As the economic impact of COVID-19 continues to resound, banks are juggling competing pressures to cut costs and manage a spike in defaults. Paul Garbutt takes stock of the key challenges for banking in 2020 and considers how to prepare for Q4.
When the financial crisis hit in 2008, banks were seen as a contributing factor, but they are now an integral part of the coronavirus recovery plan. As such, banks are feeling the pressure to do the right thing through forbearance and continuing to lend through the Bounce Back Loan Scheme, and other government-guaranteed initiatives. But managing these competing pressures is not easy and it must be viewed within the broader regulatory landscape, which is an ongoing challenge in its own right.
We've outlined six key considerations below to help you plan for the road ahead:
1 Forbearance and defaults
Retail banking books are currently running around 13-15% in forbearance, with specialist banks well above that level.
It’s difficult to accurately gauge what percentage may fall into default until the end of the furlough scheme in October, when there may be a spike in unemployment. That said, the working assumption we are picking up in discussions with the industry is that 10% of those in forbearance will default by the end of the year
Under BBLS, higher default rates of around 40-60% are expected to start crystallising from summer 2021. Estimating a total value of £40 billion worth of loans, that would suggest a default of around £20 billion.
An increase in defaults will naturally lead to a surge in demand for collections and recoveries, and from an operational standpoint, preparation is key. This includes getting the right specialist skill sets in place and providing further training where necessary.
In preparation for a spike in defaults, discussions are underway to establish a mechanism for claiming the government guarantees for the Coronavirus Business Interruption Loan Scheme (CBILS) and BBLS.
By mid-September, the sector should have a good idea of how this works in practice, and elements of the process could potentially be outsourced. While outsourcing sounds like a practical approach, putting the necessary contractual and regulatory requirements in place in such a short time frame could be a challenge.
Any further government support to either the retail or corporate sectors could have a significant impact on banking in 2020, but the future on this is currently uncertain.
3 Protecting vulnerable customers
Treating customers fairly is always a top priority and the FCA recognises there will be an increase in vulnerable customers and firms must make sure they can continue to identify and support them.
The regulator is currently consulting on how best to do this and, in future, firms will need focus on the single customer view, rather than assessing this on a product-by-product basis.
The fallout from the financial crisis has pushed fair treatment of customers to the top of the regulatory and political agenda. This will probably lead to a regulatory push to prevent lenders from selling on loans and abdicating their responsibilities to customers.
Looking at the Q2 results season, banks with significant presence in securities markets have seen an increase in trading and fees revenues, but these are not expected to continue through the rest of year.
There has been a marked increase in loan loss provisioning in Q2, which should represent a realistic figure for total expected losses under the new accounting standards. In practice, it is clear the models built by the banks for these estimates did not anticipate events of this severity and more work will be needed on refining the estimates.
For the time being, expect audit and risk boards to be more willing to book further provisions in the coming quarters than they are to release Q2 provisions as the economic situation unfolds.
Managing credit risk is tricky under the current macro-economic environment, which is outside the parameters for existing models and the IFRS 9 accounting standard. A rise in the default rate risks an increase in provisioning and a drop in lending, with a potentially cyclical effect. To get the balance right, firms will need to model against more robust scenarios, making sure they are properly validated, with careful ongoing monitoring.
5 Cost reduction
A spike in defaults and a low interest rate will make cost reduction a top priority for banks. Many banks will rethink some aspects of their operating model and embrace automation and outsourcing to streamline their operations.
At the start of lockdown, many regulatory initiatives and consultations were pushed back to give the financial sector time to focus on the economic response to coronavirus, but not all. Some key areas of regulatory focus include the LIBOR transition, climate risk management, ongoing technical changes from Basel III and developments in the supervisory process.
While preparations for Brexit are in place, those still need to be put into practice as the transition period draws to a close at the end of the year.
Next steps for banking in 2020
To prepare for the months ahead and the expected increase in defaults, banks should review the following areas:
re-allocation of internal resources, or external support, to execute and validate higher volumes of collection and recoveries
use of automated processes for loan origination, collections and recoveries, including adequate assurance over these processes
validate the triaging of customer cohorts, these can be costly to correct further down the track
validate data and structure it across the customer journey, rather than by product lines, as payment hierarchies are a common issue arising from weak data
design and validate the operating model across all three lines of defence, taking care to reduce duplication
review risk and financial stochastic models for both internal control and external reporting
consider direct and indirect tax risks arising from the recognition of losses on lending and the benefits of claims made under government guarantees
assess broader impacts on the business and potential opportunities.