Why managing further uncertainty is key to resilience for bank CROs

After navigating the COVID-19 pandemic, CROs face further disruption ahead. Careful judgements and agility will be key in meeting new tests.

In brief

• Banks have come through the pandemic well, with credit concerns from lockdowns not yet occurring.
  
• The war in Ukraine is driving broader economic change and increasing downside risk for bank CROs to manage.
• As banks continue to use overlays and judgement, regulators and the market will demand ever greater transparency on their use.

Bank chief risk officers (CROs) have already had to manage a wave of constant disruptions over the last few years. Despite those pressures, the banking system has shown great resilience and credit concerns from pandemic lockdowns have not materialized yet.

They are now facing three interacting trilemma risks:

• Money: the combination of rising interest rates and inflation with quantitative easing wind down, is squeezing consumers and creating uncertainty in capital markets.
• Energy: businesses need to plan for increased energy costs with a backdrop of further instability, while striving for lower carbon solutions.
• Supply: supply chain cost and complexity caused by geo-political pressures and tougher environmental regulations call for different supply chain models.

The war in Ukraine has added another set of issues for bank CROs to manage. While direct impacts are limited, inflation, energy security and food security are driving major economic change.

Trying to calculate the impact across these risks is extremely complex. To help build a more informed picture, we wanted to better understand where banks’ CROs’ approach and sentiment currently stood. As part of the EY knowledge collaboration with the European Banking Federation (EBF), we surveyed European bank CROs on their experiences during the COVID-19 pandemic as well as spoke to them about the impact of the war in Ukraine.

During the COVID-19 pandemic, we found smaller banks expected the peak of distress to hit them later in the economic cycle. Many CROs were also concerned about the fragility of the retail book. This reflects high inflation and the cost-of-living squeeze having increased the pressure on consumers, who are also no longer protected by furlough.

Some takeaways from our research that will shape CROs’ agenda in the short and medium term, include:

Continued use of overlays will require more detailed explanation

Banks enhanced their models post the financial crisis, and implemented International Financial Reporting Standard (IFRS) 9. But they have had to use judgement and overlays in their provisioning when dealing with the impact of the COVID-19 pandemic and the war in Ukraine. They did this well but this is a significant change and challenge for banks and regulators. Models were seen as allowing greater accuracy of forecasting, at a much more granular level, across a range of scenarios. Given overlays are likely to stay for a period of time, banks will need to explain what they represent and how they have been calculated.

Managing constant disruption will continue for CROs

Bank CROs will continue to face an uncertain macro environment. As well as the trilemma risks, they will need to plan for possible new variants of COVID-19, and consider any government measures to support consumers dealing with increased inflation. Judgment will continue to be critical in how banks navigate all these interacting forces in the months and years ahead.

Cautious approach to be welcomed

Post 2008, it was agreed banks should hold more capital and book provisions earlier. While the last few months have shown the limitations of modeling in achieving that, CROs have used their judgment to add more caution and resilience in the system. The use of overlays and provisions is much more helpful than the alternative of booking defaults and incurred losses when they arise.

Increased stresses could materialize at some point

So far, the banking system has avoided major problems. However, outstanding debt from COVID-19 loans, combined with the trilemma risks (money, energy and supply), means banks may be facing significant credit impacts in the medium-term. Bank CROs recognize that there is more downside risk at present.

This article is co-authored by EY's Laure Guégan, EMEIA Financial Services IFRS Leader and Erberto Viazzo, EY EMEIA Financial Services NPE Leader; Partner, Strategy and Transactions, EY Advisory S.p.A.