Global

The deep and far-reaching economic consequences of the Covid-19 crisis could see banks having to rethink their valuation and risk models. By Rupert Brown, founder and chief technology officer at Evidology Systems

Just four weeks into the UK’s Covid-19 lockdown and already numerous major UK retail chains had gone bust while others were threatening to hand the keys back to their landlords with no immediate prospect of a significant “return to normal”. 

Meanwhile, the UK government has announced a range of schemes to provide “interruption loans” to small- and medium-sized businesses, however few appear to have received any funds. Some grant money distributed by the UK Treasury to local authorities has recently reached its targets.

It would therefore seem ironic that the very rigorous credit assessment measures that were introduced after the 2008 financial crisis may now be strangling any hopes of rapid economic recovery once the current pandemic eases.

We should remember the 2008 crash was largely a consequence of speculative lending with little understanding of the true value of the underlying assets which were also masked by a veneer of complex derivative instruments that “smoothed” the debt servicing payments. When the music stopped and Lehman Brothers failed the challenge, it then became a case of shoring up the wholesale finance sector and investigating the true nature of the assets across its balance sheets.

Covid-19 however is primarily a problem that affects the yield on tangible operational assets, be it the revenues earned by a cruise liner or a Boeing 737 jet or even a Premier League football team. Nobody disputes their earnings capabilities in normal times and most related business projections including their second-hand resale value. However social distancing renders each of them largely worthless as they rely on large gatherings of people to both utilise and maintain their services.

As a result of this economic shock the banks have correctly enacted their “stress test” procedures as well as quietly implementing a set of background processes to increase unsecured lending costs e.g. overdrafts. It is worth remembering that the Bank of England stress test scenarios primarily focused on unemployment, house prices and stock market valuations i.e static asset values rather than a set of varying sector-based economic activity data.

While many people might think that the bankers should now be underwriting the financial impact of the Covid-19 pandemic, the reality of the situation is that we will need to rethink what the boundary is between the state and financial markets. Governments around the world are providing massive state intervention to support economies. But the approaches are different, perhaps most notably the “furlough” approach taken by the UK to temporarily pay workers vs the US approach of forced redundancy and subsequent unemployment handouts.

From ‘What’ to ‘How’

Perhaps the major change that should come out of the pandemic is a shift of focus from analysing “what” a company does to “how” it does it. Apart from the “frontline” services of the public sector, utilities and the food supply chain the only corporations that are able to function “normally” in the Covid-19 crisis are highly automated, geographically dispersed with multi-site redundancy supported by resilient telecoms.

Moving from the notion of “what” to “how” will need a new set of valuation and risk measures that focus on strategy and design as well as operational process efficiency not just the “finished” economic product.

In fact this shift from “what” to “how” has been going on for some time, driven by a series of previous global crises and political issues such as Sarbanes-Oxley (Worldcom), spinoffs from the 2016 UN Paris Climate Accord and more recently the General Data Protection Regulation (GDPR) and the Senior Managers & Certification Regime (SM&CR). These regulatory requirements are largely an unstructured and variable set of document content with no standardised reporting formats and comparative measures. 

Even in 2020, 12 years after the financial crash, we are still tinkering with the Basel risk standards and a broader panoply of global financial reporting requirements/formats/submission mechanisms so it is likely to be a long haul to standardising and automating compliance with wider principles-based regulations that are needed to underpin strategy and design regulation.

In hindsight capital buffers, be they countercyclical or whatever, as well as better balance sheet reporting, may be regarded as the supporting diagnostics and vaccine of the 2008 crash. Currently we are only able to observe the initial and largely anticipated financial symptoms of the Covid-19 pandemic, state interventions have so far been palliative rather than the complex intensive care devices and procedures that may ultimately be needed.

Perhaps because the Covid-19 crisis is truly global and knows no political or economic boundaries it will spur greater urgency and deeper comparative scrutiny of organisational processes and methods not just the current headline figures of testing capacities and personal protective equipment supplies.

While both the 2008 crash and current Covid-19 crisis have had significant impacts on the global population it is too simplistic to compare the headline decision timetables and decision-making processes of the two eras. More detailed and systematic analysis is needed but first we will need to build better tools. 

A Speakers’ Corner is an area where open-air public speaking, debate and discussion are allowed. The original and most noted is in the north-east of Hyde Park in London 

This article is free to read, request a no obligation trial access to Global Risk Regulator.