Preventing risks or dealing with consequences. The Cost of Ignoring Early Warnings.

Welcome to Deloitte’s blog series on early warning where we share our expertise and hands-on experience of building early warning systems. 

In previous blogs, we established that:

• proactive risk management enables early intervention, minimizing losses.
• AI can help drastically by providing easy access to information, summarization and translation, but having a human in the loop is critical.
• the top three questions you'll get asked when developing an AI early warning system are about quality, precision-recall balance, and fake data.

The next exam questions which we will consider in this blog are: 

• whether risk prevention is cheaper than cure? and 
• who should be paying attention to early warnings?

Let’s take a look at an illustrative example. 

A mid-sized commercial bank has a long-standing relationship with a multinational steel manufacturing firm, let’s call it GlobalTech Ltd. The company has a strong credit history, a healthy balance sheet, and a diversified revenue stream. Based on this track record, the bank approves a large credit facility to support the firm’s expansion plans.

After the loan is granted, ongoing portfolio management kicks in until one day, in a variety of different sources, negative signals are raised relating to GlobalTech:

• A credit rating agency issues a warning about potential liquidity concerns.
• News reports that GlobalTech’s biggest supplier is facing bankruptcy.
• GlobalTech’s stock price declines.
• The company delays filing its quarterly earnings report.

Each of these warnings in isolation is not conclusive evidence of credit deterioration, but in combination they give a compelling message. We know this because we’ve got into habit of continuously scraping four hundred thousand global information sources and piecing together disparate signals to create valuable insights. But if you are a bank without a comprehensive early warning system, it is practically impossible to connect these dots. 

In our example, the bank’s relationship manager is not aware of the full extent of the emerging risks and has taken no action. After all, he believes GlobalTech is too big to fail.

What happens next? The risk materialises and over the next few months GlobalTech’s problems escalate quickly:

• The company’s production is disrupted as the major supplier declares bankruptcy.
• The company has cash flow issues as revenues drop.
• Investors panic as the company misses an interest payment on its corporate bonds.
• Credit rating agencies downgrade GlobalTech to junk status.

Now the bank is in crisis mode with their client. What was once a stable corporate borrower is now struggling to survive. The consequences for the bank are severe:

• Loan losses directly impacting profitability.
• Reputational damage as analysts criticise the bank for failing to react to emerging risks, and being associated with the failure of a well-known business.
• Regulatory scrutiny as regulators question why early warning indicators were ignored. This might result in higher capital requirements, reducing lending capacity.
• Liquidity constraints: as seen elsewhere, other clients, seeing the bank’s losses, withdraw deposits or tighten their own lending relationships, creating a ripple effect.

To make matters worse GlobalTech has the highest share of steel manufacturing in the industry and now public oversight bodies are concerned with the impact of it’s deterioration on the economy and downstream supply chain. 

Cost of consequences.

For a company, the cost of such a crisis is great. A revenue drop can lead to an inability to sustain operations at the same level as before, requiring additional investment to restore business functions. Being downgraded to junk status makes it extremely difficult to attract investors, and without a capital injection, the entire business could be at risk.

For a bank, assuming a total borrowing facility of £10 million and a loss given default of £3 million, the cost consists of both direct losses (£3 million) and indirect losses, including potential future revenue loss. A single prevented write-off of this magnitude could justify the cost of an early warning system. Additionally, regulatory scrutiny and the effort required to address deficiencies in early warning processes could lead to even greater consequences.

For the economy, the implications include job losses and disruptions to downstream infrastructure development.

The answer to our first question of the blog - whether risk prevention is cheaper than cure? - yes, as Benjamin Franklin said, “an ounce of prevention is worth a pound of cure”.  

Prevention and roles: how proactive risk management could have changed the outcome

Now, let’s rewind. 

Here are some examples of the top three actions that each of the parties could have taken to prevent the loss if they had access to comprehensive, trustworthy early warning signals:

GlobalTech’s management team:

1. Reduced reliance on a single supplier and developed contingency plans.
2. Built cash reserves, acted on early warning signs, and ensured timely financial disclosures.
3. Communicated risks early to lenders, investors, and rating agencies to secure support and prevent panic.

The bank (in the role of a creditor and investor):

If the bank had acted on the early warning signals, it may have not only prevented their own loss but also extended a “helping hand” to the company to navigate the risk correctly. It could have:

1. Engaged with borrower’s management early, assessing whether they had a strategy to handle the supplier bankruptcy.
2. Reduced its credit exposure to the borrower gradually, minimizing potential losses.
3. Tightened loan covenants, requiring the company to maintain a stronger liquidity buffer.

The oversight bodies could have:

1. Identified distress patterns from ongoing market monitoring. 
2. Required the firm to report financial vulnerabilities and undergo periodic resilience checks.
3. Encouraged coordinated efforts to stabilize distressed firm before it reached a crisis.

To be able to react to early signs of course each of the parties needs to have an early warning process established effectively. 

The answer to our second question of the blog - who should be paying attention to early warnings? – is that companies themselves, their creditors, investors and the oversight bodies should all be attentive, as each bears a share of the consequences if the risk materializes. 

Read about how engaging end-users improves model predictions Early Warning Systems: The Unbeatable Team of Human and AI | Deloitte UK

Risk Alert webpage: Risk Alert: The Early Warning System of the Future | Deloitte UK