Banks must act on early warning systems or risk lower ROE
Are early warning systems (EWS) for assessing credit risk essential for maximizing corporate banking returns and shareholder value? Certainly yes! but how many follow them?
Changing external forces create many risks for corporate banks globally. Investment banks are witnessing today the end of an era. Following the financial crisis of 2008, banks rebuilt their capital and invested in technology to strengthen their relationships with their customers by improving their efficiency.
Macroeconomic factors such as inflationary pressures, pandemics, frequent climate change events and increased geopolitical risk can disrupt supply chains across all sectors and have an unexpected impact on businesses.
The banking industry now faces a new era that will test the ability of banks to sustain their risks and exposures without having historical evidence or data on how to predict or manage risk. Banks can no longer depend on their current SAP using backward-looking indicators with high false positives, to protect them from future risks. Old methods and data sources for assessing credit risk or identifying distress signals are quickly becoming obsolete.
Banks have a limited window of opportunity to adapt and react to emerging scenarios, says a latest report titled “Banks must act on their early warning systems or risk a decline in return on equity (ROE) , co-authored by Raj Abrol, CEO of Galytix; Rupak Ghose, Head of EW, Galytix; Symon Dawson, Partner, PwC; Matt Moran, Partner, PwC and Natasha Rakova, Director, PwC; and Roxane Haas, Partner, PwC .
The report shares insights that although large systematic shocks are unpredictable, it is clear that the speed with which banks are able to react to these events can have a significant effect on the ability to actively manage the loan portfolio and reduce any negative impact.
The same can be said about the ability to have early warnings of more common “daily” market movements and events. Banks are struggling to generate returns in their business loan portfolios. Galytix estimates ROE on a stand-alone basis without investment and transaction banking support to be between 3-6%.
The experience of Galytix and PwC is that currently most early warning indicators produced by banks might be meaningless. Given the increase in false positives, several manual data checks are implemented by banks to ensure consistency, efficiency and accuracy of signals, which ultimately increases the cost and time of management of the early signal detection process.
The ECB also criticized the use of ad hoc manual triggers implemented by banks and the need for a more systematic approach to alert monitoring. For many banks, existing EWS frameworks are based on more readily available and traditionally used data sources, including customer financial data and market data that is readily available. However, these indicators are generally retrospective and do not predict business failures well enough.
“An effective SAP must identify borrowers at risk of non-performance (High Hit Ratio), distress or default some time before an actual event (Time before Default). It should enable efficient and reliable assignment of borrowers to different watchlist categories and trigger further actions and escalation scenarios depending on the nature and severity of the risk. The system should use indicators derived by combining traditional and non-traditional data sources (internal and external) using a multivariate modeling or decision tree approach,” the report states.
Financial statements alone are no longer sufficient for risk managers to assess solvency. Banks that fail to improve their SAP will also face significant regulatory pressures. The European Central Bank (ECB) highlighted the huge variation in the quality of early warning systems and how micro and macro level credit assessment is central to risk management and provisioning. In addition, banks are also losing their competitive position to bonds and non-bank lenders in many countries.
Galytix estimates that more than three-quarters of business financing in the United States comes from these sources. This trend is less pronounced in continental European countries, where bank lending continues to dominate.
Upgrading SAP is crucial for corporate banks to strengthen their competitive advantage and improve their returns. This needs to be integrated throughout the credit chain, from loan origination to execution and risk monitoring.
The strategic case for developing and implementing an SAP is clear: effective risk monitoring will reduce both credit losses and capital requirements, directly improving a bank’s ROE more by 20%. Experience shows that an effective SAP could help reduce loan loss provisions by 10-20% and required regulatory capital by up to 10%. Additionally, an effective SAP will also maximize shareholder value by substantially reducing corporate banking earnings volatility. This will support higher market valuation multiples.
A LEGO framework (leverage, external indicators, governance and ontology) implemented in a solution based on an AI-driven pipeline architecture can accelerate SAP quality and efficiency.
This framework involves streaming real-time data and analytics, adjusting current metrics, adding a few high-impact metrics, and providing a systematic and automated capability to manage SAP without creating unnecessary charges. These processes allow credit risk managers to quickly assess counterparty exposures.
PwC and Galytix believe that expanding the list of early warning indicators should focus on external data sources with the greatest impact on stock market signals, governance, fraud, aggressive accounting or cyber -risks. Financial investors and banks are very interested in sentiment analysis.
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