COVID-19, black swans and the power of flexible banking technology

Conor McAleavey
Conor McAleavey

What’s this all about?

While the banking industry’s response to extreme and unexpected events throughout history has been somewhat effective, many of its reactionary measures have also fallen short. It begs the question: how will its response to COVID-19 be viewed once the pandemic has passed? In the following article, Conor McAleavey outlines why traditional banks are not set up to cope with ‘black swan’ events, and looks at how flexible banking technology can help them prepare.

Read on if you:

  • Are interested in black swan theory and how it plays a disproportionate role in our globalised world
  • Want to understand how technology can help banks become more flexible, nimble and adaptive to change
  • Are considering migrating to a software-defined banking platform

Black swan theory has its roots in ancient philosophy but it was popularised much more recently by author and philosopher Nassim Nicholas Taleb.

Black swans are unexpected large events that are impossible to predict and which play a disproportionate role in our past, present and future. Examples include the Great Depression, the rise of the internet and the 9/11 attacks.

What makes black swans all the more dangerous from a human and business perspective is that we tend to rationalise them and, as Taleb says in his book The Black Swan: The Impact of the Highly Improbable, “concoct explanations for its occurrence after the fact, making it explainable and predictable”.

This hindsight bias draws us into the mistaken belief that we will be able to accurately predict the next black swan and therefore insulate ourselves from its devastating effects. This, of course, is a fallacy because black swans by their very nature are utterly unpredictable in their form, timing and magnitude.

The COVID-19 pandemic is a perfect example of a black swan event and so far, it has played out within the banking industry with all the same hallmarks of every black swan that went before it. The hope this time, however, is that the industry responds in an altogether different way to how it has done previously and not just simply via updated risk models in accordance with some new retrospective and wholly inadequate legislation.

Risk management and retrospective legislation

When we look closely at risk management within banking, it is often a flawed concept because it only focuses on the known unknowns of traditional silos such as credit and market risk.

Enterprise risk management is somewhat better as it considers all sorts of risks from cyber to legal and from regulatory to financial. However, it still fails to predict and manage the catastrophic effects of a black swan event; a failure that results in a confluence of negative stressors across all aspects of the business.

To make matters worse, as with all black swans, the after-the-fact rationalising of the event lulls the affected industries into a false sense of security. It makes them believe that their retrospective legislation can identify the next event before it happens and mitigate its consequences.

The last crisis to hit the industry is a perfect case in point. Indeed, following the financial meltdown of 2008, annual stress tests were considered the great white knight. Legislators took the worst possible past deviation and used it as an anchor event to protect against the worst possible future deviation. They were seemingly oblivious to the logical fallacy in their thinking. Had they applied their methodology the day before the anchor event, it would not have accounted for the deviation that occurred the following day (i.e. past worst-case scenarios cannot account for future worst-case scenarios).

Even the most hawkish regulator thought that 5 to 7 per cent was an ample lower bound for the harshest scenario. Just think about that in the context of the predicted 25 per cent drop in global GDP in Q2 2020. These kinds of effects are well outside their Gaussian distribution models but regulators continue to believe they can predict and alleviate the negative effects of these unknowable events.

Invest in preparedness not prediction

So if a bank accepts that it cannot predict the next black swan event or the domino-like consequences that follow, what can it do? How can it prepare for a future that is dominated by randomness, unpredictability and a myriad of disruptive forces? 

The answer is that when a bank cannot predict, it must prepare, and the only way to prepare for an uncertain future is to become as flexible, nimble and as adaptive to change as possible. This way, when the next event occurs, a bank can not only navigate its way through the crisis but also perhaps even prosper in the new world that emerges thereafter.

In my opinion, that should start with a technology platform that underpins every aspect of its preparedness for the next black swan.

A Need for Flexible Banking Technology

The financial press has been packed full over the last couple of weeks with talk about the extreme effects the pandemic is having on the industry. In particular, it has focused on the actions that banks are having to take in relation to mortgage repayments for laid-off or furloughed borrowers. Mortgage holidays and payment breaks are essentially being mandated right across the lending industry. UK Finance has said that 61,000 payment breaks are being granted each day in the UK.

You would think something like implementing payment breaks on a loan portfolio would be relatively straightforward. But for any bank sitting on legacy technology, it’s actually quite a big deal and involves a lot of manual processes. On the LEVERIS blog last week, we wrote about this very topic and how modern banking platforms can very easily handle mortgage payment breaks due to their highly decoupled architecture.

This is not to say the architects of modern banking platforms foresaw the COVID-19 pandemic and designed flexible repayment capabilities to alleviate this first wave of consequences. Of course not. 

What they did do, however, was to understand that the future is random and unknowable and that the next wave of disruption is always on the horizon. Therefore, the best way to navigate this future is to design a technology platform that has flexibility at its core.

This approach means that flexibility in payment breaks is just a corollary of the flexibility inherent in the platform as a whole, which is a perfect illustration of what preparedness through adaptability actually means.

What Happens Next?

Dealing with these payment breaks is only the very tip of the iceberg in terms of the serious problems banks now face in the wake of this latest black swan. The remedial work will be complex and protracted. It will include managing governmental business support schemes, branch banking problems with social distancing, liquidity buffers, loan defaults, NIM pressures and much much more.

Flexible banking tech platforms are by no means a panacea though. Banks need to embed flexibility and adaptability into every aspect of their organisation and especially into their operations and culture.

Those that succeed will navigate through and prosper as a result of the next major black swan event, becoming what our friend Taleb refers to as “antifragile”. An organisation that not only resists shocks but actually gets better as a result of them.

In a world and industry this intertwined and complex, there seems no other alternative.

Conor McAleavey
Conor McAleavey
Conor is Head of Innovation at LEVERIS. He really struggles to talk about himself in blog post bios.

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