Risk is inherent to lending. Like death and taxes, there’s just no getting away from that certainty. If you operate in the financial services sector, you are in a committed relationship with risk. It’s best to accept that and act accordingly rather than ignore it and suffer the consequences. Overwhelmingly, successful lenders are the ones that can find the sweet spot between credit risk-taking and credit risk mitigation. In other words, they’ve aced the tightrope act where even a little imbalance can offset results. Given its importance, we thought it would be a good idea to look at how far the credit risk mitigation process has come and 5 reasons why it is a must for every lender in 2021.
3) Regulatory pressure is on the rise for financial institutions
The process of credit risk mitigation – Then and Now
Though it might seem like a modern concept, credit risk mitigation has been around for eons. We see traces of it going all the way back to the BC era. In 1780 BC, King Hammurabi of Babylon (present-day Iraq) wrote, what is now known as, ‘The Hammurabi Code’. In it he set down strict rules on credit repayment, ordering borrowers to do whatever it takes to repay the debt (even if it meant selling themselves or their family).
Thankfully, modern-day risk mitigation tactics do not include such archaic practices. But no matter the inhumaneness of his solution, Hammurabi recognized the importance of credit risk countermeasures. That he had no clue how to predict or prevent them is another matter altogether.
For much of the 18th century, lenders followed this same template - they responded to defaults but didn’t prevent them. Only with the birth of credit reporting and insurance in the 19th century did institutions shift to a prevention-rather-than-a-cure model of risk management. Even so, risk management was more of a suggestion and not a must in lending circles. Back then, it was like the appendix in the human body – there, but no one really knows why it is and what it does. Also, both could be disposed of easily and with little consequence.
All of that changed with the 2008 financial crisis. The recession revealed not only the failings of ongoing risk management processes but also the necessity for it. Suddenly, the financial world sat up and took notice of this once-forgotten department. Consequently, credit mitigating systems scaled up to accommodate rising regulatory demands. Credit risk management, therefore, has moved on from being a vestigial process to one that is integral to a bank’s survival now. Moreover, the onus now is on predicting default rather than just containing it.
5 reasons why credit risk mitigation is a must for every lender in 2021
According to Accenture, only around 13% of investment managers have the requisite conviction and certitude needed to manage credit risk. Here’s why that needs to change sooner rather than later:
1. We live in uncertain times
If there is anything the Coronavirus pandemic has taught us, it’s that we live in unpredictable times. Covid-19 hit the world like a thunderbolt from the blue. To make matters worse, it came at a time when uncertainty was already in the air, what with Brexit in the UK, political and social unrest in the US, and threats of nuclear war from N. Korea and Iran. The resulting economic collapse of 2020 has piled on the misery for financial institutions already burdened by digitalization challenges such as cyber threats and information breaches.
The crisis has resulted in an uptick in credit defaults and insolvencies. According to Euler Hermes, a credit insurance company, insolvencies are set to reach a record high of over 30% by the end of 2021. In addition, tanking interest rates have seen a whole host of investors descend upon the equity market. While this has been good for the economy, it has made it challenging for banks to get an accurate read on their borrower’s financial health
With all this upheaval around, it just makes good business sense for financiers to invest in an efficient credit mitigation system, such as TRaiCE, that will flag defaulters before too much damage is done.
2. Your bottom line and more is at stake
Faulty investments undoubtedly lead to negative profit margins or worse. A spectacular example of this is the collapse of Barings Bank, one of Britain’s oldest investment companies. The 200-year-old bank, which incidentally had Queen Elizabeth on its client list, crumbled in the space of just 3 days. It incurred losses to the tune of $827 million on February 23, 1995, due to the shady investment tactics of one rogue trader. Three days later, despite a bailout attempt by the Bank of England, it collapsed. While most poor investment choices do not, thankfully, end up in such a spectacular fashion, a loss of equity is guaranteed.
However, it's not just a lender’s bottom line that is at stake. Reputations are on the line too. After it played its part in the 2008 recession, banks such as Goldman Sachs and Bank of America had to fight an uphill battle to save their tarnished reputations. Public opinion about them was, and still is, scathing. The Rolling Stones went so far as to call Goldman Sachs a ‘vampire squid wrapped around humanity’. Bank of America meanwhile regularly features atop most-hated companies-in-America lists even today.
In addition to revenue and reputational hits, lenders must also deal with a decline in share prices, loss of key employees, and an exit in clients; all of which compound the losses. Enterprise companies may be able to lay low until the heat on them eases up. However, for smaller institutions that don’t have the pedigree or resources that conglomerates do, it can be a bow breaker.
3. Regulatory pressure is on the rise for financial institutions
Post the 2008 recession, lawmakers across America and Europe banded together to tighten regulations. Their aim was to prevent a crash of such epic proportions from ever happening again. Consequently, new supervisory bodies sprung up and with them came a host of fresh regulatory actions. The most sweeping of these is the Dodd-Frank Act in the US and the Basel III Accord internationally.
While the jury is still out on the effectiveness of a lot of these regulations, the fact is that financial institutions must abide by them. How can they not when the alternative includes hefty fines that can run into the millions? In the past year alone, the SEC handed out fines amounting to over $4.5 billion; this from only around 700 different cases.
All of which makes non-compliance a risk in itself. Having the right credit risk management system that includes regulatory standards is, therefore, a must today.
4. Credit risk mitigation solves the ‘risk-vs-safety’ conundrum
Investments are an integral part of the financial services industry. Without them, a lender has little chance of commercial viability. Revenues from an investment company’s financing department are intricately tied to its capital reserves. This is in turn tied to its ability to make more investments. In short, good investments lead to a virtuous cycle of financial growth and stability for the lender. Unfortunately, the opposite is also true. Faulty investments can shrink capital reserves and lead to a vicious cycle of non-investment and stagnation.
Given this twin dynamic, financiers often find themselves stuck in a risk-vs-safety conundrum. Credit risk management helps companies solve this dilemma. Early-warning risk mitigating systems can stop losses by shedding light on investments that are wandering into risk territory. This way, lenders can identify and pull out of faulty investments before any real damage is done, allowing them to be proactive rather than just reactive.
5. It acts as a safety net for bolder investment choices
When you have a system that can single out defaulters even before they renege, you essentially have a safety net. This allows investment managers to take more confident business decisions. Basically, credit mitigation systems are to lending what brakes are to a car. Just like a good braking system in a car gives you the confidence to drive at higher speeds, so a good risk management system allows you to make bolder investment choices. Both give you the confidence needed to get the best out of your respective frameworks.
AI-augmented credit risk mitigating systems such as TRaiCE can act as an investment guardrail by highlighting and even predicting company performance. TRaiCE systems can monitor hundreds, if not thousands, of investments in a matter of minutes. That it does this on a 24/7/365 basis is the icing on the cake.
Conclusion - No longer the last kid
The credit risk mitigation process has come a long way. Gone are the days when it was like the last kid picked. Nowadays, financial experts consider it an essential, first part of any investment operation. Given its propensity for facilitating commercial growth, lenders ignore credit risk management at their own peril. Sticking to traditional methods of risk mitigation is just as bad. In this day and age, banks and other lenders need an augmented credit risk managing system that can keep up with and even predict seismic shifts before they happen.