The Shifting Sands of Risk: Are Banks Prepared for the Unknown?

The global financial landscape is in constant flux, and the release of a thought-provoking paper ¹ by the European Central Bank (ECB) earlier this year serves as a stark reminder of this reality. The paper shines a light on the challenges banks face in navigating a new era of risk, one that is impacted by unprecedented economic volatility, the effects of climate change, and an evolving diversity of societal expectations. While the financial crisis of 2008 exposed vulnerabilities in traditional risk management practices, the ECB warns that we are now entering uncharted territory – grappling with risks that are not only complex and interconnected but also lacking the historical data that has been used to guide the development of quantitative risk models. For banks, this means going beyond traditional financial metrics and developing a more nuanced understanding of how niche risk factors can affect their clients, investments, and own operations.

Inflation’s Resurgence: A Ghost from the Past Haunts the Present

Inflation, famously described as a “cruel tax” by Nobel Prize-winning economist Milton Friedman for its erosion of the purchasing power of money, has taken centre stage in recent economic discourse. The ECB paper acknowledges that while inflation risk is not new, its resurgence – fuelled by geopolitical turmoil, supply chain disruptions, and unprecedented fiscal stimulus – demands a fundamental rethink of risk management approaches. Traditional models, heavily reliant on historical data, struggle to adequately capture the complex dynamics of a rapidly shifting inflationary environment. In their thematic feedback on IFRS 9 accounting practices, the UK Prudential Regulation Authority (PRA) identified the need for better quality data to fully understand the relationship between inflation, interest rates and credit losses. 

Banks must move beyond backward-looking analyses and adopt a forward-looking perspective. This requires the use of stress tests that consider a wider range of potential inflation trajectories, scenario analyses that factor in geopolitical risks and their impact on supply chains, as well as incorporating economic indicators that provide early warning signals of rising inflationary risk. Furthermore, the interconnected nature of the impacts from inflation risk necessitates a holistic approach, evaluating its potential impact not only on loan portfolios but also on banks' operational costs, funding profiles, and even on customer behaviour.

Climate Change: The Existential Threat Reshaping Finance

Climate change poses an unprecedented challenge to the financial system, and the ECB paper also underscores the urgency for banks to incorporate climate risk into their risk management frameworks. The paper draws a clear distinction between physical risks, such as the increased frequency and severity of extreme weather events, and transition risks, which stem from the shift to a low-carbon economy, encompassing policy changes, technological advancements, and evolving consumer preferences. Similarly, the impact of climate change on geopolitical risk should also be considered as a second order effect in climate risk models.

Banks face a multitude of practical challenges in quantifying and managing climate risk:

• Addressing data currency through alt-data: Historic climate data can sometimes prove insufficient when it comes to projecting future events accurately. To address the shortfall, banks are embracing alternative data (alt-data) sources such as climate modelling outputs, geospatial data, and satellite imagery to supplement more traditional datasets.
• Granularity: The PRA also noted the need for more granular and sophisticated approaches to quantifying the impact of climate-related risks on expected credit loss (ECL). This can be achieved by embedding climate risk into loan-level credit risk assessments or by analysing probability of default (PD), loss given default (LGD) and exposure at default (EAD) impacts separately.
• Cascading Effects: Accurately assessing climate risk necessitates modelling its far-reaching consequences across multiple sectors and geographies. This includes understanding how extreme weather events can disrupt supply chains, impact agricultural yields and, in extremis, trigger mass migration, leading to social and economic instability. Banks need to better understand the complex relationships between different parts of their business by performing scenario analysis.
• The Unknown Unknowns: Perhaps the most daunting aspect of climate risk is its inherent uncertainty. Predicting the timing, magnitude, and specific consequences of climate change remains a complex scientific endeavour, demanding a degree of humility from risk managers accustomed to quantifiable risks. For example, climate risks will crystallise over a longer time horizon than current stress testing frameworks are equipped to deal with. Traditional credit risk models focus on the best-estimate, but often ignore tail-events that could cause large Jensen Errors ². This can be addressed by more sophisticated modelling techniques that avoid simplifying assumptions.

ESG: From Niche Concern to Mainstream Risk Factor

Environmental, Social, and Governance (ESG) factors are rapidly transitioning from a niche consideration to a mainstream driver of financial risk and opportunity. The ECB paper stresses the importance of integrating ESG factors into risk assessments, acknowledging their potential to impact creditworthiness, market valuations, and even reputational risk.

For banks, this means going beyond traditional financial metrics and developing a more nuanced understanding of how ESG factors can affect their clients, investments, and their own operations:

• Supply Chain Vulnerability: Companies with poor ESG practices within their supply chains face increasing scrutiny from consumers, investors, and regulators, potentially impacting their financial performance and reputation.
• Stranded Assets: The transition to a low-carbon economy could render certain assets, such as fossil fuel reserves, economically unviable, posing a significant risk to banks with exposure to these sectors. Anecdotally, this is proving to be a challenge for real estate developers and investors, with stringent new EPC requirements making some properties unlettable.
• Social License to Operate: Banks perceived as not aligning with societal values on issues like climate change, racial and gender diversity, and human rights risk reputational damage, loss of customer trust, and even legal challenges.

For a detailed review and commentary of the latest regulatory guidance on ESG in Credit Risk and an overview of our innovative ESG scoring approach please see a previous blog post in the link below: 

The EBA's Report and our ESG Risk Scoring Approach | Deloitte UK

Navigating the Complexity: A Call for Transparency and Collaboration

The ECB paper emphasises the need for banks to balance model complexity with usability and explainability. While incorporating novel risks into risk management frameworks necessitates more sophisticated modelling techniques, it is crucial that these models remain transparent, readily interpretable by stakeholders, and auditable by regulators.

To address these challenges, the ECB calls for greater collaboration: 

• Enhanced Data Sharing: Banks should collaborate with each other, regulators and third-party data provides to develop standardised methodologies for collecting and sharing data related to novel risks, facilitating industry-wide risk assessments.
• Regulatory Guidance: Regulators play a crucial role in providing clear guidance on supervisory expectations for managing novel risks and promoting consistency in risk assessment approaches. Banks need to work more closely with their regulators to develop standardised methodologies for assessing and quantifying the novel risks.
• Interdisciplinary Dialogue: Addressing complex challenges like climate change requires fostering dialogue between risk managers, climate scientists, economists, and social scientists to develop a more holistic understanding of these interconnected disciplines.  For banks this leads to better understanding of how climate change can affect their clients, investments, and own operations.

The challenges posed by these novel risks are undoubtedly significant, but they also present an opportunity for banks to demonstrate leadership, innovation, and resilience. By embracing a forward-looking perspective, investing in robust data and analytics capabilities, and fostering a culture of collaboration (between different parts of the business, regulators and third-parties) and transparency, banks can not only navigate the uncertainties of the evolving risk landscape but also play a pivotal role in shaping a more sustainable and resilient financial system for the future. The journey may be challenging, but the destination – a financial system equipped to withstand the unknown – is one worth striving for.

For a more detailed review and commentary on current credit conditions and impairment levels for the UK banking sector please see the latest IFRS 9 report from Deloitte in the link below: 

IFRS 9 | 2Q24 results update: the outlook continues to improve and regulators have been busy! | Deloitte UK

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References

¹ IFRS 9 overlays and model improvements for novel risks, European Central Bank, July 2024. See also: https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.IFRS9novelrisks_202407~5e0eb30b5c.en.pdf

² Jensen Errors are made when a linear approximation is made where the true relationship is non-linear. Bounds on the Jensen Gap, and Implications for Mean-Concentrated Distributions, The Australian Journal of Mathematical Analysis and Applications, 2019. See also: https://ajmaa.org/searchroot/files/pdf/v16n2/v16i2p14.pdf

³ Optimism despite inflation, London Office Crane Survey, Deloitte, 2022. See also: https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/real-estate/deloitte-uk-london-office-crane-survey-summer-2022.pdf