Managing Credit Risk Over the Next 18 Months
Over the last three quarters, credit write-offs – on average – have continued to remain at pre-pandemic levels even as profitability for most financial institutions has decreased significantly – due to lower revenues and an increase in credit reserves. Before the onset of Covid-19, large financial institutions had more than adequate capital to withstand a reasonably severe economic environment. This – coupled with timely government assistance, proactive cost control and customer assistance actions taken during the pandemic – have allowed these institutions so far to remain healthy.
Fin-techs, especially those that had kept the loans on their books – but had not invested in adequate end-to-end credit risk controls – have suffered due to the absence of liquidity and limited demand for new loans, along with a sharp rise in credit losses. Many have been restructured and merged with larger institutions.
Looking ahead, the environment remains uncertain and can quickly morph into a more serious downturn. Good preparation now is essential for survival and success.
The positive impact of early actions has served its intended purpose. There is a distinct possibility that the key drivers of economy and the associated credit losses could worsen in the coming months. Both consumers and small businesses could face a liquidity crunch as savings deplete with time. Even the large financial institutions with solid capital strength could face challenges, in a bad scenario. Many larger companies that have held off on reductions in staff will have to let employees go in coming months.
The coming months are likely to create anxiety for all participants – borrowers, lenders, and investors. It remains uncertain:
- How Covid 19 will mutate – the trends to date do not show any signs of it ‘going away’.
- The possibility of a vaccine or cure — will it be available quickly on a global basis?
- How broad, deep and long the next set of government assistance programs will be.
- The regulatory thinking and guidance for the financial institutions in terms of capital standards, stress tests, stock buybacks, and levels of credit reserves?
The environment can become even more complicated if a clear winner is not established following the November presidential election. This uncertainty could accelerate and deepen these adverse trends.
Risk Management Professionals Beware
We are in uncharted territory where we could experience serious adverse outcomes. At the same time, clear thinking and focused action can create decades of lead over competitors in the way we serve customers and control risk.
This environment has no historic parallel, For example:
- Key economic measures – GDP growth, Unemployment rate – have become uncorrelated with credit losses. The economic measures are at or close to historic worst levels, but the credit write-off rate remains near historic
- Eight months into this cycle, there is limited visibility on where the economy is headed.
- Large volumes of forbearance programs with inconsistent reporting standards (to credit bureaus) have decoupled the relationship between – delinquency and credit loss, Fico score and the probability of default, the definition of subprime and super-prime customer – among others.
Risk management and finance professionals have to ask:
- How do we realistically forecast credit losses and risk-adjusted margins to support mid-year Fed mandated stress tests? Or to book adequate reserves? Deep expertise is required to ensure that these forecasts are bounded within narrow guardrails.
- How do I have any confidence that the current ‘models and rules’ in place, for ongoing risk management, are effective.
- What are the optimal ways to learn from this environment both immediately and for the medium term?
Credit losses, across the board, could rise way faster than the current level of reserves. Alternatively, we might be grossly over-reserved and lose important business momentum. It might become difficult to offer loans at reasonable interest rates. Investors could feel added pressure from reductions in asset prices.
Even established financial institutions could face serious challenges. Fin-techs with inadequate risk management investments could face even worse survival challenges. Well managed institutions could, of course, turn out to be large winners at the expense of weaker competitors.
What You Should Do Now:
Regardless of your beliefs in the seriousness of the economic downturn or the duration of uncertainty, you should act now and tweak your thinking over time.
Reinforce the most important credit risk management themes:
- Good Credit risk management is not just effective underwriting but end to end management through collections.
- Make sure the risk policy and risk operations are in complete alignment with each other – through continual idea and information exchange.
- With discipline, monitor model discrimination, ‘rule’ performance, and portfolios.
- Do an end-to-end review of your entire control process to address weak spots.
It is easy to become complacent right now given very low level of credit losses. I do believe that complacency could have serious adverse outcomes.
Invest in data and technology now to ensure that:
- You have visibility into your ‘true’ credit risk performance – now and in the medium term – corrected for the impact of forbearance and government assistance.
- You have flexible and nimble analytics and execution platforms – to make segmented short-term adjustments to your models and ‘rules’, by industry, loan type (e.g. auto loan, unsecured loan) geography, Covid spread – with full regulatory compliance (90% of the institutions do not).
- You have fully functioning ‘test and learn’ capabilities.
- Analytics are put into production instantly … time is of the essence here.
- You are learning from this environment and building for the medium term.
Be thoughtful as to what you can build in-house and what is best to buy. My general view is that:
- ‘Data’, ‘decision scientists’, and ‘expert credit professionals’ must be owned assets. You might still seek external expertise to strengthen these assets – the key here is to not outsource these critical drivers.
- On the other hand, certain risk management platforms – model studios and Workflow management capabilities – are best outsourced since they are very expensive to build or keep current. Here you should develop expertise to leverage them but avoid building them inhouse.
Perhaps most important, recognize the urgency and need to act.
Over the last couple of years, I have been involved in building a technology that allows you to make quick and thoughtful adjustments to your models and rules with full regulatory compliance along with instant conversion from analytics to production to monitoring. This capability – Corridor Platforms (www.corridorplatforms.com) is one of the most advanced mechanisms for this transformation. Early results have shown outstanding outcomes for complex financial institutions. I would urge you to evaluate its usefulness in your environment.