Sustaining Sound Credit Quality During an Economic Downturn

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It’s no secret that inflation, interest rate hikes and slowed economic growth are causing concern for financial institutions across the country. Banks and credit union leaders are speculating how credit quality and loan demand will shift as we approach 2023.

While navigating an economic downturn is nothing new, the challenges caused by the pandemic add another layer of complexity for financial institutions. To sustain sound credit quality amidst these ongoing economic uncertainties, financial institutions should examine their risk monitoring strategies and be ready to address vulnerabilities sooner, rather than later.

Areas Under Scrutiny

To start, bank and credit union leaders should closely scrutinize credit quality in several key areas.

One area is small business loans. Small businesses, especially those outside of larger cities, will feel the impacts of inflation more quickly and more acutely than commercial enterprises. Inflated prices for everyday goods and services have tightened consumer spending and therefore, squeezed income streams for businesses. Higher interest rates add to the mix, making borrowing more expensive. These challenges are worth monitoring, as they may pose threats to a financial institution’s portfolio performance.

Commercial real estate is another area to watch, as an American office crisis is looming, and a slew of vacant office space could overwhelm the market by the end of this year. Commercial real estate took a hard hit during the pandemic, and as lease agreements expire, more companies are expected to scale back on office space due to widespread work from home policies. Banks and credit unions with exposure in these areas should monitor closely to see if credit quality subsequently declines.

Red Flags to Watch For

To get ahead of future credit challenges, financial institutions should leverage their existing data to watch for noteworthy trends and indicators of financial stress. Certain behavioral changes among borrowers are red flags of financial trouble and monitoring for those changes makes it much easier for financial institutions to intervene before a loan is past due.

Some behaviors to watch for include declining deposit balances, high-line utilization and credit rescores, among others.

Using a system that gathers all of this information in a single, centralized place gives portfolio managers access to the information needed to manage credit risk proactively. Consistently monitoring for these behavioral changes can help banks and credit unions catch potential problem credits prior to default, alleviating surprises at annual review and renewals.

Establish What You’re Willing to Negotiate

In addition to identifying emerging credit challenges, it’s important that financial institutions understand how they can contain those challenges before it’s too late. If there are potential problem loans that need to be addressed, financial institutions should have an intervention plan to help prevent borrowers from becoming delinquent.

Consider your institution’s risk tolerance and how to account for additional risk. Perhaps there are certain industries or loan types your bank is willing to be flexible on. For instance, it may make sense to modify or extend loan terms in some cases and it’s crucial for financial institutions to plan ahead on how their teams can carry those modifications out.

Minimizing risk and maximizing opportunity within your loan portfolio is the goal for financial institutions of all sizes. While helping customers and members stay afloat during stressful economic times is key, it is equally crucial to understand your financial institution’s risk tolerance to survive and thrive in the months ahead.

For additional resources on managing your portfolio in an economic downturn, visit Baker Hill’s resource page.