Credit Risk Management Post-Pandemic

5 mins read

The year that was, and key trends in 2021. Credit risk management continues to be critically important across financial institutions. In the last year, the top concerns faced by credit risk professionals has dramatically changed, owing to the economic downturn, COVID-19 pandemic and worldwide disruption. 2020 essentially turned the concept of credit risk management on its head. With perspectives changed forever, what’s to become of credit risk management in 2021? There are always risks associated with the business of lending. In the normal scheme of things, credit risk is usually assumed on the borrower’s side, and a good lender is one who makes the best assessment of this risk. However, to make an effective assessment, the lender needs to understand all the associated risks completely, including the financial position of the borrower, as well as their projected position based on his or her business or income.

These assessments are becoming increasingly difficult today, due to:

Shorter business cycles – Business environment is changing faster than ever before, aided by rapid technological developments.
Digital payment transactions – The banking sector opening up to convenience and better user experience has led to newer risks and rising fraud.
Newer business models – Next-generation businesses are increasingly difficult for bankers to understand or assess from a risk perspective.

Banks have always had advanced financial models at their disposal to evaluate risks and predict defaults. However, 2020 brought along the COVID-19 pandemic that not only brought businesses to a screeching halt, but made predictions near-impossible through existing models.

The amount of financial distress caused by the pandemic called for a newer approach towards financial modelling and credit monitoring.

Firstly, a more interconnected global economy means the risk of contagion is higher. Risk management practitioners today need to be cognizant of global events, and need to understand the impact such happenings may have on their respective portfolios.
The regulatory push on IFRS9 and Expected Credit Losses in place of incurred credit losses is intended to strengthen credit discipline in the financial system. The exact point where there is material increase in credit risk will be determined by the credit risk manager, and this impacts the finances of the bank in a big way.
The exit of manufacturing majors from China could mean more credit demand from their counterparts in India. The Indian banking system should be geared up to meet this challenge using innovatively structured credit practices with competitive terms.

The effects of the pandemic cannot be easily understood due to its non-linear nature. Some industries, like hospitality and entertainment, are completely in doldrums, others are affected to various degrees, and still, a few are unaffected. Interventions by authorities and regulators, in terms of suspension of NPA norms and moratoriums, though necessary, have further added to the uncertainty.

Some of the immediate measures taken by authorities, include:

The RBI’s sector-wise resolution framework, based on the K.V. Kamath Committee, to mitigate the impact of the pandemic on borrowers
Restructuring the framework for MSMEs without downgrading asset classification
Emergency Credit Line Guarantee Scheme 1.0 and 2.0, in the journey towards Atmanirbhar Bharat, for providing credit to identified sectors with protection to lenders in the form of guarantees
Support to liquidity-starved NBFCs through a Special Purpose Vehicle to purchase short-term papers

While these measures have been helpful in letting borrowers’ tide over the crisis, the actual quality of the books remains to be gauged. The RBI predicts a severe worsening of asset quality across the system this year. Gross NPA levels of scheduled commercial banks are predicted to worsen – from 7.5% as of Sep 2020, to between 13.5% and 14.8% by Sep 2021.

Source: RBI FSR dated 11 Jan 21

Banking trends of 2021 and their implications on credit risk

Source: RBI FSR dated 11 Jan 21

The banks of tomorrow will prioritize customer convenience in a big way. Going digital is the first step towards achieving this.

In the future, going digital will allow customers to easily perform certain operational activities efficiently and securely – eliminating the need for physical presence. For instance, a digital signature can completely negate the need for physical presence of customers in transactions.
Further developments, like Open Banking, will interconnect all financial intermediaries so that authorised data sharing can be done for mutual benefit. For example, a loan aggregator may connect via open APIs to the HRM Systems of companies, the income tax department, and so on, to effectively assess loan eligibility in real time.
The focus will shift to cashflow-based lending, in place of balance-sheet- or asset-based lending, as cashflows can be measured faster than assets.
All of this will in turn increase the load on banks in terms of monitoring, surveillance, and risk management.

Greater digitization of borrower data would mean tighter KYC, AML and other formalized checks based on advanced algorithms.

Centralisation of credit approval processes leaves less room for subjectivity, and greater dependency on rule-based and data-driven credit policies.

To tackle unprecedented risks, self-learning AI/ML financial models will drive risk management, rendering traditional models useless.

The way things are headed, the future of banking belongs to the tech savvy. Dedicated investments in the right technologies will go a long way in helping lenders beat competition. It is important that regulatory bodies give ample guidelines to lenders on digital transformation in credit risk management. In India, the RBI and Finance Ministry have, over the last few years, been proactive in guiding banks in monitoring their credit portfolios. This sort of intervention is strongly called for, given the compounding effects of the pandemic on an already fragile financial system. From the circular on RFAs in 2015 to guidelines on monitoring parameters issued by the Department of Financial Services, the push towards fintech- and regtech-enabled digital transformation has been strong. These measures will be a strong contributor in uplifting India’s banking sector from its current precarious position.

Beating uncertainty with technology

Over the next decade, as AI & deep learning technologies evolve, they will learn to process patterns and historic data more efficiently to arrive at near-perfect predictions – even in highly uncertain scenarios as those involving pandemics. This will empower socio-economic progress on multiple fronts.

Better financial decisions by the governments and regulatory authorities
A comprehensive financial services system that is less transactional and more of a way of life
Better time and resource management and higher efficiencies through automation
More trust in the financial system through transparent and ethical conduct

The only way for us to see foresee unknown risks in the new normal is through the use of advanced technologies. Technology is the answer to not only our present challenges, but it is also the architect of our collective future in the new normal.

Author

Shankar Ravichandran

Senior Manager, Credit Risk

His profound expertise in the field of corporate and retail banking spanning across Credit Risk, Transaction Banking, Service Delivery and Product Management is close to decade. He is an MBA graduate from Indian Institute of Management, Bangalore.