Credit across Europe:
Delinquents rule, OK.

Delinquency is a word with harsh overtones. Yet it appears on every page of the latest 32-country report on Europe’s credit risk outlook. Shayla Walmsley explains why banks’ leading risk managers are so pessimistic.

No wonder banks are reluctant to lend. A new report shows that the risk managers of Europe’s banks are more pessimistic than ever that small and medium-sized enterprises (SMEs) and consumers just won’t pay back.

The authors of the 32-country report asked risk managers for their six-month scenarios. They find many pessimistic that an increase in business loan delinquencies, a widening credit gap and regulation will slow economic growth and hit spending.

Across Europe, managers expect an improvement in credit card performance but they’re significantly less optimistic about mortgage and small business loan delinquency. On mortgage delinquencies, only slightly more respondents think they’d stay about the same than those anticipating an increase. There’s similar caution about overdrafts linked to current accounts.

This is a particularly worrying signal of cash flow problems for consumers, says the report. It implies that consumers will find it hard to pay off other debts against “the most visible impact” of long-term unemployment and reduced public support payments.

There’s similar pessimism about other areas of consumer spending: 69 per cent of respondents expect that mortgage delinquency will stay the same or worsen. This “calls into question the idea of a housing segment recovery”. Coupled with the grim prognosis on overdrafts and small business performance, the report concludes that “the European economy will continue to struggle”.

Averaged across all the markets surveyed, 48 per cent of managers expect delinquency to worsen. In the UK, however, the figure is above 60 per cent for expected small business delinquencies, and 43 per cent for overdraft delinquency.

Now, all right: so these are risk managers – they’re an habitually cautious breed who aren’t necessarily paid to look on the bright side. But they’re also in a position to know: 90 per cent of the 100-plus respondents hold some level of responsibility for SME credit.

Most forecast no falling off in demand – but there’s a clear gap between what small businesses want, and the credit that’s likely to be available. Across all markets, 55 per cent expect SME demand to increase, compared with only 39 per cent who foresee an increase in the amount of credit available. In the UK, 58 per cent expect growth in SME demand against only 33 per cent who foresee more credit availability.

This pessimism about credit supply isn’t universal, though. The most recent Bank of England credit conditions report finds credit to small businesses rose slightly in Q4 for the third consecutive quarter, with a further increase forecast in Q1 2011.

And, in any case, there’s just as much argument about the strength of SME demand which mitigates the EFMA/ FICO report’s worry about a US-style credit gap. The Institute of Chartered Accountants in England and Wales (ICAEW), for example, claims demand for SME finance remains muted, poised to become more aggressive only when they’re convinced of economic recovery.

“There will be some increase in demand but not more than supply,” says Clive Lewis, the Institute’s head of SME issues. “SMEs will begin to seek finance again – but gradually. They’ve learned over the past two years to be cautious.”

All the same, if SME delinquencies have “spooked” the banks, as FICO European Managing Director Mike Gordon points out, it isn’t clear that central government requirements to lend will help much. “Now governments are forcing them to lend, banks are not sure how good the loans are going to be,” he says.

Even business organisations hesitate about the practicality of compulsion. “The government is right to identify the issue and urge banks to do more. But it can’t just snap its fingers,” says David Kern, chief economist at the British Chambers of Commerce. He also argues the banks haven’t lost much as a result of SME lending in the recent crisis: the last time they did was in the early 1990s.

Besides, there’s little evidence that banks are willing to relax credit criteria, even if they’re forced to increase lending. As the British Bankers’ Association spokesman, Brian Capon, points out, the first criterion for banks is to get their money back and the second is to get a return on it.

Yet SMEs asking for funding often don’t have a Plan B for when Plan A to pay off the loan doesn’t work out. “Banks aren’t there to bail out failing businesses. They want to see a proper business plan,” he says.

But banks also need to up their game with a more acute understanding of the needs of SMEs, according to David Cairncross, a senior policy adviser at the CBI. And for David Kern at the British Chambers of Commerce and others, that means restoring the long-neglected role of relationship managers. Kern claims that banks often no longer have managers knowledgeable enough to make decisions on lending to profitable businesses, and that their successors exaggerate the risk simply because they’re less experienced. In short, business-savvy bankers have been replaced with box-tickers.

“Business is about risk-taking but the difference is in reasonable risk and reckless risk,” he says. “Targets only help in terms of creating the right psychology. Beyond that, we need to persuade banks to create an infrastructure of managers.”

The relationship management structure could work in a number of ways. It’s a matter of which stage the loan is agreed (or not). Capon suggests higher-value loan requests might go up to a business centre, for instance, where staff have the experience and training better to deal with them.

In the meantime, if doubts over whether they’ll get their money back are dampening banks’ SME lending, so is anticipation of the negative impact of regulation. More than 60 per cent of participants in the credit risk survey say the Basel 3 requirements will reduce the profitability of consumer and SME credit portfolios.

Because Basel 3 increases banks’ capital requirements, those banks will need to decide where they’ll get the best return on their investment. “It could be that some will see it as relatively less attractive to lend to businesses and they’ll do less of it,” says Patrick Fell, director of the regulatory capital practice at PwC.

In regulatory terms, though, the good news is that the worst is probably already over. Although the Basel 3 requirements come in over an extended period, the reality is that the market had already anticipated the changes and implemented them.

Between lending and not lending there are options. It could be that, rather than pulling the plug on lending altogether, some banks look to adjust pricing on short-term loans – not least because larger, longer-term loans are more difficult to restructure.

“The issue is not really that banks will stop lending but the margins,” says Fell. “Will SMEs notice Basel 3 directly? I doubtit. But Basel 3 is very important to banks, and they’re the main source of funding to SMEs so, indirectly, yes they will.”

It isn’t just long-planned, global regulation banks are worrying about. New affordability requirements which put the onus on lenders to assess whether would-be borrowers can afford credit will likewise impact assessments of risk – but no-one is yet certain how.

As with Basel 3, banks are already thinking ahead. According to the report, 83 per cent of lenders have affordability measures in place, and 14 per cent plan to adopt their own measures. The UK (outriders in the introduction of this regulation) and Ireland lead with 83 per cent, followed by Germany, Austria and Switzerland (DACH) with 78 per cent and Iberia with 70 per cent – in other words, the largest credit economies.

“The new affordability models are not clear yet,” says FICO’s Mike Gordon. “What is clear, though, is that no-one is doing affordability the way the government intends them to do it. The sooner we have a broad-based acceptance on a scoring system or approach or analytic, the clearer it will be.”

The DACH banks, on the other hand, buck the European trend – they’re more pessimistic on small business, with 60 per cent expecting delinquency, for instance, and more optimistic on consumer debt, with 44 per cent of respondents expecting an improvement in credit card delinquency.

Here, as elsewhere, risk management forecasts are closely linked to the prospects for economic recovery. Among Iberian respondents, for instance, 90 per cent expect delinquency in every category to worsen – a reflection of economic volatility across peripheral European economies. In contrast, 78 per cent of DACH bankers expect more consumer credit to be available, and 55 per cent expect improved availability of business credit.

Not only will the credit gap narrow, but the approval criteria are also likely to be relaxed – at least according to 44 per cent of DACH respondents. As the report points out, a surplus, unique to DACH, could even create a demand shortage for available credit.

Contrast this with the Iberian economies, where almost no-one is predicting an improvement in either demand or supply. Effective stagnation is the majority forecast. “For Spain, we’ve never seen such a negative response,” says Mike Gordon. “In November they thought they were going to be the next Ireland.”

* European credit risk outlook, published February 2011 by the European Financial Marketing Association (EFMA) and the leading financial analytics provider FICO.

‘Easier said than done’

It’s clear that risk management has an even more critical role now in promoting banks’ sustainable growth, agrees PETER BEARDSHAW, Head of Accenture’s risk management practice in the UK and Ireland. But getting there, he concludes, is easier said than done.

‘Thriving in a risk culture’

High-quality risk management defines the high performing banks. Banks that have a culture of risk assessment embedded and respected throughout their organisation are the ones that thrive. In banking, risk is the competitive advantage – the pre-requisite of truly sustainable profits.

The challenge for banks is to chart a course that rewards both shareholders and customers while avoiding not only unacceptable levels of risk but business practices that perpetuate the kind of boom-and-bust cycle seen all too often in recent years. Banks and regulators, after all, share a vital common interest in protecting the world’s financial system.

‘It’s not all about risk models’

How banks look at their overall risk management in light of Basel 3 will be significant. Generally – as was the case under Basel 2 – banks will continue to use internally developed risk modelling for both lending and trading activities.

The higher capital requirements will decrease the absolute risk associated with these businesses, and the more sophisticated banks in all markets will continue to improve their risk models. However, as history has shown, effective risk management is not only  about the models.

Banks should accelerate the process of integrating the risk and finance functions. The chief financial officer and the chief risk officer should work from a single set of information, and share an understanding of the interrelationships among credit, market and operational risk.

Enterprise risk management should become a reality rather than a stated objective. Risk must be seen as a growth and profitabilityenhancing capability, not as a back-office or compliance-centric function.

‘More rigour with data quality’

Banks should improve their overall data management. Under Basel 3, banks will need to consolidate positions from their trading desks, and make their “trading book” match up more seamlessly with their “banking book”.

They will need to apply a significantly increased level of focus and rigour to the quality and maintenance of data across the full suite of activities from front office through to back office.

‘Prepare for intelligent growth’

In Asia, for instance, lending to small and medium enterprises represents a major opportunity for banks in anchor economies such as South Korea, Singapore and Australia.

In entering these new markets, however, banks can mitigate both credit and operating risk by using analytics and automating credit scoring to make the lending process more efficient and less risk-prone.

Financial reform is important for restoring the confidence of shareholders and customers, and everyone will have more faith in banks that evidence both financial stability and sound risk management practices.

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