How the Pandemic Is Changing Risk Management for Banks

Like the rest of the global economy, the banking sector has been struck by turbulence throughout the COVID-19 pandemic.

As the pandemic has ebbed and flowed since hitting the United States hard in March 2020, banks have faced multiple mini-cycles of turmoil. The initial devastation in spring 2020 turned to a limp pseudo-recovery in the summer turned to a horrific surge in the winter, followed by expansive and faster-than-predicted reopening aided by mass vaccination efforts in the US starting in the spring of 2021, even as COVID-19 surged in many areas of the world.

How do you manage risk amidst all the mayhem? Well, banks have had to figure it out while the pandemic has been roaring all along. There have been noticeable trends in risk management across the entire banking sector. Many of these trends were initiated before any of us knew about COVID-19, but the uncertainty during the pandemic bolstered several ongoing patterns.

For small business owners, understanding how banks are altering their approaches to risk management is critical. Knowing how lenders are strategizing can better position you to apply for loans in the post-pandemic world.

No American banks failed during the pandemic, largely due to liquidity and capital regulations imposed by the government after earlier financial disasters like the Great Depression and Great Recession. The Office of the Comptroller of the Currency (OCC) noted in a report for the federal government that while liquidity provided protection for banks, it was much harder for them to turn a profit during the pandemic.

“Banks maintained sound capital and liquidity levels, but profitability remains stressed due to low interest rates and low loan growth,” the OCC said in a report from May 2021.

Before the pandemic, risk management was already becoming more complicated and more expensive for banks, according to think tank McKinsey, because the overall financial environment was becoming both more regulated and riskier. The pandemic proved to make risk management even more complex—at the initial height of the pandemic, many small borrowers, for example, couldn’t come into a physical bank to submit loan applications even as the need for funding soared.

“Risk managers must understand the pandemic’s impact on credit and market portfolios to mitigate the effects on their own operations,” McKinsey advised in a recent report. “They’ve had to track emerging threats to the newly remote workforce, to current and potential borrowers, and to other bank customers. They’ve implemented government-directed moratoriums on loan collections and abided by other local or national measures adopted in the pandemic’s wake. Those actions have cut into top-line revenues at a time when banks are adding expensive new risk-management practices.”

McKinsey believes that the pandemic has caused the operating costs of risk management for banks to increase by 10% to 30%, which results in banks becoming more averse to approving loans for small businesses they deem risky.

Because the pandemic was so unpredictable, banks’ financial forecasting models had to be quickly updated amid unprecedented change. Even as COVID-19 will recede into memory years from now, many banks will be more conscious that vast instability can wallop countries as seemingly established as the US in a matter of days. Even if your business is “recession-proof,” how disaster-resistant is it? A pandemic like we are living through was unimaginable for many of us just 2 years ago—banks and businesses will probably be thinking about future large-scale disruptions when determining risk management.

“The effects of COVID-19 were so rapid, wide-ranging, and interconnected that banks’ liquidity, market, and credit risk models could not adequately reflect them,” multinational accounting firm KPMG noted in a report. “Unemployment, for example, shot up massively almost overnight in many countries and jurisdictions when in a ‘normal’ recessionary period it climbs slowly over a longer period. Assumptions behind models therefore had to be rapidly reviewed.”

The pandemic impacted different sectors of the economy very differently—e-commerce boomed and tourism was decimated. Many now might expect the reverse to occur, but the reality won’t be clear until we’re closer to mitigating the pandemic across the world. Even then, it’ll likely be difficult for banks dealing with small businesses to forget how a sudden disruption could impact your bottom line.

“Credit portfolios, which had to be reweighted away from challenged sectors such as airlines, leisure, and corporate real estate, will continue to dynamically evolve in the aftermath of the pandemic,” KPMG continued. “Lending criteria in personal markets are likely to become more stringent. However, opportunities could also arise as changes to consumer behavior create new types of credit demand.”

When a crisis like COVID-19 happens, the capital and liquidity at banks are strapped. It makes sense, then, that banks would be interested in moving capital toward businesses that remain productive even during a crisis. That doesn’t mean they are completely afraid of risk, but there has to be good evidence from accurate forecasting models that the risk is well worth the investment.

“Reliable metrics require alignment between the risk and finance functions from a business outcome perspective rather than merely ensuring technology alignment between risk and finance IT teams,” the consultancy arm of multinational corporation Tata explained in a report. “Banks that lack an active risk and finance alignment program should initiate one while banks that have already taken steps in this direction must ensure that the program is driven by broader business outcomes instead of just cost optimization and IT systems rationalization goals.”

As banks push to bulk up their risk management divisions as efficiently as possible, potential small business lenders should expect the process to be more regulated, fact-checked, and automated for at least the near future. Understanding the potential risks your operation faces is key because then you can explain how you would mitigate the impacts of something like a sudden global pandemic. While you can’t eliminate risk, you can still prepare for the unexpected. It’s not perfect, but preparation is a far better posture than reacting after a new crisis appears.