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. Articles scheduled for Volume 14 are available to view on the Forthcoming content page.

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