this approach and parameter sensitivity analysis are provided using time series models of National Credit Union Administration and Federal Deposit Insurance Corporation call report data. This paper provides a framework for incorporating simulations, simple to complex, into an existing stress testing framework to better project future losses.
Keywords: COVID-19 recession, loss reserves, stress testing, loan forbearance
Managing bank risk through the crisis perspective from Malaysia
Jeroen Thijs, Group Chief Risk Officer, Ambank Group and David Bobker, Associate Professor of Risk Management, Malaysia University of Science and Technology

This paper considers the practical implications of the COVID-19 crisis for risk management in a bank in Malaysia and goes on to draw more general conclusions. It is suggested that standard strategic and credit risk-management practices will need to be taken to the next level in order for banks to better prepare for 2021. Recommendations have been given for improving stress testing and credit risk assessment so as to provide enhanced information on the basis of which difficult decisions can be made. In particular, it is suggested that greater use of reverse stress testing will be beneficial. This use should be coupled with more sophisticated relationships between macroeconomic scenarios and potential credit losses, which will give the bank management a much improved control over uncertainties in the macroeconomy. It is also suggested that banks apply a similar, more formalised (stress testing) approach to credit risk assessment of their larger customers so that a realistic assessment of their repayment ability can be made. Finally, some hard thinking about the future shape of banking needs to be carried out and positions taken in terms of technology, staffing levels, office space and product offerings.
Keywords: COVID-19, crisis, stress test, reverse stress test, resilience, V-shape
COVID-19 triggers great nonfinancial risk crisis: Nonfinancial risk management best practices in Canada
Lois Tullo, Executive in Residence at the Global Risk Institute

The spread of viral disease COVID-19 is the most transformative nonfinancial risk (NFR) of this decade triggering the Great Nonfinancial Risk Crisis. The uniting of strategy and risk management has never been more crucial for financial institutions. The interrelationship between the pandemic and the increases in ageing, chronic diseases, interstate conflicts, nationalism, cyber attacks, cyber dependency, asset bubble, and sovereign debt is transforming our reality in previously unimaginable ways. NFR management best practices Canadian Financial Institutions (FIs) prioritised NFR and adopted a NFR framework that enabled them to identify the spread of viral disease (COVID-19). Then they reprioritised COVID-19 risk into their existing enterprise risk management framework to reduce the exposure and impact of the pandemic and re-evaluated their strategic assumptions to reset their business strategy in light of the reprioritised risk matrix. In this paper, the author reviews best practices in managing NFRs and trends from the practitioner’s point of view. Thirteen Canadian FIs are reviewed along with their positioning of NFR pre- and post-COVID-19, and their recent enhancements to their NFR-management process. The author illustrates how the adoption of the Global Risks and Trends Framework by several Canadian FIs has influenced their preparation and resilience in this pandemic. Finally, the author discusses best practice examples, as well as challenges that still exist, how organisations have adjusted their strategy linking risk to their recent experience, and what lessons other FIs can learn about managing these NFRs.
Keywords: risk management, strategy, nonfinancial risk, NFR, best practices, ERM, global risks and trends, banks, canada
Research papers:
The impact of the COVID-19 pandemic on medical and travel insurance pricing and fraud risks: An exploratory study
Hala Naseeb, Lecturer, Insurance Centre, Bahrain Institute of Banking & Finance, et al.

This study investigates how the emergence of the coronavirus disease-2019 (COVID-19) pandemic has raised many concerns in medical and travel insurance, how insurers perceive and react to this pandemic, and the role of governments in this new context, with a particular focus on the Gulf Cooperation Council region (GCC). Data has been collected using archival research and conversations with some chief risk officers (CROs), internal auditors and insurance practitioners. The authors explain how, following the COVID-19 pandemic, the GCC medical and travel insurance industry faces pricing and fraud risks that need specific planning and control. In the GCC, pricing risk is found to represent an immediate risk that is not easy to manage as historical data is not available. This causes the failure of the present risk models in anticipating the probability and severity of the claims. As a response, insurers rely on scenario analysis and brainstorming to anticipate the costs. Fraud risk is harder to manage, as traditional internal controls are inefficient. Further, both risk managers and internal auditors are currently struggling because of the ‘working from home’ situation and the massive digital transformation in all the transactions. Moreover, the time spent in fraud investigation will delay the payment for hospitalised insurance claims, which would raise concerns about the insurer’s reputation. To resolve this conundrum and manage reputational risk, most GCC insurers seek trade-offs and negotiations with the insured. The authors’ observations and analyses revealed that current responses by GCC insurers are insufficient and need enhancements. Therefore, the authors propose some potential policy solutions that would help insurers overcome both pricing and fraud risks. Through explaining medical and travel insurance risks and proposing potential solutions in this emerging market, this paper provides some practical insights for insurance researchers, insurers and CROs who are seeking solutions to pandemic-related risks.
Keywords: pricing risk, fraud risk, COVID-19, travel insurance, medical insurance, governmental controls
COVID-19: Risk-adjusted portfolio returns of emerging and developed equity markets
Maretno Agus Harjoto, Professor of Finance, Pepperdine Graziadio Business School (PGBS), Pepperdine University, et al.

This study examines the impact of the novel coronavirus (COVID-19) on the stock markets’ risk and return across emerging and developed countries. Based on a sample of 76 countries from 14th January through 19th August, 2020, the authors find that the stock excess returns are negatively related to daily new cases, but not deaths from COVID-19. The authors’ ex-post analysis indicates that the daily cases from COVID-19 are strongly related to daily stock excess returns in both emerging and developed markets during the declining period of the equity markets (pre 23rd March, 2020). Although the equity markets in the developed countries have experienced an unprecedented recovery during post 23rd March, 2020, the authors find that the stock markets in emerging countries exhibit greater positive abnormal returns above their respective market benchmarks. Findings from their ex-post analysis indicate that there is a portfolio diversification that could have been gleaned by investing in both emerging and developed equity markets during the post stock markets’ decline due to COVID-19.
Keywords: COVID-19, stock abnormal return, Sharpe ratio, Sortino ratio, daily cases and deaths
European banks and risk management: Did the 2008 financial crisis have any impact?
Joseph Falzon, Professor, Department of Banking and Finance, University of Malta and Jennifer Vella, Head of Risk Management Department, ZASMalta Limited

The ongoing COVID-19 crisis has redirected attention to the importance of robust risk management practices and well-established risk management cultures within financial institutions. Various studies have highlighted the positive implications of strong risk management practices on performance and market rewards during a single-wave crisis. Are these findings, however, consistent also across a multiple-wave prolonged crisis? To answer this, the authors analyse a prolonged crisis period ranging from 2008 to 2011 using a dataset comprising of 13 systemically important European banks. This study further analyses whether a prolonged crisis period encourages banks to permanently strengthen their risk management practices during or post-crisis turmoil, potentially capturing elements of bank risk culture. The authors find that higher levels of risk management contribute to better bank performance measured through the return on assets (ROA) and annual returns. Unlike in a single-wave crisis period, however, the results show that banks having in place stronger risk management practices do not benefit from superior bank performance and market rewards during a multiple-wave crisis period. The authors also find that banks which perform worse during a multiple-wave crisis period fail to later improve their risk management practices. The study concludes by providing insightful guidance to policy makers aiming to contribute towards enhancing bank risk management in response to the COVID-19 crisis.
Keywords: risk management, banks, multiple-wave crisis, risk culture
Financial institutions’ funding cost: Do capital and risk-taking matter?
Fernando Moreira, Senior Lecturer in Banking and Risk Management, University of Edinburgh Business School

This study shows that the relative amount of capital and risk-taking compared with peers has influence on the funding cost of financial institutions. This suggests that these two factors could work as tools for achieving financial stability by means of self-regulatory practices given that financial institutions would have incentives to increase capital and refrain from taking excessive risk. Besides contributing to the policy-making debate on the viability of market discipline in banking regulation, this paper also opens avenues for further investigations in this area.
Keywords: funding cost, bank capital, risk-taking