28 March 2023, Amsterdam, The Netherlands

BCP Key Take Aways - The Future of Credit and Risk Management: Trends, Challenges, and Opportunities in Europe

BCP attended S&P’s ‘The Future of Credit and Risk Management: Trends, Challenges, and Opportunities in Europe’ event in Amsterdam.

We heard about the challenges from geopolitical conflicts, high levels of inflation, and supply chain disruption that are forcing companies and financial institutions to reassess how they manage and monitor their risk exposure.

 The event united credit and risk management professionals, as well as data and analytics providers, to discuss the challenges and opportunities arising in Europe.

Industry leaders discussed global disruption, macroeconomic and sector outlooks, the credit risk impact of Climate Change, and transformation trends impacting the credit risk workflow.

Our Key Take Aways

Credit risk in the current environment:

Could continue to be impacted by macro-economic events: A large range of macro-economic factors such as geopolitical conflicts (e.g. China-Taiwan, Russia-Ukraine), instability  of the banking sector -> spillover in the economy, high levels of inflation, and supply chain disruption, can impact credit risk -> hence credit availability & conditions

Risk of recession is very high in the next 12 months: models estimate the risk of a full-fledge recession by 70% after inversion of both the forward and the spot yield curves. Recession expected to be mild and inflation to be back to target by 2025. ECB’s job of reducing inflation without jeopardizing financial stability becomes more challenging.

Risk at company level depends on amount of leverage: If you have low leverage, inflation is good, as revenues will go up, and cost of debt will not go up at the same pace. Conversely, if you have a lot of debt, and inflation goes up, cost of debt goes up higher than revenues growth.

Large range of risks, depending on business model, asset class, and regional: e.g. volatile COGS from volatile cost of commodities, energy and transportation for a large range of firms, supply chain risks for manufacturing companies, regional risks in conflict & neighboring areas, mortgage risks for real estate below sea level from sea rising levels due to climate change.

Credit quality expected to be under pressure: consumer confidence and trends in unemployment will remain key indicators for credit quality. Positive factors expected to be wage growth, external demand, falling inflation, and the NextGen EU recovery program.

Less systemic risk for European banks: derived from a study on ~130 European banks, 95% of their assets are cash or marked to market, only ~5% of assets are allowed to remain at book value irrespective of the fair market value underlying asset (derivatives, hedges), as opposed to US where the regulator took a looser approach for smaller banks (a high proportion of 10-20% of assets can remain at book value) -> can force a bank to realize a high loss when selling assets and if below the equity position of the bank -> bankruptcy

How is the credit issuance impacted by the current economic downturn?

Lenders are busy with the existing portfolios and the bar is increasing for new credit: many lenders have more exposures now vs. before from companies in financial difficulties i.e. lenders receive more requests for waivers, extending maturity, debt rescheduling, hence workload grows exponentially. Time spent on monitoring and sometimes provisioning also increases.

Risk mitigation is important: some lenders are proactive in identifying vulnerabilities early, and try to find a solution together with the company or act on early collections.

Additional data implies more analysis -> longer time to take credit decisions: Given the many changes in the economy, there is more data to analyze, to update, to discuss, when compared to a normal, stable, lower volatility financial situation.

Current environment still provides opportunities: despite an expected increase time spent on existing portfolios over the next 12-18 months, the current environment still provides additional opportunities.

What is 'old risk' and what is 'new risk'?

Old risk:

Gaps in regulation allowing for high risks: Gap in the regulation allowing banks to take too high liquidity risks by having illiquid bonds which needed to be traded when deposits decreasing (SVB). Or regulation allowing reporting assets at par value despite value decreasing, and taking credit or deposits against these depressed assets.

High volatility:

Generally in any crisis volatility increases, and banks need to pay more to hold risk, which alongside the decreasing value of fixed income assets, is fundamentally increasing liquidity risk of banks and other lenders.

Trends in some new asset classes resemble trends of other asset classes historically, e.g. crypto currency volatility resembles local CCY debt in emerging markets – an illiquid asset, highly fragmented in terms of information, highly volatile markets prone to rise of bad actors that are hard to categorize (In Crypto there are many different coins, different exchanges of which not all can be trusted, unclear regulation).

Layering multiple levels of risk: e.g. credit risk + commercial risk + fraud risk + insurance risk in the case of Greensill, where receivables were seen as collateral, on top of which an insurance policy was overlaid, and when fraudulent invoices were discovered, insurance was withdrawn, and resulted in Greensill’s bankruptcy.

Same risks packaged differently: Liability-Driven Investment (LDI) risk resemble LTCM (huge leverage, liquidity risk, wrong direction risk), crypto risks resemble emerging markets debt risk.

Hidden liquidity risks: the current energy market crisis is similar to other previous liquidity crisis, e.g. in energy the drivers over the last few years to do more exchange traded transactions resulted in several very large organizations having margin calls -> credit risk was transformed into liquidity risk

New:

Availability and granularity of data is higher: lenders are taking into account more data points, sources, and factors in credit risk assessment.

Fundamental increase in certain costs: supply chain, transportation, energy, which comes with an increasing need to stabilize or better forecast these costs for companies.

Sustainability has really become important: many more lenders are now taking into account sustainability, ESG, climate change in credit issuance or refinancings.

What has fundamentally changed vs. 5-10 years ago?

Climate change has accelerated and is more visible: 1 coffee has a carbon footprint of 200 CO2e grams -> If you drink 1 coffee every day -> 75kg greenhouse emissions yearly (equivalent to driving a car for 640km), @ 2.5 billion coffees every day results in 70 millions mega tonnes of CO2e yearly

Access to recent data is more important (and actionable) than ever: while historically lenders provided credit based on annual reports, now that is not enough anymore – lenders need more recent (ideally real time) data points to take the right credit decision now. For instance, New10 (ABN AMRO Bank) is considering taking credit decisions based on a 12-months rolling annual report instead of the static 12 months annual report.

Machines are strongly supporting, but not replacing and cooperating with humans in credit risk analysis: while depending on lending product, credit decisions still involve human decisions. Data enables humans to make a better assessment, but don’t replace humans with tech-only decisions on data, start credit decisions with typical analysis, on which apply standardization, add more data to it – e.g. ESG data, alternative data, recent data. Generally the 1st part of credit analysis (issuance of Non-Binding Offer) can be fully automated, while 2nd  part (credit committee approval, issuance of Binding Offer, credit agreement) will continue to involve humans on most lending products (more digitalized lenders have 70% machine, 30% humans).

What should we see going forward?

Clarity on regulatory situation for emerging asset classes: e.g. enacting and enforcing new regulation for crypto currencies, trade finance assets, and other emerging asset classes

Technology getting better: alongside an evolving regulatory framework, technology will make it easier to sign contracts (E.g. smart contracts), transfer collateral (e.g. in <1 hour vs. days), and facilitate the credit analysis process.

Lenders looking to analyze more data and more recent data: lenders will continue to integrate new data points and more recent data points in their credit analysis, and the more prepared companies are to provide these additional data points, the quicker the lenders can take a decision to provide you credit.

Risk materialization in trade finance: while many players are active in trade financing, pricing and managing risk in this area is not easy, hence we can expect defaults, fraud, insurance and liquidity risks materializing.

Institutions who will succeed will find the balance between machine and humans: in the current environment, more human involvement is necessary while continuing to trust the credit risk models.

Corporate defaults picking up: 5 defaults of rated companies since the beginning of the year. Deleveraging is the mantra currently to keep asset value, e.g. through asset disposals, identifying relevant lenders who can secure more assets and provide adequate refinancing, etc.

Borrowing costs to remain high: the era of falling borrowing costs is likely over

How can we prepare for the period to come?

Scenario analysis & mitigation actions: Run risk assessment analysis with scenarios that you see in the near and mid-term future, when taking into account the current events (scenarios now are different vs. 12/24 months ago). Analyze your potential exposures in each scenario, where is it and what would the impact be? Prepare, prepare, prepare -> anticipate impacts of these scenarios on your business -> take corrective actions early.

Control costs: analyze cash burn situation. Assess scenarios to decrease cash burn and increase the burn timeline.

Leverage data: collect, analyze, and generate insights with data from your business to provide lenders sufficient insights into your business to take a decision based on the current situation of your business situation.

Featured panelists:

• Wim van Nes, Head of Credit Risk, Goldman Sachs Asset Management
• Arnoud van Zelderen, Managing Director, New10, ABN Amro Bank
• Sidiq Dawuda, Head of Market Development (EMEA), Credit Analytics, S&P Global Market Intelligence
• Karl Sees, Global Head of Product Strategy and Marketing, Cubelogic
• Stuart Nield, Global head of Product, Financial Risk Analytics, S&P Global Market Intelligence
• Robin Willing, Sustainability Director, NIBC Bank N.V.
• Giorgio Baldassarri, Global Head, Analytical Innovation & Development Group, S&P Global Market Intelligence
• Dr. Sylvain Broyer, EMEA Chief Economist, S&P Global Ratings

Should you like to discuss a Debt financing project, do not hesitate to reach out to our senior bankers.