To say that the Covid-19 pandemic has shaken things up would be to put it very mildly indeed. The pandemic has touched almost every country in the world causing over 4 million deaths worldwide to date. Apart from affecting people’s health and livelihoods, the crisis also stalled a global economic engine that had finally stepped out of the shadows of the 2008 financial crisis. The pandemic wiped away a lot of economic progress and development. It also opened a whole new can of worms for the financial services industry - dealing with 'black swan' events. Given these emerging challenges, financiers need to tweak their risk monitoring strategies to keep up with an increasingly mercurial post-Covid world. Here’s a look at the economic impact of Covid-19 and the essential must-haves every investor or lender should include in their financial risk monitoring to stay ahead.
Examining the economic impact of Covid-19 and the global response to it
In the US, before Covid hit, unemployment was at a 50-year low, stock markets had a bullish outlook, and consumer spending was strong. All of that changed in February 2020. The public health crisis threw a spanner in the works by bringing the economy to a virtual standstill. Within a couple of months, the GDP fell by over 9%, its worst quarterly drop since 1947. To put it in context, the GDP fell around 3% during the 2008 recession. Expectedly, this was followed by a bearish stock market and unemployment rates that skyrocketed from 3.5% to almost 15% in April 2020. All of which led the International Monetary Fund to declare a recession.
With the global economy teetering on the edge of another meltdown, economists were at panic stations preparing for the worst. Financial pundits everywhere prophesied that defaults and bankruptcies would be widespread and that economies would crash. Thankfully, governments, regulators, and banks stepped up to the plate to work against these worst-case scenarios.
Around the world, governments swiftly came up with stimulus packages, equipped with fiscal and monetary measures, aimed at injecting liquidity into global markets.
The US government passed three stimulus packages in the space of 18 months amounting to over $6 trillion, the most any government has spent on Coronavirus relief. In addition, the Federal Reserve slashed interest rates to 0.25% and temporarily relaxed regulatory lending requirements on lenders. They also revived several recession-era programs aimed at keeping credit markets moving such as the PDCF (Primary Dealer Credit Facility) and MMLF (Money Market Mutual Fund Liquidity Facility) programs.
The relaxed regulatory pressure, in turn, allowed banks to help their customers. Accordingly, most financial institutions offered their customers credit extensions, loan deferrals, and temporary mortgage forbearances. In addition, several banks took steps of their own to further temper the economic impact of the pandemic. These measures included reducing interest rates on credit card payments, allowing customers to restructure their loans, and waiving fees such as ATM fees, early withdrawal fees, and overdraft penalties. These collective steps helped cushion the blow and prevented, to a certain extent, the devastating economic implosion that a lot of pundits predicted at the start of the pandemic.
A crisis averted or a crisis deferred?
That said, economists aren’t popping the champagne just yet. Many worry that the extraordinary fiscal actions have only succeeded in deferring the crisis and not in averting it. In other words, it could turn out to be a classic case of slapping a band-aid on a bullet hole. The band-aid may hold for a while, but sooner or later, it's going to fall out revealing a festering wound that hasn’t healed at all. Similarly, while the global economic measures have kept the credit cycle and the economy moving, they haven’t addressed the issue of unpaid debt.
The unparalleled monetary responses to the pandemic may have muddied the waters in terms of calculating risk exposure. Due to the unprecedented nature of it all, there is a very real danger of financiers using outdated risk benchmarks that were calibrated for past downturns but do not accurately represent the current scenario. As a financial services veteran put it to us, “The tendency to ‘fight the last war’ is strong in every risk manager."
According to the SEC, US banks have acquired over $13 trillion worth of credit exposure due to loan deferrals and forbearances due to Covid-19. Similarly, investment companies in the US have deferred $5 trillion worth of credit repayments. At this point, it’s anyone’s guess how much of this will actually be repaid once the moratoriums expire. According to McKinsey, financial institutions are likely to forgo over $3 trillion in revenue due to corporate and personal defaults in the coming year or so.
At present, everything is in a state of suspended animation. What is sure, however, is that the current state of affairs will not last forever and that a day of reckoning is approaching. As a Game of Thrones fan would put it ominously - winter is coming!
What your post-Covid risk monitoring should look like
Whether a delayed implosion happens or not remains to be seen. Whatever may be the case, the Covid-19 pandemic has changed life as we know it. To combat the virus, the world has had to change the way it goes about its business. Wearing masks and practicing social distancing is now a new normal for most people. It stands to reason then that the financial services industry must also follow suit and find its own new normal.
Here are 5 essential must-haves every financier should include in their risk monitoring strategy to effectively navigate the post-Covid world:
1. Diversified portfolios
Economist and Nobel laureate Harry Markowitz described diversification as the only ‘free lunch’ in investing. That’s because diversification can reduce risks without jeopardizing returns. Having a diversified portfolio was considered prudent even before the pandemic hit. In a post covid world, however, the advice assumes even more significance. While the pandemic did affect life on a global scale, the ferocity of its impact differed from sector to sector. Some sectors such as health care, video streaming, telecom, and insurance witnessed significant growth during the health crisis. On the flip side, industries such as aviation, tourism, retail, and automobile have taken colossal hits.
As showcased by the pandemic and the 2008 financial crisis, even traditional safe bets (such as real estate and gold) can crash. When that happens, your other investments can help offset your losses. A diversified portfolio also ensures that one bad event does not become your Achilles heel. And if there is one thing that Covid-19 has taught us, it is that bad events can and will happen. By diversifying your portfolio, you can lessen the chances of it wiping you out entirely.
2. On-demand risk monitoring
Most traditional risk monitoring practices follow a monthly or annual credit review calendar. Even in a stable economic environment, this approach is fraught with risk. During times of market stress, it is downright foolishness. Given today’s volatile economic situation and an increasing number of market interdependencies, your risk exposure can change very quickly. Just ask apparel companies such as J Crew and True Religion, both of whom had to file for bankruptcy in 2020 due to slumping sales brought about by the pandemic.
Therefore, it is now more important than ever to have a risk review system that is capable of on-demand monitoring. With real-time risk monitoring, lenders can stay up to date and, more importantly, take timely risk-mitigation steps to reduce their risk exposure.
After the 2008 crisis, financiers considered on-demand risk monitoring as a great add-on feature. After 2020, it should become an absolute must-have.
3. A recalibrated early warning system
Before Covid-19 hit, the worldwide credit cycle was chugging along nicely. Accompanying it for a ride were traditional early warning systems that depended on historical data for its monitoring parameters. Both systems depended on the status quo being maintained. The ongoing health crisis changed the existing situation almost overnight. Suddenly, both supply and demand decreased drastically, and the credit cycle went from steady to unstable. Consequently, the historical data that financiers depended on for risk monitoring became useless in evaluating creditworthiness. To make matters more complicated, the fiscal responses to the pandemic also skewed risk monitoring results.
To get an accurate picture of a borrower’s current business position, lenders must now recalibrate their early warning systems to include the loan deferrals, moratoriums, and eased regulatory guidelines that have marked the global response to the pandemic. In addition, it is important to learn our lessons here and design a system that is not overly dependent on historical data alone. Integrating alternate sources of data into your early-warning systems will give results that more accurately represent the ever-changing credit landscape.
4. Flexible, forward-focused risk modeling
The Covid-19 pandemic tested risk monitoring systems everywhere and most were found wanting. This is, of course, understandable since earlier risk models used stable parameters and assumptions that fit the pre-covid world. With change being a constant now, risk modeling needs to shift from being a static, rigid system to one that is agile enough to rapidly integrate new information and update scores speedily. In other words, you need a system that is forward-focused and not dependent on the past.
Robust analytics is the name of the game here. An ability to gather, organize, and analyze data is the key to forward-focused risk modeling. AI-augmented systems such as TRaiCE have the upper hand here as they can do all of that more efficiently and accurately. In addition, these systems can rapidly adapt and learn from changing parameters, automatically updating algorithms on the go. This continuous integration of new data improves a model’s predictive power. Just as crucial, it can reveal risk indicators and interdependencies much faster and more accurately than a manual or semi-automated system can.
5. Sector microanalysis
We’ve already touched upon how the pandemic affected different sectors differently. To take it one step further, the health crisis affected individual businesses within each sector differently too. That’s because each company is set up differently. Some business setups may just have what it takes to adapt quickly to a pandemic. For example, companies with a strong online presence even before Covid-19 hit will do better than those with only a brick-and-mortar presence. Similarly, outdoor restaurants set up for takeout and home delivery can adapt faster than indoor fine dining establishments where their gourmet food creations do not necessarily lend themselves to takeout.
Recovery too can vary within each subsector. Some businesses may have robust business continuity plans in place that can help them recover faster. In addition, a business’s reopening is entirely dependent on its locality and the speed with which lockdowns are lifted there. In some areas, the Delta variant of the Covid-19 virus is wreaking havoc again, forcing communities to go back into lockdown. Given this, reopening and subsequent credit recovery can look vastly different for businesses within the same sector itself. So, financiers should go beyond traditional macroanalysis of sectors to a more granular, microanalysis of it. A shift to assessing businesses on a one-on-one level is imperative now as conventional sector analysis can be misleading.
Conclusion - Plan for change
As we slowly step out of the Covid haze, it is hard to gauge the true impact of the pandemic. Only time will tell if we have legitimately averted an economic catastrophe or not. Crucially, financial institutes entered the crisis with liquidity in their systems thanks largely due to the lessons learned from the 2008 recession. It would be wise, therefore, for financiers to learn from this once-in-a-lifetime event too so that they are better equipped when and if the next one hits. The good news is that these risk monitoring tweaks are not a futuristic pipedream anymore. AI-augmented platforms such as TRaiCE have the advanced capabilities needed to take credit risk monitoring to the next level. The system gives lenders on-demand monitoring that is exhaustive, forward-focused, and can keep up with the times.
Given that the times seem to be ever-changing now, this can help you better plan for it.