The livelihood and human life are on crisis because of the COVID-19 pandemic. As the virus is spreading drastically, people and institutions are struggling to prevent it. It causes a major economic disruption. Along with the banking industry, every industry has been affected in this pandemic. Financial position, capital structure, and cash flow position have been hit. The traditional model run by banks is no longer working that has been interrupted.

Although few business leaders could predict the global economic shutdown, most of the financial institutions could not account for the crisis. As the financial institutions design their models based on a stable future, unfortunately, it does not work anymore. The fact that it is not the failure of the bank to use the model rather it is the fallback of bank not to have the plan to manage the current situation.

There are some reasons for such failure. First, the assumption and strategies were designed with the mind of the pre-COVID-19 world. Second, the model was developed based on historical data where highfrequency data might affect. Finally, the alternative data which is only possible theoretically, not practically, the model cannot integrate the new information. Therefore, the infrastructure is developed in a lack of flexible manner.
As the banks are fronting the failures of their model and the new issues are expected to experience over time, they urgently need to review their model strategies. They need to progress the infrastructure and apply both short term and long term actions by accessing its resilience. In the short time horizon, the bank needs to coordinate and review the model with development and in the long term, it needs to redevelop and upgrade the model-risk-development (MRM) frameworks.

Covid-19 has affected the reliability of the function and operation of all the banks’ models. Models are not confined within one business or function rather it impacts on every aspect of a bank’s operation. The effect is widespread, for instance:
i) Rating models are inaccurate as they cannot update their credit scores rapidly
ii) Early warning system (EWS) indicators are presenting the misleading number of signals causing the loss of predict power
iii) Liquidity models are failing to foresee the outflow where it puts the liquidity position is a risk
iv) Model-based market risk systems are overreacting to stressed price and credit,
v) Regulatory models are systematically increasing capital and liquidity needs and provisioning because of pro-cyclicality.

Like other sectors, the financial institutions were unprepared for the current crisis and were trying to adjust to the situation. Recently, they are initiating the model-mitigation strategies although uncoordinated ways may affect. The rapid actions include replacing models with only expert review, restructuring the model with recent data, adjusting the outcome based on expert analysis, and developing the alternative model only to fit banks’ current needs.

The mitigation actions have been vulnerable for the short term implication because of its lack of access to alternative data sources as well as the absence of an underlying agile operation model. The last obstacle is that the arising changes needed to adjust on the ongoing basis. Therefore, the mitigation action themselves are building new risks.

First, model failure – the speed at which the model is developed and adjusted, there is a high risk to underframe and failure of the model. The inefficiency of information may lead to legal and reputational risk as an inappropriate solution may arrive. Second, contradictory message and decision – adjustment and underlying assumption may create inconsistency over the model. Finally, the inability to launch effective redevelopment – redevelopment may be impeded because of a new situation and challenges in the business. Therefore, the banks need to be more efficient to develop the infrastructure in the short term and long term crisis. They should develop and set back a coherent and resilient model strategy.

What strategies should financial institutions now be putting in place?
To address the challenges and fix up the solution, the banks need to develop the strategy in two phases. The first strategy is based on short term crisis – operating model for MRM and the second strategy is based on long term comprehensive enhancement of MRM strategy to increase its resilience.

PHASE ONE: MOVING TO A CRISISOPERATING MODE FOR MODEL-RISK MANAGEMENT
Here, the banks highlight adjusting the model to fit with the purpose and reduce the risk of poor decision making. The adjustment should be developed quickly but also efficiently and consistently to avoid the undue readjustment cost. In the recommendation, an enthusiastic taskforce should be developed to lead the crisis-operating model. To run the MRM effectively and efficiently, the team should have clear governance, a disciplined operating model, and effective MRM tools. Using clear methodologies and its MRM tools, it can create a well-organized crisis response plan. The following recommendation consists of four parts:

1. Inventory of model adjustment and models at risk – the inventory needs to identify the failure objectives or will likely to be a failure shortly. Then it should identify all model adjustments.
2. Consistent model-mitigation actions – the model adjustment should be executed consistently over the functions and operations. The MRM team should ensure cross-checking and prevent contradictory messages and decisions.
3. Timely review of model adjustment – the assigned team should perform quickly and adjust and underlie the adjustment planned.
4. Short term and long term redevelopment plan – model adjustment and redevelopment need to be prioritized based on the importance of the model and probability of failure. Once complete, banks need to review the applied model and redevelop the model whenever needed.

PHASE TWO: MOVING TO THE NEXT LEVEL OF THE MODEL-RISKMANAGEMENT JOURNEY
Create transparency

As the banks are moving more proactively to manage their portfolios, they need to use MRM in more strategic and fundamental role. It should be resilient to business efficiency and management decision making. To use MRM effectively, banks need to develop a solid framework. While MRM starts to add value in the current salutation, the following core elements can be considered:

1. Overview of models at risk and model contagion – Banks should identify the models at the risk where and how it is essential for business and banking operation. The interdependence of the model can also be overviewed.

2. Model Contingency Plan – the bank should review the risk statement and enhance the model limitation with a clear tolerance level. The fallback solution should be enhanced at a zero or low tolerance in case of failure.

3. Dynamic MRM dashboard – The dashboard, a tool of MRM, should be configured to alert the banks of emerging models at risk. Both the business-wide model redevelopment and MRM enhancement should be integrated tools which will enable to track the process.

4. Flexible and versatile talent pool – banks need energetic people with essential expertise who are capable to identify the model risk from a different angle. The team should work under clear governance, ensure visibility and accountability of business-critical activities.

As the financial institutions did not anticipate the scenario of Covid-19, many of the issues that the banks are facing could be managed with more proactive MRM. However, it is not too late to initiate the strategy. MRM now can be a strategic partner that will create value to the entire organization. Therefore, the banks need to take care of their MRM to the next level of the journey.

About the research:
Banking models after COVID-19: Taking model-risk management to the next level is a McKinsey & Company article by MariePaule Laurent, Olivier Plantefève, Maribel Tejada, and Frédéric van Weyenbergh on how the COVID-19 pandemic has revealed unexpected flaws in the business models that banks rely upon.