Credit risk

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. 

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. 

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. 

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.

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.