It should be noted, however, that banks’ internal credit risk frameworks face various challenges, some of which may require some external help.
Even though the banks came to this crisis well prepared and were so far able to withstand the storm, it is key for them to be able to estimate the expected loss parameters (PD, EAD, LGD) as accurately as possible. If expected losses are overestimated, a bank might keep too much capital which might be effective in preventing future losses, but it will decrease its profitability, particularly considering the negative ECB rates. Alternatively, an underestimation of risks might lead to good profits when there is no crisis but endanger the bank during crises.
Additionally, adjusting the expected loss’ parameters to the new and uncertain scenario is key to managing the stock portfolio and the potential credit requests. Both approval and pricing policies must be adapted. Integrating relevant macroeconomic forecasts and uncertainty with the bank’s fundamentals to develop a meaningful and flexible policy framework is invaluable. In this sense, It is important to emphasize that current credit state guarantees can generate a problem of moral hazard and, thus, making use of different perspectives regarding filtering “good” from “bad” clients may be expedient.
Similarly, developing adequate stress tests, both ex-ante and ex-post the pandemic became one of the hot topics in the banking sector. These tests give a good approximation of how the bank will operate under extreme conditions and, thus, allow for adequate preparation. It is very important for banks to carefully integrate their fundamentals with negative macroeconomic indicators and uncertainty, to determine realistic impacts for them, and to avoid excess or lack of capitalisation.
Moreover, the current regulatory environment can be difficult to track, due to the frequent policy introductions and regulatory flexibility measures implemented. Tracking all the different regulatory changes as effectively and efficiently as possible is of utmost importance, both to take as much advantage as possible to secure continuity of operations, as well as to avoid costly fines or take measures that would lead to a comparative disadvantage. Quickly changing regulatory landscape may, in the short term, be the worst challenge that the (often understaffed) departments of various banking institutions face.