The Majority of CFOs Expect a 2020 Recession – Is Your Financial Institution Ready?
After more than a decade of steady economic expansion, many experts are forecasting an impending economic downturn. Nearly half of CFOs in the U.S. expect a recession by the end of 2019 – and 82% believe a recession will have begun by the end of 2020, according to the Duke University/CFO Global Business Outlook survey. Would your institution be ready for this? The market can rapidly deteriorate without notice – here’s how to make sure your financial institution is prepared.
Create consistent and objective risk scoring models
One of the most important ways to ensure your financial institution is making good loans is to create a consistent and objective risk scoring model so that all loans are assessed in the same manner. When creating a risk scoring model, it should be designed so that a consistent measurement can be applied to similar loan types. An ideal model will apply a balance of objective and subjective factors that reflect the borrower’s ability to repay the debt. Although objectivity is important for consistency, a model that is too objective can create a black box where lenders have very little control over the outcome. However, a model that is too subjective has no consistency and creates additional risk in the loan portfolio that is hard to quantify.
To make sure your risk scoring model strikes a balance between the two, there are several key objective and subjective factors to consider for your model. Common objective factors include comparative ratio analysis based on industry, loan-to-value ratios, credit scores, and payment history. Common subjective factors include the strength of guarantors, length of the customer relationship, and strength of the management team. The key is finding the balance that passes regulatory scrutiny but leaves enough flexibility for the lenders to still get deals done that fit the risk profile of the financial institution.
Bolster the 5 C’s of Credit
The 5 Cs of Credit, capacity, capital, conditions, collateral, and character, have been the foundation of assessing a potential borrower’s creditworthiness. Understanding the borrower’s or businesses’ ability to repay debt, level of debt, plan for funds, and collateral available plays an important role in evaluating loan applications. To quantify the 5 Cs of Credit in business, analysis can typically review ratios derived from a company’s financial statements. These metrics and the financial statements they come from are instrumental in underwriting the annual review of commercial credits.
There are four key financial variables industry experts utilize to represent a company’s credit risk profile and to predict their likelihood of default. These metrics include debt service coverage ratio, net profit margin, quick ratio, and loan to value. These variables provide a unique indicator of a private company’s financial standing and have significant implications when evaluating credit risk.
- Debt service coverage ratio (DSCR): The higher a firm’s debt service coverage ratio, the greater its ability to produce enough cash to cover debt payments. While DSCR will vary among borrowers, aim for at least a 1.15 ratio.
- Net profit margin: Net profit margin shows the profitability of a company by dividing net profit by total sales. The higher the profit margin, the more likely the business will be able to remain resilient in periods of unexpected losses. A lower net profit margin, on the other hand, could indicate a company’s pricing strategy, sales, volume, or expenses are out of line compared to others in the industry.
- Quick ratio: Lenders often look to quick ratio because it shows the percentage of a firm’s debts that could be paid off by quickly converting assets to cash. The more liquid a firm’s assets, the better equipped it is to adapt to changing conditions in the business environment. Ideally, a quick ratio should be roughly 1:1, meaning assets are able to cover short-term debts. To calculate a quick ratio, divide cash, cash equivalents, and accounts receivable by total current liabilities.
- Loan to value (LTV): Loan to value shows the size of the loan compared to the proposed collateral, or the percentage of the principal value covered by the appraised collateral. Lenders rely heavily on LTV because it shows the risks involved with issuing the loan. Typically, the lower the LTV, the lower the risk. Borrowers with higher LTVs have committed fewer resources, and therefore, in the event of default, would have less collateral to supplement loan payments.
Over half of lending and credit professionals agree that increased competition is backsliding in prudent credit risk practices in the banking industry, according to Linda Keith’s 2018 Credit Risk Readiness Study. To encourage safe, sound, and sustainable lending, it may be time to rethink current strategies and look to new processes to encourage consistent and objective credit risk analysis.
Every institution has a different appetite for risk, so it’s important to adjust your institution’s strategies accordingly. Loans must pass regulatory scrutiny, but loans officers should also have the flexibility in loan decisioning within the parameters of the institution’s risk appetite.
With increased competition, it can be tempting to make more risky loans for the sake of potential profitability, but this type of risk could lead your institution down a dangerous path, especially if an economic downturn was to occur. To grow your loan portfolio safely and soundly, consider the benefits of software to create scalable processes. From risk rating and loan pricing to spreading loans and creating compliant loan documentation, today’s technology affords financial institutions of all sizes to complete time-consuming, complex tasks more efficiently and more accurately.
We are currently experiencing the longest U.S. economic expansion to date, and it may be difficult to imagine what another economic downturn would be like. Whether that is six months or six years away, it is important to be prudent in credit risk analysis and ensure your institution is making smart loans in order to grow safely and soundly. Make sure your institution is keeping a pulse on its credit risk strategies and is always assessing new ways to bolster and support those policies.
For more information on creating a consistent and objective-based model – while still allowing for subjective adjustments – join Rob Newberry on Thursday, August 15 for a free webinar, “Loan Grading: A to Z.”