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Should pandemic scenarios be included in the risk management tool box?
Executive Education / 24 March, 2020
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Research Fellow at Frankfurt School
Prof. Dr. Christian Schmaltz is a consultant for risk management. As part of his PhD with Prof. Heidorn from Frankfurt School, he set up and described "A Quantitative Model for Liquidity Banks". In addition to the preparatory course for the Certified Corporate Treasurer VDT, Mr. Schmaltz teaches the module "liquidity management" in the MBA at the Moscow Academy of Finance. In the Master's programme at the Frankfurt School, he teaches "bank controlling." Apart from gaining teaching and seminar experience at Frankfurt School, he worked as a statistics tutor at the University of Karlsruhe and as a consultant at Deloitte. After completing training as a banker, Christian Schmaltz studied industrial engineering at Karlsruhe and Economics in Paris. Through an internship at the Treasury, he gained insight knowledge of the processes and methods in this area. Dr. Schmaltz is Adjunct Professor at EADA Business School (Barcelona) and affiliated with Aspect Advisory as well as Signature Management Consultants.

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Corona Pandemic – Is tourism prepared?

In the first post we discussed financial institutions’ risk management in a pandemic, and specifically in the face of the current CoVID-2019 crisis. In this post, we turn to the tourism sector, using the example of an airline company.

Companies prepare themselves with business continuity plans, capital- and liquidity buffers to withstand potential operational disruptions, losses and liquidity shortages caused by unforeseen challenges. A well-prepared company should therefore be prepared for standard recessions and market turmoil.

Pandemic scenario

What does a “Pandemic scenario” look like for non-financial corporates? Depending on the industry, the following characteristics can be more or less relevant: production is stopped or seriously hampered, turnover suddenly drops to zero, and fixed costs carry on. Financial markets collapse because growth and dividend expectations must be reversed. After this short-term “lockdown shock“, usually follows a “standard” recession.

However, the fact that we have now seen airlines apply for government assistance just two days after the U.S. travel ban of Europeans shows that for some companies, a “Pandemic” is likely more severe than their previously tested scenarios. This is evidence that they were probably (or simply) not prepared.

Example “airline”

Let’s look at an example in more detail: For 2019, an airline reported 36 bn EUR revenues (3 bn EUR per month) and 1.2 bn EUR profit. If this year all of the airline’s planes are grounded for 12 calendar days and all cost are assumed to be of fixed nature, the airline would still report no losses.

The airline has 10.2 bn EUR equity. If all planes would be grounded for 64 days, not only would the planned annual profit be lost, but 50% of the airline’s capital would also be depleted. After 115 calendar days of grounded planes, the airline would be insolvent.

Current situation

Starting March 23rd, 31,000 Lufthansa employees are working shortened hours. Only three long distance flights are departing per day from Frankfurt International Airport. The flight plan will be reduced to just 5% of regular operations. One runway at Frankfurt Airport has been closed to serve as a “Parking lot” for aircrafts, said Lufthansa CEO Carsten Spohr at the annual press conference.

It is very probable that it will take at least 50 calendar days until the economy returns to some state of normality. The later recovery of lost revenues, however, is unlikely. Lost business trips won’t be rescheduled for later. Many households may have to revise their holiday budgets due to (temporary) unemployment and income drops. Not everyone will be refunded for missed trips and cancelling holidays probably becomes problematic for employees. Therefore, there is a high chance that airlines and many other tourism companies’ stress scenarios and models have not fully anticipated the financial implications of such a pandemic and thus, they were not financially prepared for it.

Include pandemic scenarios in the risk management tool box?

Pandemic scenarios (short-term: 0 revenues, cost carry on, mid-term: “normal” recession) do not hit all companies the same way – some can move their production or sales model online, others can’t. Yet, it is also possible that while testing a pandemic scenario some companies might conclude that the cost of full pandemic preparation would be far too high, such as in the case of airlines. Those companies would simulate these scenarios but would conclude that preparation is not worth it and would instead hope for direct or indirect government assistance in the case a pandemic occurs.

If the pandemic scenario for the company differs significantly in severity and timing from typical recession scenarios, it should be included in the scenario catalogue. In any case, a virus pandemic scenario should at least be expected as a “sales flash scenario” by every company in the future.

One can expect, or at least hope, that the financial consequences of future pandemics will be less severe than CoVID-2019, because politicians and health industry will have learned their lessons. In that case, the scenarios “pandemic” can be softened. But based on the 2020 experience, the pandemic scenario must be more adverse than the 2008 meltdown of the financial system.