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Credit risk

Storm clouds forming

Financial Markets Regulatory Outlook 2023

In focus

  • Lenders face considerable risk of increased impairments in 2023 and beyond, with insolvency figures trending up – UK insolvency figures in H1 2022 were at their highest rate since the Great Financial Crisis (GFC).
  • Borrowers are facing significant pressure: retail borrowers primarily from increased interest rates and the cost-of-living crisis; commercial borrowers from increased input costs, higher interest rates and demand side challenges due to purchasers trying to trim their budgets as much as possible.
  • If lenders restrict borrowing as a result of economic conditions, rather than using their capital buffers, we expect regulators to press for review of the buffer framework.

It has been clear for some time that rising credit risk is a significant issue, albeit one where the oft-threatened wave of defaults has yet to break. But the credit outlook now appears increasingly bleak owing to a combination of economic supply- and demand-side challenges for businesses.

Retail customers face increasing inflation, higher interest rates and the associated cost-of-living and debt service challenges, and in 2023 pent up credit pressure (including latent credit risk developed during COVID) will start to translate into increased impairments for firms. This pressure is already starting to show, with UK company insolvencies in the first half of 2022 at a 13-year high and interest rates on mortgages at their highest in over a decade. 

Rising interest rates 

Across EMEA, interest rates are increasing – rapidly – as central banks try to stem the rising rate of inflation. Although nominal rates are nowhere near the levels of the 1990s, many borrowers are taking on mortgages at high income multiples, with the result that mortgage payments represent a significant portion of household incomes.

Notwithstanding the requirement for lenders in the UK and EU to undertake affordability assessments, significant increases in interest rates, when combined with other inflationary pressures, are leaving households with limited or no surplus income. Firms will need to ensure that their affordability assessments keep pace with changes in the economy. In lenders’ residential mortgage portfolios, the prospect of material falls in house prices implies the potential challenge of dealing with customers in negative equity. 

Worsening household finances

In the EU, the European Commission’s economic forecasts from summer 2022 show that all households expect their financial condition to worsen in 2023, but the proportion of households that believe their financial condition will get “a lot worse” is predictably highest among households in the lowest income quartile1. This is further demonstrated by European Central Bank (ECB) data on available liquid assets for EU households shown in the graph below. This will likely result in challenges for firms in balancing their obligations to treat customers fairly and to fulfil their duty to shareholders to minimise losses. 

…more than one in 10 [UK companies] reported a moderate-to-severe risk of insolvency in August.

Office for National Statistics2


Figure 1: Household liquid financial assets

Source: ECB Economic Bulletin, November 2022 

Given their concerns about worsening financial circumstances, it is no surprise that retail customers are putting off major purchases and looking for ways to stretch their household budgets as far as possible. The resultant depressed demand will flow through to yet greater revenue and profitability challenges for businesses, potentially leading to a downward spiral in profitability and reduced capacity for companies to service their existing debt burdens - just as rising interest rates are increasing those debt burdens.

Supervisors were already concerned about increasing volumes of leveraged and highly leveraged debt exposures. Moreover, as companies face earnings pressure the pool of exposures that meet the leveraged or highly leveraged definitions will increase. Banks will need to be able to explain how they are managing the associated risks to their supervisors. 

In the third quarter of 2022, the seasonally adjusted number of declarations of bankruptcies increased by 16.3% in the EU and by 19.2% in the euro area, compared with the second quarter of 2022



Dealing with increased risk of defaults

Lenders, as well as other firms that are significant holders of issued debt or other assets with elements of credit risk, face a period of considerably increased risk of defaults and non-payment. This will manifest in an increase in the base level of IFRS 9 impairment allowances (Expected Credit Losses) in stages 1 and 2. Increased flow into stage 3 (default), a traditional measure of credit risk, will likely follow in subsequent years, but the financial impact on balance sheets will start earlier, reflecting the forward-looking nature of the accounting standards.

All this will happen as banks are in the midst of bringing back into their capital positions the deferred impairments arising from the COVID-related International Financial Reporting Standards (IFRS) 9 transitional arrangements. Firms will need to ensure that they can demonstrate to supervisors and auditors that the underlying parameters in their IFRS 9 models accurately reflect the risk in their balance sheets.

Credit concerns exist in many sectors. In commercial real estate, the International Monetary Fund (IMF) recently warned about tightening financial conditions5, while a recent Deloitte global survey of the sector indicated that sustained high inflation is a significant concern for Chief Finance Officers (CFOs), and that as many as a third of respondents are looking at cost-cutting measures in 2023, up from just 6% the previous year6. The hospitality and tourism sectors face lower demand for their offerings in an environment where discretionary spending is constrained. Deloitte’s October 2022 CFO survey shows UK CFOs in all sectors expressing concern over the cost of borrowing, with a resultant increase in expectations that cost control – including reducing hiring expectations – will be a key business priority in 2023 and possibly beyond. As commercial and corporate customers face reduced revenues and profits, the likelihood of lay-offs is considerable, and increased unemployment will exacerbate the pressures on retail customers already discussed. 

Insurers and investment funds

Insurers and investment funds hold significant volumes of issued debt instruments, as well as investments in property and other assets, as part of their management of premiums and client investments. Changes in asset values have already led to challenges to some business models, and insurers and investment funds may face further asset price and credit-related pressures in their existing portfolios.

Insurers and investment managers are increasingly seen as potential investors for Environmental, Social and Governance (ESG) and infrastructure projects, given the longevity of cashflows those projects generate. However some insurers and investment managers may need to strengthen their credit teams to ensure that any investments made during a recessionary period meet long-term expectations. For UK insurers in particular, we expect the Prudential Regulation Authority (PRA) to adopt a more granular approach to credit risk within the matching adjustment (MA) calculation for life insurers that use it to reflect the increased sensitivity of long-term productive asset classes that are more long-dated and illiquid.

Use of banks' buffers

There is little chance that firms can avoid a significant rise in impairments, likely accompanied by a slow-down in demand for the financial services and products they offer. Firms will, at the same time, face pressure from regulators and finance ministries to continue lending and investing to support the economy. Regulators reviewed the operation of the buffer framework following the COVID-19 pandemic and concluded that banks are extremely reticent to utilise buffers that are not formally released by regulators. This led to calls from some regulators for the buffer regime to be amended so as to enable a greater portion of the buffers that banks hold to be formally released by regulators in times of stress.

Although no action is currently planned by the Basel Committee on Banking Supervision (BCBS), should banks reduce their lending significantly in the face of increased impairments and related credit losses through profit and loss with the explicit purpose of preserving their buffers, then we expect to see regulatory pressure for amendment of the buffer regime to re-emerge. 

Potential government intervention 

The unknown in all this is the potential for further government intervention. Twice since the start of 2020, governments across the world have intervened to cushion the effects of large exogenous effects - firstly with unprecedented support through the COVID crisis, and now to mitigate the effects of rapidly rising gas and electricity prices. Spain is adopting place a scheme to shield the most vulnerable segments of the population from rapidly increasing housing costs, albeit the cost of this will be borne by banks rather than by government. Other EU Member States are likely to follow suit.

In the UK, the Financial Conduct Authority’s (FCA) recent review of the credit information market demonstrated that over 40% of consumers were not aware they are entitled to access their statutory credit report without charge.8 The FCA has requested industry to set up a representative body in 2023 which will work with the FCA to address this and other shortcomings in the credit information market.

For many staff across the industry the economic conditions likely to prevail in 2023 will be somewhat novel, with junior and mid-level credit officers unlikely to have experienced a higher interest rate environment in their careers to date. There will be a need for those more experienced credit officers who have dealt with these conditions to share their experience and ensure that credit teams, including collections and recoveries teams, understand the challenges that higher interest rates pose for customers. More broadly, senior staff will need to draw on their depth of experience from previous decades to help navigate the years ahead.

Actions for firms

Capacity, skills and resources

  • Ensure capacity, skills and resources are in place and trained to deal with rising insolvencies, distressed borrowers, and borrowers transitioning to leveraged or highly leveraged status.

Dealing with risks and impairments

  • Make sure the UK Consumer Duty plan is clear around the process for dealing with credit-impaired customers with repayment challenges (as per UK Consumer Duty spotlight).
  • Undertake ongoing sector-level portfolio and market analysis to ensure supervisory concerns around exposures to high-risk sectors (including real estate, hospitality, energy and leveraged exposures) can be addressed.
  • Enhance understanding of the drivers of impairment and potential future scenarios, to ensure impairment overlays can be clearly explained to supervisors; and to monitor and manage balance sheet impacts proactively. Stress testing assumptions will need to be updated to reflect updated impairment expectations.

Models and indicators

  • Apply greater focus to developing and implementing early warning indicators in order to undertake proactive sector-, region- and customer‑specific credit analysis and risk management as necessary.
  • Update affordability and income and expenditure validation models to reflect cost-of-living movements appropriately. 

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