Pandemic Presents Opportunities For Bank Credit Risk

Market Commentary
November 23, 2020

By Acuity Trading

It is a critical moment for bank credit risk right now. While US banks were in reasonably good shape heading into the Covid-19 crisis – especially their Tier 1 ratios – credit levels were already high. The initial government stimulus programs have helped lessen the impact of the financial downturn, but many have run their course, and additional stimulus does not appear imminent.

On many levels, the current situation is not easy to read. Direct support from the government has flattered financial metrics for both sound and struggling consumers and small businesses, making true risk differentiation difficult. And the Fed’s broader “easy money” policy has bolstered liquidity, making capital available to companies with unhealthy as well as healthy underlying economics. Meanwhile, the pandemic is not receding and, in many regions, is intensifying, hurting consumers, small businesses and the overall economy. Meanwhile growing geopolitical challenges, including the trade war with China, create increased uncertainty for the months ahead.

In other recent financial crises such as the dot-com bubble or the Great Recession, the voice of credit risk wasn’t heard early enough. Now, with banks facing a potential tsunami of bad debt, there should be greater attention and action focused on their credit capacity and capability.

What is clear is that credit risk has increased. For example, loss reserves as a percentage of total loans were at 2.19 at the end of Q2 2020; compared to 1.15 at the end of Q4 2019. The highest recent level of credit risk was 3.70 back in Q1 2010 when the economy was in the depths of the financial crisis. Meanwhile, 24 firms in the U.S. alone have been downgraded to fallen angel status (i.e., BBB- or lower rating) so far in 2020, adding about $300B to the high yield universe of bonds.

Banks’ chief risk officers face significant challenges in assessing the current conditions and their credit supplies. Many corporates, for example, are heavily leveraged and have slipped to “near-junk” BBB status and may not outlast the pandemic or survive a second shock. Others are waiting it out, trying to bridge the period until the next round of government support or the introduction of a vaccine. The recovery scenarios are evolving dynamically and trying to use historical data, processes and assumptions around credit risk alone will likely lead to inaccurate assessments of risk due to the unique nature of this complex current cycle.

In such an environment, risk officers need to process and optimise credit policy and portfolio analysis to account for fast-changing data, an uncertain timeline and increasingly irrelevant modelling assumptions. Reliable data is scarce, particularly as it pertains to operational risk, people and the workforce, infrastructure, supply chains, third parties and distressed customers. This is a new world; banks need to adapt their processes, tools, data and frequency of communication, especially while contending with other fundamental shifts such as risks from digitisation and climate change.

Chief risk officers should be taking steps including:

·      Working in shorter cycles while adopting new technologies, including advanced analytics such as sentiment analysis, network analysis and machine learning tools to detect real-time signals, recognise portfolio trends and identify at-risk portfolio segments under pandemic scenarios. They should also identify and develop needed skills in areas such as data science, re-skilling risk teams as necessary.

·      Using new, reliable and frequently obtained data to create early warning signals, isolating true underlying risk. For example, risk teams can incorporate Covid-19 specific KPIs and metrics for timely updates for sensitive segments. Doing so will enable risk leaders to recalibrate and redevelop rating models and pre-delinquency analysis to reflect the pandemic environment.

·      Establishing a cross functional “war room” with functions like strategy and investor relations, testing for stress in a variety of scenarios, while supporting the finance function with analytics to reinforce the balance sheet and maximise returns through the cycle.

·      Working with regulators to optimise reserve and provisioning levels, and contributing to the formalisation of new reserve standards

·      Creating efficiency in the collections process by re-evaluating forecasts and strategies for collections and setting up a system to continuously monitor accounts receivables with Covid-19 relevant key metrics. Banks can also analyse and optimise the grace period for charge-offs of delinquent accounts, adjusting their strategies to increase collections efficiency and returns, without damaging the banks’ reputation. Lastly, they can foster effective communication with clients and customers by redesigning invoicing efforts, including making payment methods frictionless and establishing processes to generate timely payment reminders.

The pandemic will continue to evolve and other challenges will emerge as we solve for the challenges we face today. We can therefore only anticipate that the credit environment will remain highly volatile and uncertain for an extended period. Banks’ risk organisations will need to consolidate internal loan data with new data sources ranging from news feeds to customer comments to macroeconomic indicators. And they will need access to real-time, AI-driven reports and alerts for immediate visibility. By leveraging data, advanced analytics and technologies such as AI and machine learning, CROs can more rapidly develop the capabilities needed to address not only the current headwinds but to identify and respond to the crises yet to come.


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