What is on the agenda for Credit Risk Managers in 2023?

None of us need reminding how tumultuous a year 2022 was. Just as we were emerging from a global pandemic, we entered a cost-of-living crisis with stresses impacting all the critical areas of our personal expenditure. The combination of quantitative easing, government support and personal savings growth during lockdowns, together with sharp rises in energy costs due to the war in the Ukraine, have fuelled double-digit inflation, which now sits a at a 40 year high in the UK.

As expected, Central Banks responded to the inflationary pressures by increasing interest rates. The Bank of England (BoE) Monetary Policy Committee (MPC) increased the BoE base rate to 3.5% from 3% on the 15th of December 2022. Contrast that to 15th December 2021, when the rate stood at 0.25% and you realise just how markedly the cost of credit increased in a year.

With this as the background to the start of 2023 there are some significant areas for managers of credit risk to focus on to ensure not just survival but staying ahead of the competition. We will look at those that we believe are the most material in a series of five articles over the next few weeks.

Our top five macro credit risk measurement themes to look out for in 2023

We’ve distilled our observations into five themes, that we believe must be at the top of the credit risk managers’ agenda in 2023:

1. Protecting balance sheets and customers as credit risk levels rise: The credit cycle is turning and whilst credit risk managers feel well equipped to navigate this as an industry, we must avoid a wait and see attitude.
2. Enhancing risk identification processes to weather a potential storm: New capabilities are needed to complement prevailing credit risk practices and proactively manage emerging risks; this is where Robust Early Warning Systems & Insightful Credit Risk Analytics are becoming increasingly important.
3. Understanding and managing Climate Risk: Behaviours, expectations, and risk types are evolving due to climate change; these climate transition and regulatory changes need to be factored into credit risk frameworks.
4. Getting a return on regulatory investment: With no signs of regulatory expectations easing, the hard work continues, and we must look to make the most of regulatory changes.
5. Maintaining a firm grip on model risk: In the risk managers model driven world, sound Model Risk Management has never been more important.

Over the next couple of weeks, we’ll dig into each of these topics in more detail. In this first blog of the series, we will expand on the first theme on in our list.

Credit risk is back, and risk levels are rising

We believe that the UK has reached the turning point in the credit cycle. One could argue that we’ve predominantly been in a benign credit cycle since 2010; during this period, we’ve become accustomed to low interest rates as well as remarkably low default rates. The low interest rate environment helped fuel a global debt expansion, and with that asset prices. Compared to pre 2007/8 financial crisis levels we’ve seen global debt more than double, peaking at around $300 trillion in 2021. In the UK we’ve seen more stable debt levels, but we did start from a higher base. As a percentage of GDP, UK household and financial corporate debt levels remain significantly higher than the global averages for these categories (see Figure 1).

Focussing on the UK, we expect inflation and weak demand to push corporate profits down and increase the number of corporate bankruptcies. In the first three quarters of 2022 UK company insolvencies were already 76% higher than in the same period in 2021. Credit is less available and more expensive, making it harder to raise finance for leveraged, higher-risk projects. Investors will put a premium on assets that deliver profits and protect against inflation.

Even stripping out soaring energy and food prices, core inflation is running at very high levels by the standards of the last 20 years. Labour markets have proved resilient in the face of a massive tightening of monetary policy. The unemployment rate in the UK is close to a 50-year low and wage growth in the private sector is accelerating. Central banks believe they will need to raise rates further to bring inflation back to their 2.0% targets. We see UK rates, which are currently 3.5%, peaking at 4.5% and euro area rates rising from 2.0% to 3.5%.

As interest rates increase, it becomes more expensive to service existing debt. With a population suffering from reduced disposable income, the levels of spending on discretionary items that were witnessed during the post COVID recovery period can’t be sustained. This introduces uncertainty in the continuity of corporate cashflows.

The structural model of default tells us that when the value of a company’s assets is more volatile, and its liabilities increase, the probability of a default event also increases. Combining this with widely predicted falls in residential and commercial property, the main sources of bank security, it is reasonably safe to suggest that the level of overall credit risk in the financial system is rising and that the credit cycle is finally turning.

Figure 1: Global vs UK Sectoral Debt between 2005 and 2022
Source: IFF Global Debt Monitor, November 2022

What to look out for in the changing cycle

The credit risk management industry evolved significantly after the last financial crisis. Predominantly driven by changes in regulatory expectations, banks are well capitalised and have made significant investments in their data, models, and risk management systems (particularly stress testing). As a result, the consensus in the credit risk community appears to be that it is well equipped to weather the next storm.

Figure 2: UK Banking Sector Regulatory Capital
Source: Bank of England

As always, there will be winners and losers from a downturn in the market, some historical relationships between risk drivers and credit outcomes will be broken due to changing market dynamics and fiscal environment. This is where proactive credit risk management will be critical and risk managers must consider industry or sub-sector vulnerabilities to better understand and be able to target the management of the risk without spreading resources too thinly to be effective, or over controlling the wrong areas.

Two areas that should be carefully monitored are the property and Small Medium Enterprise (SME) lending markets:

1. SMEs can be seen as somewhat of a hidden risk. Depending on the length and severity of the energy crisis smaller enterprises may not be able to pass costs on to consumers or adjust business model/capital structures sufficiently to survive. There are many so called “zombie” companies that have been able to survive over the last decade through access to cheap sources of funding, but which no longer have sufficient cashflow to cover increased interest payments.
2. The more apparent risk resides in the property market, where we will look at commercial and residential property in turn:
   • Commercial property contracts may be running risk of covenant/lease breakages, (which will be important to monitor) and increased refinancing risk. Commercial real estate business margins will also be particularly squeezed in the higher interest rate environment, bringing business viability into question. The risk for commercial property is also compounded by behavioural changes from the pandemic, which forced many companies to re-evaluate office requirements.
   • Residential mortgage portfolios on the other hand face increased inflationary risk due to the cost-of-living crisis. We are already seeing reduced collateral valuations and an increase in mortgage defaults with the FCA warning that more than 750k households are at risk of default over the next two years. Portfolios with significant exposure to low-income borrowers especially at the margin of the affordability calculation will undoubtably feel pressure sooner.

With old risk indicators weakened, developing new early warning capability can create competitive advantage

Generally, risk management tools (including models) rely on historical relationships and data. With the current levels of economic, geopolitical and climate uncertainty, these historic relationships are breaking down and may no longer provide reliable indications of risk.

There is a need, therefore, to supplement current risk management techniques with:

• clear and understandable scenario analysis,
• adequate forward-looking indicators, and
• appropriate early warning indicators to identify emerging distressed borrowers.

Most lenders have already started investing in their credit analytical capabilities and early warning systems because of the global pandemic.

Evolution in credit risk modelling capabilities is also being encouraged by the need to manage climate change related financial risk. Essentially, consumer and corporate behaviour is changing and regulatory expectations in this area are increasing. Risk modelling capabilities need to capture this interaction between a changing climate and changing economy. We believe there is a need to go beyond regulation in 2023 and embed proactive risk management frameworks, making the most of the wealth of information that is available.

Regulatory expectations will continue to increase

Most banks are partway through implementing changes to their capital and impairment models to account for changes in regulatory requirements. Whilst being in the middle of such challenging and costly change programmes, we recognise that it is difficult to also think about investing in credit analytical capabilities. The regulatory change agenda also shows no signs of easing with the PRA publishing its long awaited consultation paper (CP) on the UK implementation of Basel 3.1 before the new year (read our summary here).

Another area where investment is needed to address regulatory requirements is model risk management (e.g., CP6/22). This should be no surprise as credit risk managers are increasingly reliant on models to make decisions.

To summarise, the advancements in the regulatory landscape are positive. The banking industry is well capitalised, which is essential to a healthy financial system. Credit risk managers have better tools in place to navigate the turning credit cycle and manage risk than ever before. However, we must remain vigilant as the risks that we manage evolve.