Defining Trends and Ways to Prepare

2023 undeniably etched its place in financial services history, a year marked by accelerating change and a precarious financial climate. It brought calamity in the form of largely unforeseen bank failures – five of them, in fact, including Silicon Valley Bank, the largest such collapse in 15 years. But it also showcased remarkable economic resilience amid a tapestry of market relationship changes, geopolitical shifts and pervasive uncertainty.

Last year’s defining feature was perhaps the elusive recession that never materialized. Despite headwinds such as an inverted yield curve, surging corporate bankruptcies, heightened interest rate volatility, persistent inflation and, yes, bank failures, the economy has remained surprisingly robust. This outcome echoes the adage that "the market climbs the wall of worry," a truth particularly evident, albeit in an unconventional manner.

Divergent Impacts

The ascent in equity markets, predominantly propelled by the exceptional performance of a select few tech giants, the "Magnificent Seven", has masked the struggles faced by the broader market, including the rest of the large caps and small caps. This divergence was not limited to financial markets. It also manifested in the banking industry. The fallout from Silicon Valley Bank’s failure has affected banks asymmetrically, highlighting a stark contrast between the resilient and the vulnerable.
On a macro level, this divergence extends globally, with the U.S. economy rebounding swiftly from COVID-19’s shocks compared to its G7 counterparts. The disparities, especially when juxtaposed with the European and emerging market trends, underscore the bifurcated nature of the current macro landscape.

Against this backdrop, what are the paramount trends risk professionals might expect to define 2024? I predict the top five:

1. Banking Sector Pressure and M&A. Persistent inflation, elevated interest rates and more demanding and discriminating depositors will continue to exert pressure on banks, many of which are saddled with unrealized losses on their balance sheets. This pressure will separate weak from strong and serve as a catalyst for a significant increase in merger-and-acquisition activity. Regulators, mindful of the optics of bank failures, will be supportive of industry consolidation. Navigating this environment will require a thorough understanding of the issues banks face and accurate modeling and forecasting of their balance sheets.
2. Corporate Credit and Defaults. High yield and bank loan debt due in 2025 and 2026 will start getting refinanced in 2024. Banks, constrained by high interest rates and capital regulations, will provide less liquidity to the corporate credit market. Initially, private credit and institutional investors will continue to support demand, but eventually, investors, hurt by rising losses, will pull back. High yield spreads will widen, and concerns will extend to BBB-rated bonds, which will start to trade more in line with high yield products. Faced with higher debt service costs, a rising number of companies will be forced into default or debt restructuring.
3. Technological Progress and the Economy. Advances in artificial intelligence and automation will drive productivity gains. The capital-to-labor ratio will also rise, further boosting productivity. These impacts will be sufficient for most economies to avoid recession, despite rapidly rising defaults. The picture will be quite different at a sector level, however, where some segments will experience recession-like conditions.
4. Changing Nature of (Un)employment. The accelerating pace of technological progress, combined with further de-globalization, will lead to a persistent rise in structural unemployment. Initially it will be labeled as transitory, with measurements likely obscured by an increase in part-time work. However, combined with unfavorable demographic changes, these unemployment trends will likely exacerbate a number of socioeconomic problems.
5. Risk Modeling Challenges. Financial model performance will deteriorate, despite growing sophistication in modeling and supervisory approaches. The increasing incidence of unexpected events ("unknown unknowns") will be the key factor driving this trend. This will impact both advanced internal models and complex regulatory rule-based approaches, prompting calls for simplification and greater transparency in risk quantification. Firms will need the ability to consider a far greater number of scenarios and more coherent integration across risk types.

Preparation As Its Own Reward

As with many things in life, certainty in the financial markets does not exist. Some of these predictions may not come to fruition, and possibly none of them will. Nevertheless, in my view, these are plausible outcomes and thus constitute credible risk considerations.

Come what may, preparation is often its own reward, particularly in the realm of risk management. There are several actions risk pros can take to help their firms better navigate uncertainty and benefit from emerging trends.

• Regularly assess credit risk, your own organization’s included. As the pace of change accelerates, early warning systems and risk measurement infrastructures will need to function at higher frequency to keep pace.
• Use multiple lenses. Models are an imperfect representation of an infinitely complex and computationally irreducible reality. Each model is defined by its own set of unique assumptions. Those assumptions are simplifications that lead to imprecision at best. In the worst case, they produce errors that lead to incorrect and misleading outcomes. Combining multiple credible models results in better-informed decisions.
• Know the limits of your models. Strong model risk management processes and discipline will be required. The environment that unfolds in the coming months will likely violate the stationarity and ergodicity assumptions necessary for most statistical risk models to work. Thus, understanding model assumptions will prove more important than ever. The corollary to this is that models must be transparent.
• Be ready to respond swiftly. As model assumptions diverge from observed experience, more frequent re-estimations or revisions will be required. Often, such updates are triggered by an adverse market event and performed under severe time pressure. Having an established process and technology to perform and implement re-estimations in streamlined fashion will be important for agility and controlling operational risk.
• Use credit models fit for purpose. For example, temporal differences in outstanding corporate credit maturity call for a term-based default model that is a more targeted tool than a point-in-time or even a through-the-cycle measure for managing future risk.
• Simplify to do more. Adopting best practices, such as integrated balance sheet management, remedies the unnecessary complexity resulting from multiple data sources, reconciliations, and duplicate or disparate modeling processes. Looking at financial risks on a holistic basis naturally extends to more efficient, timely and insightful scenario analysis, which will prove vital in both the preparation and response phases.

2024 is already shaping up to be an eventful year, with changes likely matching or exceeding the magnitude of those experienced in 2023. The good news is that, while the cone of uncertainty is wide, so is the potential upside.