Three Imperatives to Navigate THE Uncertainties in Credit Risk Management

Bank leadership teams must immediately review credit risk management in light of the ongoing market complexity.

FREMONT, CA: Rising interest rates, high inflation, low unemployment, supply chain issues, high commodity prices, strong but changing consumer balance sheets, low consumer sentiment, and tense geopolitics. These are just a few of the factors that have contributed to periods of financial and economic instability and increased uncertainty for bank credit exposures. The past data frequently does not make sense in the current situation when utilised to support credit choices. Numerous banking executives are realising that innovative strategies are needed to navigate the current environment and identify possible opportunities.

Financial institutions need to find techniques to balance macro and micro risks in the face of a variety of unique connections, taking into account the many economic drivers and comprehending the implications for clients and portfolios. The current confluence of circumstances, however, is unprecedented, and the problem cannot be tamed by making minor changes to model parameters. More basic adjustments are needed to reduce risk and uncover pockets of opportunity.

Three types of edge are honed by organisations that prosper in uncertain environments: better insights, clarity and dedication to specific activities, and speed of execution. Below mentioned are the three requirements that could enable credit risk management edge sharpening along the following dimensions:

• Revisiting risk limits and triggers to reflect changes in the business cycle and developing a variety of scenarios to swiftly predict potential outcomes at a detailed level.

• Developing novel decision metrics.

• Preparing action menus in advance to enable quicker and more adaptable execution.

Decision-makers may be better able to overcome uncertainty and have a deeper knowledge of the variables that affect credit quality over time if they match their credit playbooks with these three imperatives.

Enable Agile Decision Making through Cross-functional Perspectives and Flatter Hierarchies

Typical decision-making hierarchies are frequently too rigid to react sufficiently to a highly uncertain environment. Banks must revamp their governance structures to allow for much quicker decision-making. Mobilisation might be challenging, even though it can be beneficial to establish initiation parameters and prebake steps. Decisions should be operationalised through current governance mechanisms but at much faster rates if they are to be effective.

Fast decision-making necessitates ensuring that there is 360-degree information flow at each forum, which is made possible through cross-functional collaboration. The risk function and the front office also need to communicate considerably more frequently in real-time. The goal should not be exact accuracy but rather a faster understanding of the direction of motion so that activities can be coordinated. Similar to how authority should be allocated within set parameters to reduce bottlenecks. Making sure authorities are still appropriate for their tasks and modifying them in light of conceivable events will enable the organisation to respond more quickly.

Use Decision Metric Outputs to Inform and Prebaked Management Levers

A greater standard of managerial readiness is implied by the acceleration of change. Leadership teams can benefit from creating pre-baked activities that can be used immediately to respond to growing uncertainty. When judgements are made in advance, they can be more creative than those that are made on the spot and can be carried through more clinically when necessary.

Bank leadership teams can effectively address a variety of credit oversight issues, from designing collections/repossessions to adjusting portfolio allocation and fine-tuning customer engagement strategies as well as time planning for second-order effects like talent shortages by prudently monitoring forward-looking metrics and indicators. For example, relationship managers and credit analysts may need to be better trained on restructurings in order to ensure efficient implementation.

Refine Risk Limits and Triggers

The majority of banks set their present risk appetite levels during a prolonged era of low-interest rates and less volatility. According to the current economic consensus, these circumstances might not reappear any time soon. It is plausible to assume that the business cycle has changed and that through-the-cycle portfolio behaviour may have changed dramatically. Therefore, from the perspectives of risk management and business expansion, banks must examine through-the-cycle views of client performance in a higher-rate environment as well as confirm that monitoring frameworks, triggers, and cascade mechanisms are still relevant and functional.

Moreover, banks need to worry about baseline and stress loss results, utilising the data to reevaluate triggers for risk appetite. Based on the assumption that through-the-cycle portfolio behaviour will change from the past, there will be sectors where they wish to tighten up on credit provision, but there will also be others where the risk/return trade-off may be more favourable in the following two to three years. Precisely, bank leadership teams must review their approaches to credit risk management immediately in light of the ongoing complexity. Action across the five dimensions mentioned above is encouraged to navigate the necessary adjustments, with analysis and solutions being optimised using highly automated implementation platforms.