The impact on COVID-19 can be talked about in phases, the  initial shock, the reaction phase, the response and then the  recovery. 

When the pandemic situation surfaced, it was a bolt from the  blue. All of a sudden there was a state of confusion. Business  Continuity Plans / Disaster recovery programmes in place could  not give clear directions as there was no past experience  available for this magnitude of disruption. 

In the first wave, the sudden lockdown announced put the Banks  also under lock initially. Repeated advisories were advertised for  usage of digital services as an alternative for Bank transactions. The Covid-19 has no doubt wreaked havoc without any  discrimination. Being the backbone of the economy, the banking  industry takes the brunt in supporting the larger interest of the  country’s economic strategies to minimise damage and also to  speed up recovery. 

Risk has a larger role to play in guiding the business through  these troubled waters. Every category of risk needs a relook. The  initial Risk impact was on the operations and customer service.  The crisis brought about a sudden shift in the actions; the  policies, the processes, the business model itself. The Financial  institutions had to respond without much lead time to go through  the usual rigours as a part of the Risk governance. The sudden  spurt in digital modes lead to surge in volumes of transactions  throwing open a window of opportunity for the unknown faces for  phishing, smishing, hacking etc. Popularising digital services  required educating the masses in a shorter time. 

Added to the operational modifications adopted was the change  in credit sanction, monitoring and recovery aspects on account  of modified regulatory prescriptions and the financial support  advised by the Government.

The stimulus by way of Moratorium, Asset classification  forbearance allowed and stand still for initiation of recovery  measures, reassessing of the working capital limits and  reduction in facility margins to accommodate additional finance  to facilitate the corporates to tide over the negative effects of  stoppage in activity, direct benefit credits to the accounts as a  sustenance facility, are some of the measures which increased  the service efforts at bank branches. MSMEs were to be given  additional finance to tide over the difficulties and with  government guarantee. 

In case of loans where moratorium is extended, FY 20–21 may  not see any pressure on asset prices, but the same cannot be  ruled out in FY 2021–22. If that materializes, Banks would face  dilution risk and consequent increase in provisions. With low  level of cash flows in FY 2020–21, accounts which are already  Non Performing, may migrate downwards and result in increased  provision requirements. 

Under the Risk and compliance function, Business impact study  has to be redone taking into account the internal as well as  external environment.  

The forward looking models have gone for a toss and whether it  is the thresholds fixed, the forward looking numbers used for  strategizing, trigger levels, portfolio diversification proposed, the  rating grades or the PD levels estimated. All such outcomes will  have lost relevance in the current decision making process. 

The loss of employment and salary cuts among the general  public will take time to normalise and is likely to have a cascading  effect on retail recovery in the near term. This may have an  impact on the probability of default in retail loans. 

Liquidity risk appears under control on account of steps taken by  the regulators. However it could be a mirage as we approach the  horizon and liquidity perceptions may change. In many  economies the appetite for credit offtake is subdued though  banks are sitting on excess liquidity. The restoration of supply chain to normal levels, and industries, service units taking off  upto the pre covid-19 levels, is likely to take time. Hence stress  will be seen on liquidity risk and is a factor to be watched on a  continuous basis. 

With all the impact on the banking industry, we need to see  where the stress situation stands. 

In the current circumstances if one does a back testing of the  previously computed outcomes, variations will be seen. 

What would the future be like is a million dollar question ? 

There are probabilities and uncertainties. The second wave has  affected many and begun in several countries. The uncertainty  continues until the vaccination drive world over reaches an optimal level.  

Indicative steps that can be taken to manage the risk in the  current circumstances: 

1. Balance sheet projections. Impact on the bottom line and the  increased provisions have a negative impact on plough back to  Capital, or payment of dividend affecting the investor  expectations. 
2. Extended moratorium and large scale restructuring during the  first phase of COVID during last financial year may result in higher defaults, which entails higher provisions, allocation of  additional capital to Credit Risk, though in the short term it  prevents higher defaults. 
3. Even after normalisation of current trends, asset quality  downgrades are a certainty with a lag of one to two years upon the extent of restructuring and rephasement provided and the  satisfactory performance during this phase. Hence continued  allocation of higher capital to credit risk in future years is also  likely to be required.
4. Higher capital requirement for Counterparty Credit Risk Credit  Value Adjustments to be evaluated. 
5. Increase in Market Risk capital requirement mainly on account  of mark to market impacts as well as Potential Future Exposure  in case of Forex transactions/ Derivative transactions. 
6. Increase in Operational Risk in case of those in Basic Indicator  Approach (BIA) or The Standardised Approach (TSA) may not  be of much impact given the methodology applied as per  guidelines. However, operational losses can be expected due to  disruption in business, hardships faced by employees, loss of  life, protracted health issues, process flaws etc. The people's risk  under the Operational risk category is on the increase due to  reduced services, infections, mortality, and low morale of employees.  Loss estimation needs to be assessed as cost is involved apart  from the humane emotional considerations. 
7. Probability of Default (PD) Models need a review of estimated  PD. Increase in defaults is expected. 
8. Loss given default (LGD) is expected to be higher especially  in secured loans as the haircut on collateral is likely to increase  as collateral value in the current market will go down.  Foreclosures may not yield the desired recovery in value terms  on account of subdued demand. 
9. Exposure at Default (EAD) will increase as the drawals in  sanctioned Line of credit is bound to increase as the business  units may resort to drawings for meeting expenses, without  relative increase in top line. 
10. If the 3 Risk estimates as above increases, especially in high  exposure brackets, the absolute default amount is going to have an impact on Expected Loss (EL). Given that the downturn is here  or in the coming year, the level of conservatism expected has to  be prudently decided as any over enthusiastic decision would be  adverse, given that expectations of better days ahead is a certain  hope. This apart Unexpected Losses (UL) moves to higher levels which  calls for increased need for more capital. 
11. Rating Model review is another challenge as given the  current situation, most borrowers rating is likely to be  downgraded in the Internal rating Model as well as External  Rating Models affecting credit decision and increased Credit  Risk premium. 
12. Pricing is a function of Repo rate as well as loading of Credit  risk premium, Liquidity & Term Premium and Profit margin. In the  backdrop of increased credit risk premium, transmitting  reduction in rates is going to be difficult as this would mean  subsidizing the borrower at the cost of Banks profits. 
13. Downsizing the Balance sheet can be a solution, but the  thrust on increased lending has to be weighed into this decision  in support of the measures of regulators in the interest of the  economy. 
14. Credit Concentration Risk, Default Risk are likely to show an increasing trend thereby requiring higher pillar 2 capital. Likely  low levels of Gross Income in current year and in future years may  also call for maintenance of Pillar 2 capital for operational risk.  Pillar II impact is expected to be worsened this year and the  impact of Capital to Risk Asset Ratio (CRAR). 
15. Lastly, the impact on Expected credit loss on account of large  scale restructuring causing the accounts to shift to Stage 2. The  Banks have not yet moved to Ind AS 9 and this could be a  blessing in the current situation. However, the reality of expected  increase in credit loss remains. 

The financial sector is passing through a tough time and getting  muddled in the quagmire of supporting the economy, supporting  borrowers, supporting markets, supporting its own numbers  ultimately and amongst all these disruptions trying to maintain the acceptable business parameters to the investors and stakeholders. 

The situation is an eye opener that the graph of growth does not  always climb up. Forward looking Models are not as predictive  as we desire or rather we believe it to be. A Black swan can come  and hit us any time. It’s foolhardy to think that Model outcomes  give a perfect direction to enterprise decisions, ignoring the  assumptions and the data inputs and imputations etc. 

A review of Models is now going to be a challenge if the current  year is likely to indicate a downturn coupled with the sentiment  of negativity. Risk managers have a tough job ahead in getting  to decide on a reasonable, acceptable but equally conservative  outcome. 

It’s time to think of strengthening systems to meet certain  contingencies as holding capital to cover the stress situation  would only result in sub optimal utilization of capital hindering  credit growth. The future is going to be a changed world and Risk  Management has a long road ahead to review and reform its  policies, processes and re-engineer strategies being cognisant  of the altered work environment. 

Apart from executing the regulatory and Government driven  programmes, the banks will have to start with; 

1. Adjusting , refining and redefining the policy guidelines,
2. Put the business process reengineering team to work  overtime, attend to IT infrastructure upgrades, enhance /  strengthen the functions of security operations centre,
3. Review the capital models,
4. Recast the risk appetite statements and review risk limits and  see impact on ROE, ROA, Margins, credit cost on account of  reduction in interest rates, recast the marginal cost and be aware  of impact.
5. Thorough review of ICAAP, as Pillar 2 capital impact is likely  to increase, the correlation among the risk factors have to be  reworked.
6. Focussed attention required on impact of stress tests on the  CET1 Capital.
7. Reverse stress testing model to be reviewed as the CRAR  targeted will undergo a change given the rebalancing of business  mix.
8. Draw a road map for bringing the additional limits provided by  reducing facility margins to normal levels in a phased manner, 9. Review at intervals to track the movement of policies modified  and rerouted at the right time.
9. Create new cohorts in the models for obligors to whom we  will have to pay more attention in monitoring to avoid  slippages.
10. Rules in fraud monitoring, AML, or early warning systems  need to be reviewed thoroughly to ensure they conform to the  current situational challenges in identification.
11. Evidently the requirement of capital is going to rise and in  these troubled times the source of capital could be a challenge  which needs serious thought by all Bank managements.
12. Macro economic factors considered in the economic capital  model or the Expected credit loss model have to be reworked. The weightages may have to be changed to be more realistic  given the type of stress we are seeing.

The increase in flow of deposits to the Banks, given the vagaries  of market instruments, will increase the interest outgo burden.  There doesn’t seem to be an immediate concern on liquidity, ably  supported by the regulator and also since credit growth is  subdued. However, once businesses start operating full stream  and credit demand goes up, there could be withdrawals in big  ticket borrowers, an effect already seen after the first wave of  COVID. 

Given the low rates, it is likely that large corporates may get the  sanctions and keep their limits available to take benefit of the 

situation. However, this does not augur well for the bank’s  margins and EAD models. 

The Banks are also going through a learning process in  operational resilience, digitisation of operations, Cyber risk  models, adaptation to the new normal, calibrating model outputs  and quantification of risks for the pillar 2 and stress models. 

Need of the hour in banking is robust risk management with  high degree of management prudence to decide on the overlay  required in model outcomes and also to calibrate not just for  current year but also in future years until the effect of the current  pandemic evens out. Building multiple ‘what if’ stress scenarios  using the macro economic factors with prudent judgement is the  way forward in the present situation. 

Impact on Manufacturing sector is no doubt expected, but the service sector will see much more damage, especially the  unorganised segment in Rural and Semi urban areas. The  Banking sector is encountering a manpower impact with the  employee infections, mortality, an effect of continued service in  frontline branches. In such a situation, neither the credit growth  nor the recovery is likely to reach the desired level of contribution  to the economy at least in the first half of 21-22. The silver lining  is the ambitious vaccine coverage by Dec 2021 to a majority of  citizens, opening up of all businesses without fear and  retributions. 

All things come to an end , Good or Bad. Looking for the positive  light in the horizon.

Smt. Shashikala Ramachandra, Retired General Manager and GCRO from Canara Bank. Associate partner Pegasus Institute of Excellence, Director , Kogta Finance India Ltd, Blogger on Risk and Banking related subjects (https://medium.com/@shashi.ramachandra)