Why fast top-down risk analysis is better for margins all around.
Richard Reeves | SME Pre-Sales, Europe, Capital Market Solutions, FIS
January 21, 2021
With profit margins under new pressure, it’s never been more important for banks to understand stresses on, and opportunities for, the balance sheet. In times of short-term uncertainty and long-term change, you need to know all of your risks – and you need to know them fast.
Planned regulatory stress tests can only go so far, with a prescribed set of assumptions about interest rates, impairment and so forth. But in a real-world, out-of-the-blue stress scenario, like the COVID-19 pandemic, you won’t have those inputs for your risk models at the time you need them most.
Nor will you have the time or resources to set up and carry out the calculations. In periods of stress, risk teams and operational systems across the bank will already be fully occupied, with higher volumes of data to manage around the clock.
However, the bank still has to make a lot of decisions quickly, whether about individual loans, the lending portfolio or the banking book as a whole. And that’s difficult when you can’t see the full impact of the latest shock on your customer base or predict the ultimate outcome.
Then there are longer-term, cross-industry trends to consider, such as the growing emphasis on ESG. With so many interrelated factors involved, how can you strike the right balance between maximizing profits and minimizing concentration risk, especially when you don’t have the whole picture?
But maybe you don’t actually need the whole picture. In the real world, you can’t know how an unprecedented event will unfold. What you can do is make good use of what you know right now and let advanced technology help you formulate a quick, appropriate response.
Traders have long based their investment decisions on fast, machine-powered calculations. Now, with top-down digital analysis of your loan portfolio, risk managers can take a similarly dynamic approach to identifying risks, avoiding potential problems and seizing opportunities.
You could define your own stresses, set the severity, shape, length and status of the cycle, and see the projected effects on the portfolio straight away. You could then identify the customers and sectors that increase your risk, see the early warning signs of defaults and take action in good time to reduce the impact on the bank.
As a result of this analysis, you may wish to simulate the effect on profitability, concentration risk and capital reserves over time. You may also want to evaluate potential changes in the portfolio mix. That way, you can avoid growth in those sectors worst hit by a given stress scenario or with an unfavorable ESG profile – while still optimizing profitability, controlling capital requirements and reducing concentration risk.
Why wait until competitors have changed course? With this proactive approach, you can make faster decisions before you’re outpriced and lose a customer or the cost of hedging increases.
You’ll also be able to give senior managers faster feedback on their big ideas. Even with a wall-to-wall risk system, it can take weeks of work to show how a suggested new strategy could take effect; now it will only take seconds.
It’s not uncommon to make a business decision before commissioning a report to back it up. But working this way around is not exactly what regulators have in mind when they talk about risk reporting.
Fast risk analytics put the horse back before the cart. And when you’ve completed your top-down analysis, you could always test the strategy even more thoroughly by performing an integrated, bottom-up analysis of the risks.
With a view from above and below, and speed on your side, your potential margins will never have looked healthier.