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InsideNOW

A stress test of the financial system

The COVID-19 pandemic has caused unprecedented disruption to the global economy, and the outlook remains highly uncertain.

Authors

Authors

David Strachan - [Sponsoring] Partner - EMEA Centre for Regulatory Strategy - Deloitte

Andrew Bulley - Partner - EMEA Centre for Regulatory Strategy - Deloitte

Linda Hedqvist - Manager - EMEA Centre for Regulatory Strategy - Deloitte

Ben Thornhill - Senior Associate - EMEA Centre for Regulatory Strategy - Deloitte

Published on 11 August 2020

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COVID-19 has prompted regulators, central banks and governments worldwide to introduce exceptional measures to mitigate some of the near-term damage to the global economy. Despite this, the outlook remains highly uncertain, and firms will likely have to make some difficult decisions about cost-cutting, consolidation, and business model reform. We see the pandemic as akin to a “stress test” of the financial services regulatory system forged by the 2008 financial crisis. The current framework’s resilience will undoubtedly influence the shape and direction of regulation in the years to come. In this context, we have identified five key themes that have emerged since the start of the year and are likely to influence the regulatory agenda over the next six months:

  1. Full steam ahead
  2. Near-term supervisory focus
  3. Operational resilience in the new normal
  4. Good customer outcomes
  5. Digitization: its necessity and challenges

First, while some regulatory priorities were shifted or delayed due to COVID-19, several regulatory initiatives including Brexit, the interbank lending rate (IBOR) transition, and climate change and sustainability remain full steam ahead. Therefore, firms should continue to allocate resources and investment to their regulatory change programs, and may even have to increase these allocations to make up for momentum lost during the peak phase of the COVID-19 disruption. For example, the original end-2021 deadline for the IBOR transition still stands; therefore, firms should continue to review and enhance their existing risk management frameworks and establish firmwide milestones to stop IBOR offerings.

Second, while the near-term supervisory focus is still on exploring the tools available to respond to the pandemic as necessary, it is shifting from immediate crisis response to securing firms’ financial resilience and recovery in the medium term. Firms should create a broad range of stress scenarios to test their ongoing financial resilience in rapidly changing circumstances, identify appropriate management actions, and update their capital management plans accordingly. For banks, an area of particular supervisory interest will likely be their provisioning for expected credit losses under IFRS 9, and supervisors will continue to work with the industry to try to neutralize the pro-cyclicality caused by the current exceptional circumstances.

Third, as firms have moved much of their organizations online, with large chunks of their workforce working remotely, regulators will have to consider carefully

how their rulebooks and accountability regimes should adapt to this “new normal”. Firms will likely be more vulnerable to novel types or changing operational risks, and working-from-home arrangements could also alter and/or facilitate financial crime. Firms should explore how these new or enhanced risks could affect their operations, and revisit their systems and control frameworks accordingly. Stress test results and lessons learned should inform business continuity and disaster recovery plans, and these will receive renewed supervisory interest.

Fourth, some conduct regulators have introduced several extraordinary measures to provide relief to customers experiencing financial hardship during the COVID-19 pandemic, and will expect firms to ensure their continued fair treatment when these temporary measures end. Firms will need to demonstrate fairness and flexibility in addressing the challenges that COVID-19 continues to pose to customers, and should review their products and services to ensure these still deliver good outcomes and value to customers. We have also observed that the regulatory focus on organizational culture is more pertinent than ever, not just due to the pandemic, but also as a result of the much-intensified recent focus on social justice issues in society at large. How firms respond to supervisory expectations during the pandemic will inform subsequent supervisory assessments of their cultures, including whether firms’ underlying purposes are driven by a desire to achieve good customer outcomes or simply to limit the financial impact of external events on their business.

Finally, COVID-19 has underscored the need for the digitization of financial services to meet consumers’ changing demands and to reduce costs, given current pressures on profitability. Supervisory concerns remain especially around resilience, digital risk and controls, artificial intelligence (AI) model governance and the use of consumer data. Given the pronounced regulatory focus on providing relief to customers during the pandemic, firms should keep these concerns at the forefront when innovating. Firms may experience additional pressure from supervisors to demonstrate they are doing all they can to support their customers, including using technological solutions such as open banking to understand better the financial position of both retail and small and medium-sized enterprise customers. In terms of AI governance, COVID-19 may contribute to “model drift” due to abrupt changes in consumers’ behavior and economic conditions, requiring some models to be retrained and revalidated.

Conclusion

  • The COVID-19 pandemic is an unexpectedly profound stress test of the regulatory framework that was constructed in the wake of the 2008 financial crisis.
  • As discussed in this article, we have seen several new challenges emerge for both firms and regulators, while in some cases COVID-19 has cast a new light on certain pre-existing regulatory concerns.
  • We expect a period of regulatory reflection to follow, and lessons learned from the pandemic will strongly influence the regulatory direction in the years to come.
  • In some cases, regulators may feel that their objectives have been achieved systematically, while in other cases only where they observe “best practice”.
  • How and when the unprecedented level of state intervention in the economy is withdrawn could also influence the regulatory system, which may be expected to play a key role in facilitating economic recovery.
  • Overall, the situation is a tightening pincer on the industry: a challenging period of economic stress and a potentially heightened set of regulatory and supervisory expectations.
  • Firms will have to navigate these challenges carefully and work hard to avoid the pinch, and their responses will set the regulatory course into the next decade.

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Financial Markets Interim Regulatory Outlook 2020

Our interim assessment from Deloitte’s EMEA Centre for Regulatory Strategy explores trends, specific regulatory themes and the impact of the COVID-19 pandemic that will shape the financial services industry for the rest of 2020 and beyond.

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