Scenario-based analysis in the time of COVID19: has the Adverse scenario become Baseline?
The events of the last few months have quickly burst into our lives and work routines, turning them upside-down. In a very short period, Italy, and then the entire world, have faced a serious pandemic with radical but necessary restrictions. #stayhome has become the imperative to follow and most of our country’s economic activities have been interrupted.
The health emergency remains the first concern, but there is another ghost haunting the globe: the economic recession. The restrictive measures adopted by the countries involved in order to flatten the contagion curve will lead to an economic slowdown; the longer the restrictions will last, the stronger the impact will be.
We find ourselves in a crisis that was not foreseen, not even in the most negative scenarios, which are used by the competent authorities to periodically test the banking system. The Adverse scenario proposed by EBA, the European Banking Authority, for the Stress Test exercise, which was supposed to take place this year, predicted a 1.2% drop in Italian GDP. Clearly, the current reality has made this assumption, designed in 2019, outdated. Therefore, has the worst-case scenario become the new normal?
Global risk landscape
In the first half of January, the World Economic Forum published the Global Risk Report 2020. Reconsidering the scenarios here described in light of the past months’ events is really interesting. In the Impact-Likelihood graph, the area that had raised much concern was the one in the top right, i.e. the most likely and powerful events: climate change and natural disasters of different types. The report was published, shared and quoted in news and social posts, where the importance of a change in the direction of sustainability was stressed.
However, another event was also plotted in the graph: Infectious diseases, with a lower than average likelihood of occurrence. Few days later that event had turned into the black swan of 2020.
Scenario-based analysis
The black swan is an impactful unexpected event and therefore it is, by definition, difficult to predict. However, scenarios and assumptions defined to simulate an adverse occurrence should also take this type of event into account, integrating them with current techniques used to test the banking system.
While banking authorities should modify the regulatory scenarios used for stress tests to better reflect the reality of the economic landscape, they should also extend the exercise towards a more strategic purpose. In this way, less likely but possible scenarios could be assessed and analyzed in advance, preparing the system for an unexpected crisis.
The banking technology system must also follow this direction: the tools used for this type of simulations should be flexible and efficient enough to allow configurable and frequent scenario-based analyses.
Nevertheless, the real difficulty lies in designing and quantifying the possible impacts of COVID-19 on the banking sector and the economy. This has become the main activity of analysts. What will be the effects in the coming months or maybe years? How to quantify them and how to prevent a financial crisis?
Quantifying the impacts
Paolo Surico and Alessandro Galeotti, professors of the London Business School of Economics, have created a series of interesting lessons on the effects of Covid-19. The first part deals with the epidemic from a health point of view, while the second part is dedicated to the economic impacts, where the possible effects on GDP and different specific sectors, such as tourism or transport, are analyzed.
Unfortunately, as shown in the graph (source Centre for Economic Policy Research — CEPR), the restrictive measures adopted to contain the contagion will aggravate a possible economic crisis. Probably in the coming months we will see a contraction in supply due to company closures and, later, a contraction in demand due to economic and health uncertainty and reduced incomes for workers affected by the containment measures. The risk is that we will enter a loop of supply and demand contraction from which it will be difficult to escape.
The Covid-19 executive report produced by McKinsey present the first possible evolution scenarios, that will depend on the speed and efficiency of containment of the virus spread and on the effectiveness of government economic interventions aimed at preventing a financial crisis. The growth projections for 2020 and the timing of recovery will depend directly on these factors, some of the most affected sectors may not be able to recover until 2021, for example air transport.
Considering that even in one of the most favorable cases, scenario A3, a loss of 4.4 percentage points on 2020 GDP growth for Europe is currently projected, it will be necessary to prepare our banking system for a significant shock.
How to not be taken by surprise by the next black swan?
Banking authorities are announcing the postponement of regulatory deadlines, as in the case of the EBA EU-wide Stress Test exercise, which has been postponed to 2021. The purpose of these actions is to allow banks to allocate time and resources to respond to the crisis that countries are facing.
However, this extension in the compliance deadlines could also offer time and ways to modify the current methodologies, adding a strategic component to the regulatory one, a possibility already explored by EBA in the discussion paper On the future changes to the EU-wide stress test.
Integrating scenarios of different types into normal banking processes, from those that represent a period of normal degrowth, to those that reproduce extreme events such as climate change or pandemics, passing through all the intermediate nuances, is one of the fundamental tools to analyze the possible impacts of a black swan, and prepare accordingly.
