Are banks underestimating the risks of Covid Emergency Loans?

During the last few weeks, the volume of loans issued by banks has snowballed as governments release programmes to bail out businesses affected by Covid-19. As a result of these higher volumes, the exceptional increase in underwriting activity raises several issues for banks. Most notably, banks, like all commercial institutions, are also having to cope with the effects of the pandemic on their processes and have had little time to manage and control any direct or indirect risks associated with the emergency loan issuance process.

As well as the risk of managing operations while many staff are working from home with limited access to key IT systems and support, there are credit and liquidity risks associated with the underwriting process that triggered fast-moving prudential regulatory amendments. Also, there are several indirect risks related to loan compliance that need careful assessment such as anti-money laundering (AML), know your client (KYC), consumer protection, conduct risk compliance, as well as the potential threat of loans being mis-sold.

The next class action?

The problem of mis-selling is a particular risk that should not be underestimated, in light of the recent class-action lawsuit in the US against four large banks. The banks are alleged to have favoured larger clients rather than the small business clients the financial assistance Paycheck Protection Program is designed to support. While the economic circumstances are very different, there are litigation similarities with the UK’s Payment Protection Insurance (PPI) scandal which, since 2011 has seen banks pay out over £38bn of redress to consumers so far, according to a report by the UK’s Financial Conduct Authority (FCA) in April 2020.

A changing role for banks

The current situation also raises issues on the societal and economic roles banks are expected to play. In many of these emergency loan programmes; banks take on the role of agent with the government acting as principal. In this situation, while the credit risk moves from banks to governments (taxpayers) and central banks (currency holders), compliance on the underwriting process remains with the banks. So, as a consequence of governments using banks to bail out the economy, they effectively delegate their public responsibilities. At the same time, the burden of risk on banks is increased, raising issues of moral hazard and conflict of interest.

The change in emphasis raises more profound questions about the overall role of banks and their place in the economy as direct actors of the state whose function is to execute economic plans, as well as to boost, rescue and support economic growth.

Due diligence will be key

It’s clear that as core banking risks begin to show clear signs of stress, a revision of external and internal controlling and monitoring teams could be triggered. The audit risk matrix will also need to be adjusted and put under scrutiny, particularly as internal controls have been re-organized to face the challenges of increased loan issuance while working remotely. In terms of governance of risk, the three lines of defence will have to reprioritise and redesign working programmes.

Looking ahead, authorities will want to ensure that taxpayers’ money has been appropriately used. In such a scenario, banking supervisors and governments will inspect and challenge the loan issuing process to ascertain that compliance with the state emergency loan rules, along with the usual AML, KYC and consumer protection regulations, have been followed.

Support for banks that helps mitigate the risks associated with Covid-19 emergency loan issuance is therefore vital. As governments continue to inject liquidity into the economy through lending institutions, banks need to be agile and responsive in adapting their existing infrastructure and processes to comply with loan requirements. Alongside current infrastructure and operational challenges associated with Covid-19, banks will need to place additional focus on customers’ risk profiles as they process and sign off on incremental volumes of applications in a shortened time frame. Due diligence will be key.

Challenges remain, but banks can stay ahead of the curve by establishing a governance framework to manage the impacts associated with the programmes. Work on addressing backlogs and bottlenecks caused by the high volume of loan requests to ensure timely execution and payments to small businesses, as well as using customized data analytics will help address compliance issues.  In addition, a focus on quality assurance throughout the process will help to ensure banks not only play their role in supporting the economy but do so by keeping the risks firmly under control.

For more information on how we can help with establishing a robust framework, click here.


Emmanuel Dooseman

Partner, Global Head of Banking and Capital Markets - New York