The COVID-19 pandemic has forced individuals and businesses to continually adapt to a “next normal,” and financial institutions are no exception. While credit risk in the banking industry has, for the most part, remained surprisingly stable throughout this volatile time, the pandemic has driven significant changes in the way financial institutions evaluate credit risk and monitor for signs of deterioration in their existing loan portfolios.
Loan approval is just the beginning of credit risk monitoring
Prior to COVID-19, most financial institutions could reliably determine how they would monitor a loan’s performance and assess changes in the borrower’s risk profile at the time that they approved the loan. Lenders could use the information gained from the application process to determine what tests could effectively monitor the loan and how frequently to apply them. Tried and true methods could range from analysis of tax returns and financial statements on an annual basis for low-risk loans to more frequent and thorough tools such as covenant compliance checks, evaluation of borrowing base certificates, or the preparation of quarterly or even monthly financial statements. Smaller or less risky loans may be handled on an exception basis only, requiring action only when adverse information is received, such as notification of a judgment, lien, or low credit agency score.
The pandemic has driven home to lenders just how quickly the quality of a loan can deteriorate and how ineffective some of the common tools can be at identifying changes in risk. In addition to the standard reporting requirements that community lending institutions have relied on to monitor the ongoing risk associated with a loan, the following indicators have come to the forefront during the pandemic as helpful early warning signs of potential problems:
- Rent rolls that provide information on tenants and rents in commercial property can be extremely helpful in assessing the ongoing repayment capacity of the borrowers. They can be particularly useful during the first quarter of the year as a proxy for annual tax return reporting, which is frequently delayed by extensions of the filing date.
- Verification of liquidity for borrowers or guarantors where this is considered a significant factor in the underwriting decision.
- Use of Smith Travel Research, or “STR,” reports for hotel/motel borrowers in order to monitor trends in occupancy, average daily rates, and competitive market position.
- Site inspections to verify property condition and occupancy. This would also help detect any potential deferred maintenance and needed capital expenditures.
- Field audits on accounts receivable and inventory for borrowing base lines of credit.
Communication is key
In light of the ongoing macroeconomic pandemic-driven challenges affecting commercial and agricultural enterprises, it’s critical for lenders to combine continued credit risk diligence with enhanced borrower communications. Financial institutions can get a much better understanding of changing risk profiles when they talk to borrowers on topics like:
- Constraints on production or service delivery due to supply chain disruptions, such as a lack of raw materials, component parts, or labor.
- Unexpected weather events such as hurricanes, floods, or wildfires that affect industrial output.
- Inflation pressures affecting costs of production and the (in)ability to pass these increased costs on to end consumers.
- Crop insurance for agricultural production.
It’s also important to remember that even when these challenges don’t apply directly to a specific borrower, they can still have an indirect impact on the supply chain or customer base that a borrower counts on. For instance, if a large customer of a borrower is affected by a natural disaster or a COVID-19 outbreak, that customer may be unable to purchase products as previously agreed.
Don’t overlook the basics
Lastly, it’s important for financial institutions to remember the following monitoring items that may have been put on the back burner while they were addressing the more immediate risks brought about by the pandemic:
- Succession planning for small business or family-owned enterprises where management is concentrated in one or among a few key personnel.
- Tax implications that could arise from the Build Back Better Act or other future legislation.
These basic components of credit risk haven’t disappeared just because businesses have been struggling with more immediate day-to-day challenges of the pandemic.
Without a doubt, the pandemic has touched just about every aspect of our clients’ business operations, and the lending area is no exception. It’s important that your credit risk monitoring process rely on both time-tested and newly relevant tactics to help your credit management team remain vigilant in the pandemic landscape.
