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Insights on Financial Services 

Financial decision-maker sentiment during the COVID-19 pandemic: A global perspective

COVID-19 is, first and foremost, a global humanitarian challenge. Thousands of health professionals are heroically battling the virus, putting their own lives at risk. Governments and industry are working together to understand and address the challenge, support victims and their families and communities, and search for treatments and a vaccine.

Solving the humanitarian challenge is, of course, the first priority. Much remains to be done globally to respond and recover, from counting the humanitarian costs of the virus, to supporting the victims and families, to finding a vaccine.

We are tracking financial decision-maker sentiment and behavior across multiple countries to provide facts and insights that will help finance and business leaders navigate throughout the crisis. Please check back regularly for updates.

Banking models after COVID-19: Taking model-risk management to the next level

The COVID-19 pandemic has revealed unexpected flaws in the business models that banks rely upon. How can they best address this challenge?

 

The COVID-19 pandemic is taking a terrible toll in human life and in the livelihoods of millions the world over. As people and institutions struggle to contain the spread of the virus, the measures necessarily imposed have caused major economic disruptions. Every industry has been affected, and banking is no exception. Capital, profit-and-loss, and liquidity positions have been hit very hard. One consequence has been that banks’ models have broken down across their business. The flaws have put the reliability of these models in doubt and suggest that they cannot be trusted to help banks navigate through the crisis.

 

Few business leaders could have foreseen a global economic shutdown of this magnitude. The models that financial institutions depend on to run their businesses simply did not account for such a crisis. Most models are almost by necessity designed to predict a stable future. In truth, the real failure is not that banks used models which failed in this crisis but rather that they did not have fallback plans to manage when the crisis did come.

There are a number of reasons for the failures. First, model assumptions and boundaries defined at the design stage were developed in a pre-COVID-19 world. Second, most models draw on historical data, without the access to high-frequency data that would enable recalibration. Finally, while access to the needed alternative data is theoretically possible, models would not be able to integrate the new information in an agile manner, because the systems and infrastructure on which they are built lack the necessary flexibility.

Banks are experiencing ever more model failures, and further issues can be expected with time. Financial institutions must now urgently review their model strategies. They need to develop and apply both efficient short-term actions and a long-term plan to improve model resilience. Over two prioritized time horizons, banks can carry out coordinated model adjustments to enable business continuity in the short term while reviewing their model development and redevelopment needs and upgrading their model-risk-management (MRM) frameworks over the longer term.

COVID-19 has affected model reliability across all bank functions and operations

Model issues are not confined to one business or function but instead have emerged in every aspect of a bank’s operations. The effect on standard operations is widespread:

  • Rating models are inaccurate because they are unable to update scores rapidly, rendering them irrelevant in assessing creditworthiness across sectors or customer segments.

  • Early-warning-system (EWS) indicators are showing a misleading number of signals, causing a loss of predictive power.

  • Liquidity models are failing to predict large outflows and portfolio rebalancing, thereby putting liquidity positions at risk.

  • Model-based market-risk approaches are overreacting to stressed price and credit, as well as to liquidity shortages, leading to inflated profit-and-loss impact and costly extra funding of cleared and over-the-counter (OTC) transactions.

  • Regulatory models are mechanically increasing capital and liquidity requirements and provisioning because of their procyclicality.

 

The short-term effects on regulatory models, including those for the IRB approach, IFRS 9, and stress testing, are expected to be partially neutralized by regulatory and supervisory flexibility.1 We do anticipate further guidance in the future. Inevitably, banks will have to adjust their data and methodologies to reflect the new normal.

 

Inevitably, banks will have to adjust their data and methodologies to reflect the new normal.

 

By contrast to the effects on regulatory models, the impact of the COVID-19 crisis on business models was immediate. Their failure has rendered them useless for supporting decision making in the crisis. Banks must urgently address the model failures and make needed adjustments to avoid having to rely only on the analysis and judgment of experts.

The speed of banks’ reaction to the crisis has triggered new risks

Like companies in other sectors, financial institutions were unprepared for a locked-down economy and have scrambled to adjust. Rapidly, they are taking model-mitigation actions, often in an uncoordinated way. The rushed actions include the following:

  • replacing models with expert views only

  • recalibrating models using recent data

  • adjusting model outcomes according to expert analysis

  • building alternative models to fit banks’ current needs

 

These mitigation actions have been hampered by short implementation timelines, a lack of access to alternative data sources (such as high-frequency data), and the absence of an underlying agile operating model. This last obstacle prevents banks from addressing arising changes with timely adjustments on an ongoing basis. The result is that the mitigation actions themselves are generating a host of new risks:

  • Model failure. The speed at which solutions and adjustments are being deployed increases the risk of model underperformance and failure. Poor and biased model outcomes could lead to legal and reputational risks because of the inappropriate solutions.

  • Contradictory messages and decisions. Adjustments and underlying assumptions applied inconsistently across the different types of models may prevent informed and aligned decisions.

  • Inability to launch effective redevelopment. The redevelopment of models can be impeded because of a lack of perspective on the new normal and its impact on business.

Banks need to do more than act efficiently in the short term to manage the crisis. They must also prevent short-term solutions from becoming long-term problems by taking a step back and developing a coherent and resilient model strategy.

What strategies should financial institutions now be putting in place?

To address the challenges thrown up by COVID-19 and the risks of quick-fix solutions, banks should develop their two-phase strategy. The first phase is a short-term crisis-operating mode for MRM, and the second is longer-term comprehensive enhancement of the MRM strategy to increase resilience and enable proactive adjustments to arising changes.

Phase one: Moving to a crisis-operating mode for model-risk management

In the first phase, banks focus on effectively adjusting models to make them fit for purpose and mitigate the risks of poor business decisions. The adjustments should be made quickly but also efficiently and consistently to avoid undue redevelopment or readjustment costs.

We recommend that a dedicated taskforce be created to lead banks in crisis-operating mode. To run the MRM crisis response effectively in a highly disruptive situation, the team should have clear governance, a disciplined operating model, and useful MRM tools. It will lead a rebalancing effort away from business-as-usual activities to crisis activities. Taking an agile approach, the team should perform a quick and effective MRM review. Using clear methodologies and its MRM tools, including model inventory and an MRM crisis-response dashboard, it can then develop and implement a well-organized crisis-response plan. We recommend that this consist of four parts:

  1. Inventory of model adjustments and models at risk. The inventory will identify models that have failed or are likely to fail in the near future. It should then identify all model adjustments that have been applied and map them against the identified models at risk.

  2. Consistent model-mitigation actions. Model adjustments should be applied consistently across functions and operations. The MRM team should ensure cross-checking of model adjustments and underlying assumptions for the different types of models to ensure consistency and to prevent contradictory messages and decisions.

  3. Timely review of model adjustments. The team should quickly perform an effective challenge of all model adjustments and underlying assumptions planned, taking an agile approach and applying a focused review methodology.

  4. Short- and long-term redevelopment plans. Model adjustments and model-redevelopment needs must be prioritized according to the criticality of the model for the business and probability of failure. Once this is complete, banks must review the applied model adjustments and the recommended model-redevelopment or model-adjustment needs.

 

Phase two: Moving to the next level of the model-risk-management journey

Banks need to use MRM in a more strategic and fundamental role, as banks move proactively to manage their portfolios of models. The purpose of MRM will be to enhance business efficiency and management decision making while increasing the resilience of the model landscape.

 

To enhance their MRM, banks should develop solid framework elements to inform business and strategic decisions. While MRM will add value in a number of ways in the current situation and the overall model strategy, the following core elements can be considered essential:

  • Overview of models at risk and model contagion. Banks should be able to identify models at risk by evaluating whether and how each model is essential to business and banking operations. It should enhance tiering and model-risk-assessment methodologies to gauge exposure to failure—model limitations and boundaries. The overview should also enable the evaluation of model interdependencies. This capability will allow banks to assess and anticipate the risk and impact of model contagion.

  • Model contingency plan. The bank should review model-risk-appetite statements and enhance model boundaries and limitations with clear tolerance levels for specific scenarios. A fallback solution should be developed for models at risk with zero or low tolerance for failure (high criticality). A plan is needed for the continuity of model-related activities in case of disruption. The plan might include a remote operating model, remote access to data systems, and adequate infrastructure to continue activities.

  • Dynamic MRM dashboard. The dashboard is an MRM tool that can be configured to alert the bank of emerging models at risk. Plans for business-wide model redevelopment and MRM enhancement can be integrated into the tool, which can also enable the tracking of progress against milestones based on key performance indicators.

  • Flexible and versatile talent pool. Banks need people with the necessary expertise and capabilities to identify the models at risk across different functions and businesses and to perform focused model-risk assessments. The team should work under clear program governance, ensuring visibility and accountability of business-critical activities, such as model development, adjustments, review, and monitoring.

 

While the extent of the COVID-19 crisis was not anticipated by financial institutions, many of the issues that banks are now facing could have been avoided with more proactive MRM. It is not too late to create this capability, which links models to a bank’s risk appetite and management. Rather than acting purely as a control function, MRM can now be a strategic partner, bringing value to the entire organization. By planning ahead while operating from within the COVID-19 crisis, banks can take their MRM to the next level in its journey.

Model risk management: The latest insights into the evolution of model governance practices across North America, Europe, and Asia

 Look closer at model risk management since SR11-7 and understand the main themes shaping the AURA space.

Model risk is still nascent within typical banking risk inventories. While originally viewed as a subdomain of operational risk, it has evolved and is increasingly considered as a risk category on its own. Similarly, model risk management (AURA) has evolved as a clearly defined discipline over the last decade, fueled by spikes of regulatory intervention in the aftermath of the 2008–09 financial crisis.

The publication of supervisory guidance on AURA during 2011 by the Federal Reserve Board within the eponymous supervisory letter SR11-7 is widely considered as the key event that launched and shaped AURA practice globally. It has influenced not only industry practice but also the measures adopted by other regulators and supervisors outside the US, triggering a wave of AURA activity spreading from the US epicenter through Europe and more recently to banks in Asia.

In this publication, we take a closer look at AURA eight years after SR11-7, reflecting on how practice has evolved and the trends taking AURA into the future.

  

IFRS 9: A silent revolution in banks’ business models

Banks have addressed the technical requirements of the new rules, but what about their significant strategic implications? Here’s how to prepare.

 

Over the past few years, European banks have been preparing for the implementation of International Financial Reporting Standard 9, a new accounting principle for financial instruments that becomes effective in January 2018. IFRS 9 will change the way banks classify and measure financial liabilities, introduce a three-stage model for impairments (stage 3 being nonperforming), and reform hedge accounting (see sidebar, “What is IFRS 9?”). In preparing for the new principle, banks have dedicated most of their efforts to technical and methodological issues—in particular, how to incorporate forward-looking assumptions and macroeconomic scenarios into their existing models and approaches.

 

What is IFRS 9?

 

Essential though this work is, banks run the risk of overlooking the strategic repercussions of the new standard. These repercussions will be so significant—requiring banks to rethink their risk appetite, portfolio strategy, and commercial policies, among other things—that we believe nothing less than a silent revolution is under way. If banks fail to grasp the importance of IFRS 9 before it comes into force, they will have to manage its impact reactively after the event, and could lose considerable value in doing so.

Why a revolution? What IFRS 9 could mean for your business

We believe banks face a number of strategic and business challenges in adapting to the new environment under IFRS 9. Addressing these challenges will require fundamental changes to their business model and affect areas as diverse as treasury, IT, wholesale, retail, global markets, accounting, and risk management. Banks that start to plan for these changes now will have a considerable advantage over those that have yet to consider the full implications of IFRS 9 for their business. To help banks get ahead, we have identified strategic actions in five areas: portfolio strategy, commercial policies, credit management, deal origination, and people management.

1. Adjusting portfolio strategy to prevent an increase in P&L volatility

IFRS 9 will make some products and business lines structurally less profitable, depending on the economic sector, the duration of a transaction, the guarantees supporting it, and the ratings of the counterparty. These changes mean that banks will need to review their portfolio strategy at a much more granular level than they do today.

  • Economic sector. The forward-looking nature of credit provision under IFRS 9 means that banks will need to reconsider their allocation of lending to economic sectors with greater sensitivity to the economic cycle.

  • Transaction duration. The more distant the redemption, the higher the probability that the counterparty will default. Under IFRS 9, stage 2 impairments are based on lifetime ECL—the expected credit losses resulting from all possible default events over the expected life of the financial instrument—and will therefore require higher loan-loss provisions.

  • Collateral. Unsecured exposures will be hit harder under the new standard. Collateral guarantees will help mitigate the increase in provisions for loss given default under IFRS 9, particularly for exposures migrating to stage 2.

  • Counterparty ratings. IFRS 9 imposes heavier average provision “penalties” on exposure to higher-risk clients, so counterparty ratings will have a direct impact on profitability. Industry observers expect provisioning for higher-risk performing clients to rise sharply once the new framework is in place.

 

This shift in structural profitability suggests that banks should, where possible, steer their commercial focus to sectors that are more resilient through the economic cycle. This will reduce the likelihood of stage 1 exposures migrating to stage 2 and thereby increasing P&L volatility. Higher-risk clients should be evaluated with greater care, and banks could introduce a plafond (credit limit) or other measures to review the origination of products most likely to be vulnerable to stage 2 migration, such as longer-duration retail mortgages and longer-term uncollateralized facilities, including structured-finance and project-finance deals.

 

Banks could also consider developing asset-light “originate to distribute” business models for products and sectors at higher risk of stage 2 migration. By originating these products for distribution to third-party institutional investors, banks could reduce their need for balance-sheet capacity for risk-weighted assets and funding, and avoid the large increase in provisions they would otherwise have to make for stage 2 migration. Pursuing such a strategy would involve developing an analytical platform that can calculate fair-value market pricing for each corporate loan and enable banks instantly to capture opportunities for asset distribution in the market.

2. Revising commercial policies as product economics and profitability change

IFRS 9 will reduce profitability margins, especially for medium- and long-term exposures, because of the capital consumption induced by higher provisioning levels for stage 2. In particular, exposures with low-rated clients and poor guarantees will require higher provisions for stage 2 migration. For loans longer than ten years, provisions for lifetime expected credit losses may be up to 15 to 20 times higher than stage 1 provisions, which are based on expected loss over 12 months. To offset this negative impact on their profitability, banks can adjust their commercial strategies by making changes in pricing or product characteristics:

  • Pricing. When possible, banks should contractually reach agreement with clients on a pricing grid that includes covenants based on indicators that forecast the probability of migration to stage 2, such as the client’s balance-sheet ratio and liquidity index. If a covenant is breached, the rate would increase—for example, by 10 to 20 basis points to compensate for the extra cost of stage 2 for exposures between five and ten years, and by 25 to 35 basis points for exposures longer than ten years. If flexible pricing is not possible, the expected additional cost of a stage 2 migration should be accounted for up front in pricing. This cost should be weighted by the expected time spent in stage 2: for example, 3 to 5 basis points on average for exposures with a maturity of five to ten years, and 5 to 10 basis points for those longer than ten years.

  • Product characteristics. Banks could adjust maturity, repayment schedule, pre-amortization period, loan-to-value, and break clauses to reduce the impact of IFRS 9 on their profitability. In particular, they should aim to reduce their maturity and amortization profile by providing incentives to relationship managers and clients to shift to shorter-term products, and by introducing new products or options that allow early redemption or rescheduling.

 

3. Reforming credit-management practices to prevent exposures from deteriorating

Under IFRS 9, the behavior of each credit facility after origination is an important source of P&L volatility regardless of whether the exposure eventually becomes nonperforming. Banks therefore need to enhance performance monitoring across their portfolio and dramatically increase the scope of active credit management to prevent credit deterioration and reduce stage 2 inflows. Different approaches can be used to do that, including an early-warning system or a rating advisory service.

Forward-looking early-warning systems allow banks to intercept positions at risk of migrating to stage 2. This system would extend the scope of credit monitoring and shift responsibility for it from the credit department to the commercial network. “Significant deterioration” will be measured on a facility rather than a counterparty level under IFRS 9, so virtually every facility will need to be monitored to preempt the emergence of objective signs of deterioration, such as 30 days past due. Monitoring facility data and ensuring that information about guarantees is complete and up to date will be vital in preventing the expensive consequences of migrations to stage 2.

The commercial network should be fully involved in a structured process through which risk management flags any facility approaching migration and identifies the likely reason: for instance, a deterioration in a debtor’s short-term liquidity or a problem with data quality. An algorithm—or a credit officer—then assigns possible remediation and mitigation actions, such as opening a short-term facility to solve a liquidity issue or updating balance-sheet indicators to improve data quality. Finally, the relationship manager sees the flagged position and proposed remedial actions on the system and contacts the client to discuss a set of strategies.

 

These might include helping the client improve its credit rating through business or technical measures like those just mentioned, taking steps to increase the level of guarantees to reduce stage 2 provisioning, and adjusting timing and cash flows in the financing mix to the assets being financed so that long-term maturities are used only when necessary.

By a rating advisory service, banks could advise clients on ways to maintain good credit quality, provide solutions to help them obtain better terms on new facilities, and reduce their liability to migrate to stage 2. Banks could offer a fee-based service using a rating simulation tool that enables credit officers and relationship managers to propose how clients could improve their rating or prevent it from worsening. The tool would need to include a macroeconomic outlook and scenarios to forecast how different economic sectors might evolve; a list of actions for improving or maintaining the client’s rating in situations such as a drop in revenues, declining profitability, or liquidity issues; and a simulation engine to assess how ratings may evolve and what the impact of various actions could be. Over time, the bank could build up a library of proven strategies applicable to a range of client situations.

4. Rethinking deal origination to reflect changes in risk appetite

IFRS 9 will prompt banks to reconsider their appetite for credit risk and their overall risk appetite framework (RAF), and to introduce mechanisms to discourage credit origination for clients, sectors, and durations that appear too risky and expensive in light of the new standard.

For example, if banks consider global project finance to be subject to volatile cyclical behavior, they may decide to limit new business development in such deals. To react quickly and effectively to any issues that arise, they should also adjust the limits for project finance in their RAF, review their credit strategy to ensure that new origination in this area is confined to subsegments that remain attractive, and create a framework for delegated authority to ensure that their credit decisions are consistent with their overall strategy for this asset class.

5. Providing new training and incentives to personnel to strengthen the commercial network

As banks are forced to provide for fully performing loans that migrate to stage 2, their commercial network will need to take on new responsibilities.

In particular, relationship managers will assume a pivotal role, becoming responsible for monitoring loans at risk of deterioration and proposing mitigation actions to prevent stage 2 migration, as noted above. However, most relationship managers have sales and marketing backgrounds, and though they typically originate loans, they do not actively manage them thereafter. As a result, they will need to be trained in new skills such as financial restructuring, workout, and capital management to help them deal with troubled assets effectively.

In addition to introducing training programs to build these capabilities, banks should review their incentive systems to ensure that relationship managers (RMs) are held accountable for any deterioration in credit facilities in their portfolio. The RMs should be evaluated and compensated on an appropriate risk-adjusted profitability metric, such as return on risk-weighted assets, return on risk-adjusted capital, or economic value added, with clear accountability for how well stage 2 costs are managed.

The strategic and business implications of IFRS 9: A CEO checklist

 

The new US standard: CECL

 

Most banks have been busy addressing the methodological and technical aspects of IFRS 9—but only a few have got as far as considering and acting on business implications.1 To anticipate the far-reaching strategic impact, CEOs, CROs, and heads of business will need to challenge existing IFRS 9 programs with sets of important questions in each of the five areas we have been discussing.

 

1. Implications for portfolio strategies. Should we revise our credit portfolio allocation and lending policies?

  • Should we reduce lending to volatile sectors with a poorer outlook? How do we reflect this in our lending policies?

  • Should we weigh the financial duration of portfolios more heavily in our lending decisions and reduce lending on long-term transactions?

  • Should we focus on collateralized lending portfolios to mitigate loss given default and reduce lending to unsecured exposures?

  • Should we treat higher-risk clients differently in our lending decisions? Should we scrutinize lending to performing high-risk clients more thoroughly? How should we reflect this in our risk appetite?

 

2. Impact on commercial policies. Should we rethink our product offering? Should we adjust our pricing to sustain profitability?

  • Should we adjust maturity and amortization to shorten product lifetimes? How can we encourage relationship managers and clients to shift to products with shorter terms or early-redemption options?

  • Should we raise prices for longer-term and less collateralized products and for higher-risk clients? Would that damage our competitive position?

 

3. Changes to credit risk management. Should we strengthen our monitoring of counterparty and data quality to prevent increases in ECL?

  • Should we improve our early-warning mechanisms to detect any deterioration in a client’s lifetime credit risk?

  • Should we increase our monitoring of collateral data?

  • How should we flag warning signs to our relationship managers to trigger remedial actions?

 

4. Evolution of deal origination. Should we adjust our credit strategy and policies to change the course of new business development?

  • Should we introduce new risk limits for the clients, sectors, or products most affected by IFRS 9?

  • Should we change our origination process—for example, by adopting a delegated-authority system or improving the link between our risk-appetite framework and our underwriters?

 

5. Impact on people management. Should we revise our incentive and compensation schemes for relationship managers? Should we change their accountability?

  • Should we change our performance metrics to reflect IFRS 9–adjusted profitability?

  • Should we provide training for our relationship managers on the consequences of IFRS 9 and appropriate remedial actions?

 

The introduction of IFRS 9 is likely to change banks’ behavior and reshape the credit landscape for some products and segments—but it may also tempt nonbanks into the market. In particular, banks should keep a watchful eye on the alternative lending sector. Credit provision by private equity, mini-bond issuers, insurance companies, and the like has grown by more than 20 percent in Europe in the past five years alone. These new competitors are governed by a less stringent regulatory framework and could pose a growing threat to banks, especially if they are slow to react to the new challenges and costs of IFRS 9.

There is little time left to prepare. To anticipate the repercussions of the new standard and control how they play out, banks must move fast. The silent revolution of IFRS 9 will affect all banks, ready or not. The effort taken to understand the new rules and put a response in place will be well spent.

Diversity still matters

Image by Omar Lopez

COVID-19 is confronting companies around the world with a daunting degree of disruption. In the immediate term, some face devastating losses of revenue, dislocations to operations and supply chains, and challenges to liquidity and solvency. Others are coping with enormous unexpected spikes in demand. In the medium term, we can expect material and lasting shifts in customer markets, regulatory environments, and workforce deployments. Leaders and managers will need a great deal of resolve and resilience as they seek to navigate an economically and socially viable path toward a “next normal.”

The lessons from previous crises tell us there is a very real risk that inclusion and diversity (I&D) may now recede as a strategic priority for organizations.1 This may be quite unintentional: companies will focus on their most pressing basic needs—such as urgent measures to adapt to new ways of working; consolidate workforce capacity; and maintain productivity, a sense of connection, and the physical and mental health of their employees.

Yet we would argue that companies pulling back on I&D now may be placing themselves at a disadvantage: they could not only face a backlash from customers and talent now but also, down the line, fail to better position themselves for growth and renewal. Some of the qualities that characterize diverse and inclusive companies—notably innovation and resilience—will be much in need as companies recover from the crisis.2 Indeed, it could help companies to unlock the power of I&D as an enabler of business performance and organizational health and contribute to the wider effort to revive economies and safeguard social cohesion. In this article, we explore what companies can do to ensure that I&D remains a core part of their agendas during the downturn, and beyond.

The benefits of I&D are clear now—and that doesn’t change in a crisis

Our research has repeatedly shown that gender and ethnic diversity, inclusion, and performance go hand in hand. Our latest report, Diversity wins: How inclusion matters, reinforces the business case.3 Over the past five years, the likelihood that diverse companies will out-earn their industry peers has grown. So have the penalties for companies lacking diversity. Another forthcoming Aura report, about Latin America, highlights the strong correlation between gender diversity and positive behavior directly related to better organizational health—which, in turn, is associated with better business performance. Similarly, our previous research found that women tend to demonstrate, more often than men, five of the nine types of leadership behavior that improve organizational performance, including talent development. Women also more frequently apply three of the four types of behavior—intellectual stimulation, inspiration, and participative decision making—that most effectively address the global challenges of the future.

Diversity winners that deploy a systematic approach to inclusion and diversity and don’t fear bold action to foster inclusion and belonging are most likely to reap the rewards. Now is the time to be even bolder.

The bulk of this research on the business case for diversity was carried out during the past five years, when economic conditions have been mostly favorable. Yet the evidence from past crises shows that diversity can also play an important role in recovery. For example, several reports have shown that in the 2008–09 global financial crisis, banks with a higher share of women on their boards were more stable than their peers. This research also suggests that banks run by women might be less vulnerable in a crisis.4 And we are seeing, right now, that cities and countries with women leaders are thought to be facing the COVID-19 pandemic more successfully than those without them.5 It may be, some researchers conclude, that female leadership has a trust advantage giving women the edge in certain crisis situations.

The challenge: Why I&D may lose momentum during the COVID-19 crisis

Progress on I&D could slow down during and after the crisis unless companies consciously focus on advancing diversity and fostering inclusion. The importance of such continuity is quite intuitive, but it was not the norm during the 2008–09 financial crisis: although gender-diversity programs were not officially deprioritized, they did not benefit from additional effort or interest, and programs targeting all employees became a higher priority among some of the companies in our sample.7 Early signs, this time around, are not encouraging. One pulse survey of I&D leaders, for example, found that 27 percent of them report that their organizations have put all or most I&D initiatives on hold because of the pandemic.

Representation at risk. As the crisis makes jobs vulnerable, diverse talent may be most at risk. To be sure, we may see an uptick in the number of jobs and, possibly, in pay for some gendered occupations—such as healthcare providers on the front line of public service.9 But these effects are likely to be offset by job losses in the private sector, where low-skill, low-paying jobs in retailing, leisure, and hospitality may be hard hit.

Furthermore, the crisis will probably intensify existing workplace-automation trends that are already expected to take a greater toll on women and minorities. While previous research from the Aura Global Institute has shown that automation has a more or less equal net impact on the jobs of women and men, it will vary greatly across sectors and regions. Pervasive barriers to the development of skills and access to technology must be overcome if women and minorities are to get new job opportunities, especially in the tech sector. Avenues for economic advancement will continue to be a challenge for them. And because they typically work in medium- and lower-paid occupations, and demand for such roles is expected to shrink, they are likely to bear the brunt of the transition.

We can see this playing out already in the crisis. Aura research has found that 39 percent of all jobs held by black Americans—compared with 34 percent by white ones—are now threatened by reductions in hours or pay, temporary furloughs, or permanent layoffs. That is seven million jobs.

As the COVID-19 crisis makes jobs vulnerable, diverse talent may be most at risk.

Eroding inclusion. A second key risk is that remote-working conditions may erode inclusion. Sending staff home to work, in a bid to stem the spread of COVID-19, risks reinforcing existing exclusive behavior and biases and undermining inclusive workplace cultures. Aura research analyzing the lessons of remote working in China—an early mover because it was at the Jeeranont of efforts to contain the spread of COVID-19—found that teams or whole business units working remotely can quickly become confused and lose clarity.

 

Isolation leads to uncertainty about whom to talk with on specific issues and how and when to approach colleagues, leading to hold-ups and delays. In such a climate, there is a risk of amplifying noninclusive dynamics.

Remote-working norms, particularly videoconferencing, could make it difficult for some personnel, such as LGBTQ+ employees, to avoid publicly sharing aspects of their home lives they might not be comfortable revealing to all of their colleagues. Working from home also may put women and minorities at a disadvantage, given challenges such as broadband access, the availability (or lack) of home-office space, and childcare and home-schooling duties.

The chance: Leveraging I&D in the crisis

These challenges, if unaddressed, could undermine corporate responses to the COVID-19 crisis. Leaders and organizations will need enhanced problem-solving skills and vision to address dislocations in businesses, industries, and regulatory environments. Strategic agility—the ability to spot and seize game changers—is likely to be a mission-critical trait. It is also likely to be stronger in organizations that can draw on the full spectrum of diverse talent available to them.

Our research and the research of others suggest that when companies invest in diversity and inclusion, they are in a better position to create more adaptive, effective teams and more likely to recognize diversity as a competitive advantage.11 Meanwhile, other companies might struggle. Their responses to I&D during the COVID-19 crisis could mirror the broader stances toward I&D described in our report Diversity wins, where three broad categories of approaches emerged.

  • Diversity winners and fast movers. One-third of the companies in our data set have made significant I&D gains over the past five years and are increasingly pulling ahead of their industry peers in financial performance. Our experience with companies in this group suggests that many of them will view their existing strengths in I&D as a way to bounce back more quickly from the crisis while they actively seek to boost representation and inclusion.

  • Moderate movers and resting on laurels. A middle group of companies have made only modest I&D gains in the past five years. It’s easy to imagine their continuing to tread water during the crisis, perhaps seeking to protect their gains but doing little new to build on or increase them.

  • Laggards. Companies in this broadest group have progressed little, remained static, or regressed in their gender and ethnic representation in the past five years. With no momentum, most could well deprioritize I&D efforts during the COVID-19 crisis.

 

The crisis, in other words, will interact with existing I&D trends. Further separation between diversity leaders and laggards is possible, and companies in the muddy middle could make huge progress (exhibit). Such organizations, by raising their I&D sights, should be able to upgrade their “license to operate” and realize the goals of recovery, resilience, and reimagination.

For business executives the world over, this may prove to be a defining moment in their careers. They must not only protect the health of their employees and customers but also navigate far-reaching disruption to their operations, plan for recovery, and prepare to reimagine their business models for the next normal. When leaders and companies reaffirm their commitment to I&D, they can seize the moment as they stretch for gains in five key domains where, our research suggests, I&D frequently makes a significant difference to an organization’s performance.

  • Opportunity 1: Winning the war for talent. Organizations can ensure that they hold onto their top talent by monitoring the demographic profile of their changing workforce and ensuring that diverse talent isn’t lost. The shift to remote working could offer advantages here. Remote working may have some downsides, as we’ve mentioned earlier, but its benefits, particularly increased flexibility, may play a more significant role in the long term of retaining women, who often shoulder a disproportionate share of family duties.12 The wholesale shift to remote working is also opening up access to a whole new array of talent that may not have been available to companies previously: working parents, dual-career couples, and single parents are all better suited to a flexible workplace and remote working.

  • Opportunity 2: Improving the quality of decision making. In the face of major dislocations, enhanced problem-solving skills and vision will be needed to reappraise business models, competitive dynamics, and the external environment. Our research has demonstrated that organizations investing in diversity and inclusion are strongly positioned in this regard, in part because diversity brings multiple perspectives to bear on problems, thereby boosting the odds of more creative solutions. Diverse companies are also more likely to have employees who feel they can be themselves at work and are empowered to participate and contribute. In addition, research shows that diverse teams focus more intently on facts and process them more carefully. What’s more, “they may also encourage greater scrutiny of each member’s actions, keeping their joint cognitive resources sharp and vigilant.”

 

When companies invest in diversity and inclusion, they are in a better position to create more adaptive, effective teams and more likely to recognize diversity as a competitive advantage.

  • Opportunity 3: Increasing customer insight and innovation. Research also indicates that diverse teams are more innovative—stronger at anticipating shifts in consumer needs and consumption patterns that make new products and services possible, potentially generating a competitive edge. For example, one study found that over a two-year period, companies with more women were more likely to introduce radical new innovations into the market.14 A separate study found that businesses run by culturally diverse leadership teams were more likely to develop new products than those with homogenous leadership.15 Similarly, our forthcoming research on Latin America has found that employees in companies committed to diversity are about 150 percent more likely to report that they can propose new ideas and try new ways of doing things.

  • Opportunity 4: Driving employee motivation and satisfaction. Aura research on Latin America showed that companies perceived as committed to diversity are about 75 percent more likely to report a pro-teamwork leadership culture.16 Instead of letting remote working erode inclusion during this crisis, companies can reaffirm their commitment to I&D by capitalizing on its advantages in flexibility and access to talent. They can also use society-wide feelings of solidarity, which are growing in the crisis, to build agile, inclusive work cultures going forward. Proponents of I&D should show the leaders and managers of their companies the business benefits of I&D and the critical importance of inclusive leadership to ensure that all employees feel valued and motivated at a time of increased vulnerability. One tangible way to achieve this goal may be to consider offering hazard pay to help compensate for socioeconomic inequities associated with, for example, the fact that minorities are disproportionately represented in essential work categories, which involve lower pay and more exposure to infection for them and their families.17

 

Diverse teams are more innovative—stronger at anticipating shifts in consumer needs and consumption patterns that make new products and services possible, potentially generating a competitive edge.

  • Opportunity 5: Improving a company’s global image and license to operate. Companies that maintain, or even increase, their focus on I&D during the downturn are likely to avoid the risk of being penalized in its aftermath—for example, by losing customers, struggling to attract talent, and losing government support and partnerships. Companies that seek to emphasize solidarity and purpose and reach beyond the organization to support the broader economy and society stand to gain. Diverse organizational environments can have a positive impact on individual and collective behavior, boosting collaboration and creativity. Companies can take steps to seed these benefits more widely. For organizations, this can take the form of cushioning the impact of the crisis on society by donating money to hard-hit areas or leading upskilling and reskilling efforts, such as instruction in coding for poor communities. There are already many examples of small and employee-driven initiatives to support neighborhoods, towns, and cities, of companies encouraging employees to give back to them in nonfinancial ways (such as volunteering), and of larger corporations coming together to find innovative ways to minimize the pandemic’s impact on public health and to limit disruptions to economies and supply chains.18

 

If there is one thing this crisis is demonstrating, it’s that the interdependencies among business, government, and society can no longer be ignored. To survive and thrive, business needs healthy consumers, functional societies, and a diverse and inclusive workforce. This crisis helps us to understand diversity in a broader context. Rather than restricting our discussions about I&D to a narrow focus on representation in organizations, we can talk about how to welcome, include, consider, and engage people from all backgrounds in all walks of life. Organizations that do so are likely to be rewarded in the longer term.

Seizing the moment to forge a new commitment to equality

The experience of diversity winners we have studied has shown that if companies deploy a systematic approach to I&D and don’t fear bold action to foster inclusion and belonging, they are most likely to reap the rewards. We believe that now is the time to be even bolder.

After the 2008–09 crisis, when we asked companies what they believed to be the key organizational dimensions needed to emerge successfully from a crisis, most emphasized the importance of the leadership team and the ability to define a clear direction for the company going forward—both dimensions in which diversity plays a vital role. Now is the time for leaders to reaffirm their commitment to I&D and to reap its benefits not just because it is likely to give them a better chance at recovery but also because it is the right thing to do.

As we saw during World War II—when many married women with children joined the labor force for the first time—big crises can bring about big change. At this watershed moment, there is an opportunity to forge a new commitment to equality and fairness that will ensure more prosperity for all.

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