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BIS Newsletter on credit risk issues for banks and supervisors: Navigating the Uncharted Waters of Credit Risk in a Post-Pandemic World
Overview of the BIS newsletter on credit risk issues, addressing key areas of concern for banks and financial institutions and ongoing challenges in credit risk management and provisioning as an aftermath of the persisting effects of the COVID-19 pandemic.
In the face of enduring economic uncertainty, banks are tackling to assess the creditworthiness of borrowers across various sectors. It is crucial that banks maintain rigorous provisioning practices to identify potential deterioration in credit risk timely and consistently.
On July 4th, 2023, the Bank of International Settlements (BIS) published a newsletter on credit risk issues highlighting several key areas of concern for banks and financial institutions addressing ongoing challenges in credit risk management and provisioning amid the persisting effects of the COVID-19 pandemic, rising interest rates, and volatile market conditions. These areas are crucial for maintaining the stability of the banking sector and ensuring the sound management of credit risk. Since the Newsletter on Covid-19 related credit risk issues published in March 2022, credit risk has been a key area of focus. Failure to effectively measure credit risk may lead to potential future losses, impacting the banks' capital adequacy and undermining confidence in the sector. It is noted that the newsletter is for informational purposes only and does not constitute new supervisory guidance or expectations. Here are, in our opinion, the most important topics identified, along with suggestions on how to mitigate or monitor these issues:
- Ongoing Economic Uncertainty and Credit Risk Assessment: The ongoing economic uncertainty, due to factors like rising interest rates, high inflation, and market volatility, is making it challenging for banks to assess the credit quality of borrowers and vulnerable sectors. Banks should enhance their risk assessment models to better capture the evolving economic conditions. Regular monitoring and updating of credit risk models to reflect the current economic environment is crucial.
- Variations in Internal Ratings-Based (IRB) Models and Provisioning Practices: There are observed variations in the practices on IRB models and provisioning across banks, which could affect the timely recognition of changes in credit risk. Supervisors should continue to monitor these practices closely and take necessary actions, such as issuing guidance and conducting onsite investigations. Banks should also strive for consistency in their IRB models and provisioning practices and ensure they are in line with best practices and regulatory guidelines.
- Reliance on Judgment-Based Adjustments in Credit Risk Modelling: Banks are heavily relying on judgment-based adjustments to compensate for model and data limitations, which could disconnect credit risk from the actual risks of the portfolios. Banks should continuously enhance controls around model risk management and development to ensure they remain fit for purpose. They should also monitor the effectiveness of these adjustments and make necessary changes when required.
- Undercalibration of Probability-of-Default (PD) Models: Supervisors have observed under calibration of PD models, which could lead to inaccurate credit risk assessments. Supervisors should continue to monitor the calibration of PD models and take remedial actions when necessary. Banks should also regularly review and adjust their PD models to ensure they accurately reflect the probability of default. This could include model overlays, risk-weighted assets (RWA) overlays, PD scale-ups, and RWA add-ons.
- Impact of Macroeconomic Changes on Borrowers: Recent geopolitical events and economic shocks have made it difficult for banks to assess how these changes affect different portfolios, leading to heightened model risk. Supervisors should focus on how banks are using their sensitivity analysis capabilities and how effective their processes are in identifying vulnerable sectors.
Three Main Challenges Identified by Supervisors
The below graphic presents the Main Challenges identified by BIS while doing a deeper dive into the remediation approaches banking institutions should follow in order to minimise model risk.
Tackling Credit Risk in the New Normal:
The current volatile economic scenario necessitates ongoing revisions and improvements in credit risk modelling. Recent geopolitical events have introduced a new cycle of credit conditions, even before the full impact of the pandemic has been absorbed. Banks need to factor in the effects of rising interest rates, high inflation, and market volatility on borrowers. In this regard, identifying cycles and isolating the downturn period for the Expected Credit Loss (ECL) process and for Internal Ratings-Based (IRB) models can be rather challenging and might pose new challenges for banking institutions.
In conclusion, banks and supervisors must be ready to tackle challenges related to ECL provisioning processes and IRB models as these topics highlight the importance of robust credit risk management practices in the face of economic uncertainty and evolving risk environments. Banks and financial institutions should take these issues into account in their risk management strategies and work closely with supervisors to ensure the stability and integrity of the financial system. It is time for banks to adapt, recalibrate, and gear up for the new world of credit risk.
How can Grant Thornton help?
At our firm, we offer expert consulting services to assist institutions navigate through these challenging times. Our experienced and broad team of professionals understands that regulation continues to drive the strategic agenda for banks and investment firms. We are able to provide guidance in fine-tuning credit risk models, enhancing the identification of potential credit deterioration, and improving governance controls. We specialise in assisting clients across the financial services sector in navigating through the maze of regulation and support clients to identify regulatory obligations and work towards full compliance balanced with your business needs. We strive to empower our clients with robust strategies for risk management, helping them stay resilient in an ever-evolving financial landscape.
