Covid-19: Major risk considerations for the banking sector

Mon 06 Apr 2020

As we continue to feel the effects of the global pandemic, the banking sector, like many other sectors, now faces unprecedented uncertainty about the economic outlook ahead. While banks go into this pandemic in a stronger position than the global financial crisis of 2008, the current environment presents particular challenges and disruption to standard accounting procedures and processes that could impact a bank’s risk profile.

First, in terms of completing financial statements as at 31 December 2019, it’s important to be clear that COVID-19 is a non-adjusting event after the reporting period. Thus it has no effect on the balance sheet or P&L. However, entities that have not yet authorized the financial statements for issue should provide specific disclosures in the notes to their year-end 2019 financial statements.

Also, an entity’s ability to continue as a going concern has to be assessed continuously until financial statements are authorized for issue. Given the economic context, particular attention should be paid to ensuring the existence and quality of the liquidity risk monitoring process.

For upcoming closing of accounts at 31 March 2020 or 30 June 2020, several risk factors now need careful assessment.

Credit risks

COVID-19 crisis triggered significant changes in the environment. In this context, current models may be less relevant than in the past, but in practice it is impossible to update them in such a short period. Therefore, banks need to reflect this change in the economic environment by updating both the Significant Increase of the Credit Risk (SICR) and the expected credit losses (ECL) parameters. Parameters that are likely to be impacted by COVID-19 include the probability of default (PD), loss given default (LGD), staging and bucketing parameters, forbearance, nonperforming loans (NPLs), as well as forward-looking information and weightings allocated to multiple scenarios approaches. ECL calculation will be a judgmental area of estimation, even more than usual.

The particular case of suspended payments (debt moratorium measures) is a further credit risk. It would be inappropriate to consider that the suspension of contractual payments as part of moratorium measures automatically results in all the loans concerned being in default. Equally, it would be just as inappropriate to consider that none of the companies benefiting from the moratorium measures will default in the coming months.

Analysis, therefore, should be conducted on a case-by-case basis, taking into account several factors. These factors include the bank’s policy for granting moratorium-related measures, modalities of the moratorium implemented (e.g. does interest continue to accrue?), as well as the risk profile of the counterparty which benefits from the moratorium (e.g. pre-crisis rating, sector of activity). Such analysis may have to be performed at a portfolio level before being able to collect individual information.

Operational and liquidity risks

The operational risk is to be monitored since, unlike in 2008, finance teams may be reduced in number. Besides, information systems and home office procedure may weaken the process of closing accounts and its internal control environment. Careful attention to cyber risk is also advised, which is potentially more significant in this context.

In terms of liquidity risk, even though the situation is different from the one the banks were facing in 2008, liquidity is once more a key element of the business continuity or going concern capacity of credit institutions during this period of crisis

There are, of course, a number of other potential impacts banks need to bear in mind. These include assessment of valuation and fair value; levels in the IFRS 13 fair value hierarchy; as well as goodwill impairment tests for cash-generating units (CGUs) that were already close to reaching impairment thresholds. Also to be aware of the impacts on demand deposit withdrawal and loan early prepayment assumptions.

While it is still early days in terms of the full impact of COVID-19 on accounting procedures for banks, the continual assessment of potential risks is a top priority.