Managing credit risk in uncertain environments

Following three years of disruption caused by the Covid-19 pandemic, senior risk managers, risk management consultants and chief risk officers (CROs) from the banking and insurance industries gathered in Singapore for Asia Risk’s CRO Club roundtable

Throughout 2023, Asia-Pacific (Apac) risk managers have had a lot on their plates. Some of these issues – such as China slowdown contagion fears – can be addressed via prudent risk management measures. But issues such as climate risk management may require more co‑operation between the region’s financial regulators.

During Asia Risk’s CRO Club roundtable, participants discussed a range of topical risks, including China’s debt problems, the Bank of Japan’s (BoJ’s) possible decision to end its yield curve control (YCC) policy, climate change and, of course, emerging regulatory risks.The discussion revealed that risk managers are particularly worried about the outlook for China. The recent slowing of Asia’s largest economy, potential contagion effects from this below-expectation recovery, the possibility of local government financing vehicle (LGFV) defaults and the country’s troubled high-yield bond market were all cited as concerns by the risk managers.

“LGFVs in China account for [an] astronomically large [amount of] exposure – $6.6 trillion – which is effectively in the shadow banking environment. [This will make China] the second-largest debtor on the planet,” said a senior risk manager at a UK bank. “The World Bank also estimates 20% of short-dated exposures will be vulnerable.”

For example, in early July, the Beijing Financial Assets Exchange issued a warning about the debts of property developer Kunming Municipal Urban Construction Investment & Development. But its troubles could be just the tip of China’s debt iceberg.

Although institutions inevitably face a host of risks when investing in China, a CRO at a European bank said that investment tends to be “fine” when financial institutions have a diversified pool of collateral.

“But, if you are investing in senior secured commercial real estate and adopting onshore offshore structures, you will have issues like the big banks, which have taken unsecured corporate exposure in a lot of troubled Chinese developers,” he said. “It all comes down to what kind of business model you’re following.”

He added that many non-Chinese financial institutions are wary of acquiring large long-term financial exposures in China because the regulatory and political risks are often beyond what they are able to tolerate. The risks cannot be easily priced into transactions either, he added. 

“It’s very important to have a robust hedging strategy and hedge the risks,” he said. “You can’t [take on] a long-term exposure in China unless you’re an onshore bank and you understand the market quite well.”

Japan’s YCC shift

Besides China, risk managers have also been closely monitoring Japan’s possible YCC policy change in recent months.

The previously mentioned CRO at a European bank also shared his view on the BoJ’s possible move to phase out its long-standing ultra-easy policy.

“Given the way yen flows, it’s very difficult to even build a scenario because there could be a massive selloff in emerging markets and a lot of Japanese investors have invested overseas,” he said. “If the BoJ ends the YCC policy, those investors will start investing back in Japan, which will have impact on the currency.”

The European CRO also pointed out that banks operating wealth management businesses could also be especially impacted if the BoJ takes this action. These banks’ wealth management divisions have “diversified pools of collateral”, and they invest in the “value of equites and bonds”, meaning the investment – especially in emerging markets – would be very likely impacted.

A risk consultant at a research organisation agreed with this, saying that Japan’s disorderly exit of the YCC is a major risk because Japanese investors are very influential in global financial markets.

Climate change and regulatory risks

In addition to these concerns, the European CRO mentioned another key risk – El Niño, the weather pattern that scientists say is exacerbating global warming and has added to the intensity of extreme weather events in recent years.

Such incidents can have a knock-on impact across a wide spectrum of risks faced by financial institutions, the CRO pointed out. 

“When [El Niño hits], you have already seen drought, flooding and how those impact commodity prices – and it’s very difficult to predict right now,” they said. “They can have implications on inflation and geopolitical risks.”

The CRO’s insights are echoed by the efforts of regulators in the region. For example, the Hong Kong Monetary Authority conducted a stress test and published the results for its banking sector in 2021. It also intends to conduct a second climate test this year to battle the risks of rising temperatures and catastrophic events such as earthquakes and floods.  

The Hong Kong regulator also launched a consultation on green taxonomy in May to offer financial institutions a clearer way to identify investment opportunities within the environmental, social, and governance (ESG) scope.

But, while some regulators are beginning to look at ways to address the lack of standardisation in ESG finance, there remains a disconnect between that lack of standardisation and the new ESG demands regulators are placing on financial institutions. This is a growing headache for risk managers at present, said the senior risk manager at a UK bank.

“First of all, the size of the fines related to ESG is getting bigger each time, and it’s following the regulatory filings,” they said.“Second, the landscape, legislation and regulation are not well defined,” they added.

“So, we’re operating in an environment where the teeth are getting sharper from the regulators’ side. More fundamentally, the quantitative modelling capabilities to achieve standardisation across the industry just aren’t there.”

 

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