3 Ways Banks can Adapt to Post-Pandemic Credit Risk

By Scott Roberts

The impact of Covid-19 was extensive, leaving no part of our lives unaffected, including banking and the economy. The pandemic lead to a shocking recession, resulting in historic levels of unemployment and economic disruptions. From supply chain issues, to inflation, to interest rate hikes, Covid’s splash has made huge waves in our economy. With these disruptions came great uncertainty, increasing the overall risk associated with lending practices of banks and many other financial institutions. As a result, the attention given to credit risk has been understandably increased. This article will highlight notable credit risk trends and the different strategies banks are implementing in order to combat heightened credit risk given the Covid-19 pandemic.

First and foremost, it is important to establish why this extra attention extended to credit risk is warranted. Before getting into different risk mitigation strategies, it is important to first consider how credit risk has been affected. According to experts at McKinsey and Company, credit risk has transformed in the following five different areas due to the Covid-19 pandemic.[1] First of all, there have been varying changes in credit risk in different industries. For instance, airline, hotel, and retail industries have experienced huge increases in risk compared to other industries, and consequently need much more attention. Additionally, the real commercial real estate industry has seen an increase in credit risk due to supply chain issues.[2] For banks that have high concentration risk in the commercial real estate industry, action is needed to update the models reflecting their risk.

Secondly, within these sectors, it has become harder to differentiate between borrowers in the same sector. In other words, borrowers need individual analysis given unique circumstances and conditions. The third change regards scarcity on data when it comes to crisis conditions like the Covid-19 pandemic. Because the pandemic is a new and continually developing circumstance, there is no playbook to go by. Banks need to actively gather data, update existing data, and create new appropriate models to account for risk. The fourth change details how customer preferences have changed given the new environment of the pandemic. This has affected income in varying ways for different borrowers. Lastly, the fifth change regards the large wave of nonperforming exposures that has begun, and consequently need to be addressed.

One proposed strategy to combat these adverse changes in credit risk is increasing efforts in data aggregation. The Covid-19 pandemic has created tons of unforeseen circumstances, and therefore there are many new areas in which data aggregation is necessary. Without a readily available and up-to-date data set, banks cannot complete a comprehensive view of potential credit risk.[3] Banks should actively be updating their risk models and conservatively accounting for the added uncertainty created by the Covid-19 pandemic. For instance, banks need to adjust the classification requirements when it comes to credit risk, as many borrowers have experienced atypical increases in credit risk due to unfavorable conditions. With properly adjusted and updated data, it will be easier to foresee future risks associated with credit risk and potential defaults.

Furthermore, proactive systems need to be employed to identify distressed borrowers in advance, and have a plan of what to do upon their identification. It is important lenders evaluate borrowers on an individual level, as each borrower has a unique set of circumstances and challenges given the Covid-19 pandemic. From a lending perspective, it would be strategic to reach out to riskier borrowers and updated their early warning services (EWS).[4] The EWS should be tailored to the current crisis, for example by introducing new indicators.[5] By proactively taking measures like this to assist higher risk borrowers, lenders can reduce risk of default in high credit risk circumstances.

There is no doubt that credit risk has been greatly affected by the Covid-19 pandemic. However, there is no reason for lenders to panic, as taking the suggested preventative measures can greatly combat the increased credit risk their borrowers now carry. If the necessary effort is given to properly gather data, identify high stress borrowers, and provide aid to stressed borrowers, then credit risk will pose much less threats to banks and borrowers alike.

[1] Efstathia Koulouridi, “Managing and monitoring credit risk after the COVID-19 pandemic”, McKinsey and Company, 2020 [2] SungJe Byun, “The Pandemic's Impact on Credit Risk”, The Federal Reserve, 2021, https://www.federalreserve.gov/econres/notes/feds-notes/the-pandemics-impact-on-credit-risk-averted-or-delayed-20210730.htm [3] “COVID-19: gaps in credit risk management identified”, Banking Supervision, 2021, https://www.bankingsupervision.europa.eu/press/publications/newsletter/2021/html/ssm.nl210519.en.html [4] “COVID-19: gaps in credit risk management identified”, Banking Supervision, 2021, https://www.bankingsupervision.europa.eu/press/publications/newsletter/2021/html/ssm.nl210519.en.html [5] “COVID-19: gaps in credit risk management identified”, Banking Supervision, 2021, https://www.bankingsupervision.europa.eu/press/publications/newsletter/2021/html/ssm.nl210519.en.html