Storm clouds on the horizon…Why effective and innovative credit risk management is no longer an option

Unbalanced economic growth

In the year following the 2008 financial crisis, economic activity declined in half of all countries in the world. Among the economies that experienced a banking crisis in 2007–08, about 85% are still operating at output levels below pre-crisis trends. The number is smaller (around 60%) for the group that did not experience a banking crisis in 2007–08. Did the aftershock of this crisis and the subsequent falls in disposable incomes in advanced economies embed deep seated resentment that has been building through the last decade?

When we look at the growth of the world economy over the last five years it is fairly consistent, at between 3-4% per annum. Advanced economies have experienced a year on year increase in the last few years. The steady expansion under way since mid-2016 continues, with global growth for 2018–19 projected to remain at its 2017 level. At the same time, however, the expansion has become less balanced and may have peaked in some major economies. According to the IMF, downside risks to global growth have risen in the past six months and the potential for upside surprises has receded.

Political uncertainty

It could be argued that the dramatic political changes we have seen in the last two years have been a direct outcome of the banking crisis and its aftermath. A more extreme political climate has been evident in major developed economies. The election of Donald Trump in the United States has had some significant changes to the geo political landscape that has introduced major uncertainty. The trade war between the US and China and the more protectionist approach to world trade has led to a more uncertain environment for business. Across the Atlantic in Europe we have seen equally dramatic political changes that continue to drive business uncertainty. Brexit has been a provider of confusion and disruption for business in Europe. Growth has been dampened and the risk of recession has risen significantly.

Deteriorating lending standards

The current political environment is having significant impacts on businesses ability to generate revenue and transact business smoothly. There are also speculative excesses in some financial markets which may be approaching a threatening level. For evidence, look no further than the $1.3 trillion global market for leverage loans, which has some analysts and academics sounding the alarm on a dangerous deterioration in lending standards. This growing segment of the financial world involves loans, usually arranged by a syndicate of banks, to companies that are heavily indebted or have weak credit ratings. These loans are called “leveraged” because the ratio of the borrower’s debt to assets or earnings significantly exceeds industry norms.

At this late stage of the credit cycle, with signs reminiscent of past episodes of excess, it’s vital to ask: How vulnerable is the leveraged-loan market to a sudden shift in investor risk appetite, which could be driven by a deteriorating political landscape? If this market froze, what would be the economic impact? In a worst-case scenario, could a breakdown threaten financial stability? It is not only the sheer volume of debt that is causing concern. Underwriting standards and credit quality have also deteriorated in the last two years.

All this has led to dramatic falls in share prices and a number of recent credit defaults with more surely to follow. So how can businesses protect themselves from the coming storm? Traditional credit risk management techniques are obviously a vital part of the risk function, from setting limits, monitoring exposures to defining a more conservative risk appetite. However, more proactive techniques can also be deployed to further mitigate the risks.

Early warning indicators are essential

Firstly, the credit officer should have a toolset of early warning indicators. These would include obvious market trend indicators such as share price movements, rating agency downgrades and CDS spreads. Add to this the emergence of real time social media and live news data feeds that could be channelled into a sentiment analysis tool providing real time sentiment changes. This can provide the risk manager with more real time data and earlier warnings of potential risks, giving traders vital hours and days to reduce positions and for risk managers, vital extra time to fast track credit risk mitigations.

A second element relies on unlocking the data already present in the organisation to spot underlying patterns and trends. Powerful business intelligence visualization can highlight unusual trading patterns or changes in payment behaviour that could also be a precursor to a default. E.g. why has the weighted average days to collect trend diminished for a particular counterparty over the last two months?

In conclusion, the current geo-political landscape makes investing in solid credit risk management ever more vital. Technology innovation and the emergence of social media and big data can add to the risk managers armoury and can help to ensure that risk mitigation strategies are deployed in advance of a coming storm. Can you afford to wait?