Working with borrowers to manage credit risk

Government stimulus packages and lending programs developed and launched during COVID-19 have had a positive impact. Given the numerous public health and economic uncertainties, however, the road ahead remains perilous for both lenders and their borrowers.

Many small businesses that applied for loans from the Paycheck Protection Program anticipate needing additional financial support in some form over the next 12 months. Individual consumers who obtained forbearance from lenders and landlords are facing the stark reality that they will have to find ways to manage for a much longer time than expected before the situation improves. Absent further government action, many of the benefits available to borrowers are shrinking or going away, and participants on both sides of the credit market need to prepare for what comes next.

For consumers, widespread deferrals mean lenders really can’t tell which borrowers are creditworthy. On the business side, the likelihood of significant changes in their operations post-pandemic means that looking at historical performance will not be relevant. New credit decisions will need to consider fully how changes in the operating models of these businesses will impact future revenue and debt service coverage ability. Added to these issues is a lack of transparency over the ability of major financial institutions to withstand surging credit losses.

What does this mean for financial institutions? There are immediate actions institutions can take to continue to support their borrowers and mitigate credit risk.

• Reassess existing loan portfolios. Reassess how credit concentrations are aggregated and reported, and modify them to align with the pandemic. Consider putting a different lens on the credit portfolio by evaluating professions, geographies and rating agency downgrades, among other areas.
• Enhance data collection. Continue enhancing data collection and ensure data collected during this time period is complete and can be relied on to provide deeper insights into credit risk on a go-forward basis. Establish COVID-19 system indicators or flags to help with ongoing monitoring and reporting. As an example, some institutions have established COVID impact flags to distinguish borrowers that have been severely impacted from those that have had moderate or no discernable lasting impact.
• Reevaluate underwriting criteria. Ensure that credit evaluations are forward-looking and not based on historical performance of an industry segment or individual borrower. As much as most financial institutions want to work with borrowers during these troubled times, poor credit decisions will serve neither the financial institution nor the borrower in the end. Lenders must be able to differentiate between borrowers suffering temporary disruptions and needing bridge support until normal operations can resume from those whose business models are no longer viable.
• Keep abreast of changes. Create a task force focused on credit risk management strategies. Ensure the institution has a process in place to assess and react swiftly to the rapidly evolving regulatory landscape as it relates to policies like forbearance, foreclosure moratoria and credit reporting changes.
• Reevaluate borrower communications. Reexamine how the institution communicates with borrowers. Enact self-service models that incorporate technology that allows customers to message, share documentation, contact or text via a mobile app or website. Analyze concerns of borrowers and look for trends that could potentially result in further policy changes. Engage early with borrowers considered most at risk.
• Recalibrate credit risk rating models. In this global crisis, rating models used to calculate probability of default and loss given default may have lost their predictive capabilities. Consider recalibrating model inputs and assumptions to align with today’s environment. In addition, they might consider establishing a temporary COVID-19 risk rating.
• Be realistic about balance sheet risks. Possible changes to Federal Reserve stress testing requirements aside, perform frequent (at least quarterly) scenario analysis to understand and manage the financial impact of credit risk to the organization.
• Remove barriers for resources. Assess what resource skill sets are needed, such as legal and compliance knowledge, special assets and problem loan workout experience, and customer service. A swift inventory of these skill sets across the organization, including identifying personnel that can be cross-trained, will help support areas with the greatest need and identify shortfalls to be addressed.

COVID-19’s effects on businesses and the economy continue to evolve. As governments worldwide take steps to stem the pandemic, financial institutions should take action to understand borrowers’ current conditions, express empathy with the circumstances they are experiencing, and support borrowers while protecting the condition of the institution through effective credit risk management practices.

Bill Byrnes is a managing director in the risk and compliance practice at Protiviti.

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