With the coronavirus taking hold of economies around the world, a deep recession is on the horizon. The scale of the impact is unknown and could be so large that governments might not be able to bail out their economies. Once again, banks find themselves in a period of extreme uncertainty. Their business models, the health of their balance sheet and their profitability will likely be affected in ways that cannot currently be predicted with any confidence.
The last financial crisis – two factors that shaped a bank’s response to the recession
As we cast our minds back by just a few years to the Financial Crisis, it is pertinent to note that there were, broadly speaking, two key factors that influenced how well a bank responded to the resulting recession:
The composition and quality of its balance sheet at the start of the Financial Crisis. Clearly, those banks that started with high-quality assets on their balance sheets and a diversified funding mix fared better than those that didn’t.
The speed with which the bank took early decisive mitigating actions to de-risk its balance sheet. Those banks that took mitigating actions rapidly – those that ‘caught the knife’ before it was really falling – benefited from a first-mover advantage. For instance, those that were able to reduce certain clients’ credit lines early – ie before they drew down cash in order to fund the increased working capital requirements that tend to arise during a recession – benefited from superior impairment performance. Similarly, banks that were able to sell portfolios early while they could still get a good price for them, or that revisited their intraday liquidity limits and contractual agreements, fared much better than their peers.
Given where we are today, with extreme market volatility already here and a potential economic downturn imminent, this second item – ie de-risking the balance sheet early – will be a key differentiator of bank performance over the coming months and years. This may appear a self-interested perspective for banks to take at this time of societal need; but an insolvent bank is of no use to society, and banks must ensure that they risk-manage themselves robustly in order to be able to serve their customers and markets throughout this crisis.
What can banks do now to put themselves in the best position to catch the knife before it starts falling (or, at least, before it has gathered too much pace)?
What should banks do now?
Many of the banks that were able to act quickly and in a coordinated way in the last recession quickly mobilised a team to accelerate their risk management response. These teams built centralised processes to coordinate mitigating actions. They typically did this in three steps:
Step 1 - Compile a centralised inventory of mitigating actions: Knowledge where specific possible mitigating actions resides is usually dispersed across many areas of the bank, often by business, product and region. While Chief Risk Officers (CRO) or Financial Directors (FD) are aware that reducing unutilised limits are a quick and relatively painless mitigating action, he or she may not know in practice which specific limits may be cut. The challenge is to bring this information into the centre of the bank, allowing the CRO to coordinate risk management activity in a joined-up way. During the financial crisis some CROs collaborated with their business lines and regions to develop detailed lists of possible mitigating actions. These ranged from ‘no regrets’ actions that incur zero cost, such as the example above of cutting unutilised credit lines, through to particularly difficult decisions that would change the business model and sacrifice future revenue, such as selling material portfolios and businesses. Banks that exited commodities earlier bore less pain than those that had a long and protracted exit. Importantly, there is no commitment at this stage that any of the actions will be taken.
Step 2 - Group mitigating actions into prioritised waves: Prioritising these actions is key to conducting coordinated ‘waves’ of risk mitigation. This prioritisation typically involves classifying individual actions into three or four areas, starting with the no-regrets actions, and ending with the particularly tough decisions. This should be a collaborative process where businesses and regions allocate actions into the different areas, and should be done in consultation with the central team. Central coordination of this prioritisation process gives comfort to each business that any actions taken are consistent with those actions taken by other businesses. Some banks also associated triggers (eg certain levels of GDP or house prices) to the different waves of activity. These triggers are typically only prompts for discussion, rather than mechanical triggers to act. Their value is that they establish a common working assumption regarding how early in a possible recession any action should be taken.
Step 3 – Coordinate waves of mitigating actions centrally: The initiation of a given wave would typically be a decision made by the firm’s Executive Committee, with advice from the CRO. Once a wave of actions has been initiated, it is important to be able to regularly report back to the firm’s leadership team as to which actions in each wave have been taken, and what the benefit of these actions was.
Adopting this framework can accelerate a bank’s ability to act by three to six months – which can be hugely beneficial given the amount that prices, balances and liquidity can change in that timeframe, particularly during periods of uncertainty.
Who in your bank is accountable for managing the rapid execution of this process so that the knife can be caught before it is falling?
Please click here to see how Baringa can support you in driving the right set of actions, and reach out to Alex Woodhead or James Belmont if you would like to discuss any of our ideas further.