By Harrison Heaton
Covid-19, most likely the deadliest pandemic every human life has had to face in the last century. Yet, “deadly” doesn't encompass only the physical well being of a person or nation, but the harmful effect it has on the financial industry. Covid-19 has triggered numerous challenges all across the nation impacting the ability for banks and financial institutions to operate efficiently and properly. As we all know, the financial shock this virus employed and the record breaking economic downfalls such as unemployment, GDP inhibition, etc. resulted in massive amounts of fear, speculation, and withdrawals. Credit risk was especially prominent due to people losing their job, not having any/enough income coming in, and having to default on their debt obligations as a result of financial disparity. Yet, unlike other economic downfalls in the past, banks are not the problem in this case but they are changing their strategies to try and be the solution.
Now, with this being said, when times of inevitable credit risk increase, so does the financial institution's ability to manage that risk. This is not only a necessity, but vital for the banks/FIs success amongst its competitors. Most, if not all, financial institutions use credit risk models to assess the situation of issuances of debt obligation in a time of economic downturns. However, economic downturns are a broad umbrella for a wide array of possible scenarios, and it just so happens that Covid-19 might have been outside that spectrum. A halt in a nationwide supply chain, market demand altering in unpredictable ways, and government shutdowns would classify as a bit more than a “downturn”. Therefore, credit risk management could not keep up with the declining pace of the economy, making it hard to assess the financial institutions positions when loaning out debt.
With this being said, I want to fast forward to the modern day, in which financial institutions have made efforts in adapting their credit risk strategies. Banks and financial institutions actually are in a much better position than they were compared to other financial crises. With institutions having stronger capital positions, they are able to mitigate risk much better, credit risk being the most prominent issue. Now this is in large part due to the learning curve institutions had to part take in after the 2008/2009 market crash, but nonetheless it has provided a safer, more bulletproof financial sector that we need. They have higher provisions coverage ratios for nonperforming loans and have taken huge strides in the decline of default ratios.
Stimulus support,the lowering of federal interest rates by around 100 basis points, and government aided programs like paycheck protection has enabled consumers to have a helping hand in this time of great economic decline. This is an important point because it goes along with the phrase, “help me help you”. When banks and the Federal reserve perform all these functions and follow through with them, people have more money in their pockets and more confidence in the financial system therefore implying that they also have the ability to pay back debt obligations with the money they are saving. Payments get paid, banks get their money from the loan obligations and the financial institutions continue their growth. Yet, this happens rather quickly. In the earlier stages of covid as mentioned above, people were defaulting left and right, and credit risk was at a record high due to unemployment and what now. However, the simple utilization of providing temporary stimulus and programs has made all the difference. Now, with this being said there are some great issues that arise from this aid due to someone having to pay for it, but when it strictly comes to credit risk it has been a declining rollercoaster.
Creditworthiness is a crucial part in the evaluation process banks must go through, and going beyond business sector analysis to a more individual case by case basis is what is going to develop more confidence in their credit scoring models. Creditworthiness is a huge concept and banks are working toward making a more efficient and effective system of analyzing loan applications. The first mitigation strategy might seem rather simple, but if done correctly can vastly improve the speed and quality of provided debt obligations and that is data aggregation. Having data available and well structured can remove the hindrance of previous cluttered data and provide the opportunity to secure a more in depth report of the credit borrower and the characteristics needed to determine qualification. Moving forward to after qualification is secured, banks need to have a more in tune strategy to communicate with borrowers at the first sign of distress/default. Being able to assess each debt obligation on a very miniscule level like single borrowers would give a good idea of viable or nonviable borrowers. With this being said, some banks did not change this identifying mitigation technique from pre-covid, therefore making it harder to determine delinquency. Cumulative loss projections resulting from credit risk can be a difficult thing to quantify, yet with the proper procedure put in place can be done. The thing that made banks over/underestimate their losses was the absence of updated credit scoring models which had a foundation from pre-covid, when credit risk was not as high as the early stages of covid.
Anytime there are modifications to a series of loans, it is the bank’s obligation to track and monitor the status and potentially flag them if Covid-19 is causing the loan portfolio’s performance to deteriorate. These modifications can create massive amounts of mitigation and potentially save a lot of money for the bank, but only with proper monitoring. I believe the story of credit risk and covid, especially in the later half of the pandemic is that it is quite easy to borrow money from financial institutions because interest rates are so low, the government is giving stimulus, and programs such as PPP loans are being utilized on a great scale. However, this is where a greater issue of credit risk comes into play. Just because it is easy to borrow in the short run and banks are able to issue out debt obligations and collect payments every month, that does not mean that this will continue. Matter of fact in recent months, we have seen inflation hit the 30-year high, surpassing 6.22% and talk of the Federal interest rate threshold jumping up due to “economic stability” and the vaccination rate.
Only time will tell whether we have contributed to a more improved economic system with procedures and mitigation tactics put in place to reduce credit risk in a time where it was predominantly high, or whether we are putting a short-term bandaid on a long-term issue that has the potential to develop into a greater issue that we and the credit scoring models are measuring.
Work Cited
“The Pandemic's Impact on Credit Risk: Averted or Delayed?” The Fed - The Pandemic's Impact on Credit Risk: Averted or Delayed?, https://www.federalreserve.gov/econres/notes/feds-notes/the-pandemics-impact-on-credit-risk-averted-or-delayed-20210730.htm.
Koulouridi, Efstathia, et al. “Managing and Monitoring Credit Risk after the COVID-19 Pandemic.” McKinsey & Company, McKinsey & Company, 10 Nov. 2020, https://www.mckinsey.com/business-functions/risk-and-resilience/our-insights/managing-and-monitoring-credit-risk-after-the-covid-19-pandemic.
Reno, Ariste, et al. “Managing and Mitigating Credit Risks and Losses through the Crisis and Beyond.” The Protiviti View, 7 May 2020, https://blog.protiviti.com/2020/05/07/managing-and-mitigating-credit-risks-and-losses-through-the-crisis-and-beyond/.
“Current US Inflation Rates: 2000-2021: US Inflation Calculator.” US Inflation Calculator |, 10 Nov. 2021, https://www.usinflationcalculator.com/inflation/current-inflation-rates/.
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