According to Fitch Ratings, the projected collective loan default rate from 2020 to 2023 will be 17% to 20%. By contrast, the 3-year (2008 to 2010) cumulative default rate during the 2008 financial crisis hovered around 15%. This jump in loan default rates is, no doubt, reflective of the devastating economic impact of the Coronavirus pandemic. Due to the pandemic, nearly 98,000 businesses permanently shut down in the US last year and corporate bankruptcy levels reached a ten-year high. Given that we could be seeing increased delinquencies and, consequently, a bigger onus on credit portfolio managers to prevent them, we ran an informal poll to see what their biggest fears during these tumultuous times are. Here is how they voted:
The poll results
We conducted our poll in a LinkedIn group of credit risk management professionals. As you can see, with 43% of the votes, missing default-indicating red flags was their biggest fear as a credit risk manager. This was followed closely by anxiety over being misled by false positives and negatives at 34%. And coming in at the third position, was an inability to predict future risk at 23%.
While none of these results are very surprising, they do make for a poignant reminder of the limitations of traditional portfolio monitoring processes. In addition, if current economic trends are any indication, the pivotal role that credit portfolio monitoring plays in ensuring financial growth and stability is set to come to the fore once again (just like it did during the 2008 financial crisis). So, we thought it would be a good idea to take a deeper dive into your biggest fears as a credit portfolio manager and, more importantly, what you can do about it.
For the purposes of brevity, this will be a 2-part blog. In this blog, we will focus on fear #1: Missing out on red flags. Check out part 2 here.
If you're in a hurry, check out our video summary:
The importance of catching default-indicating red flags
Catching red flags, or warning signs that point to financial ill-health, has long been a risk management 101. And for good reason too. Being able to detect these early warning signs can often be the difference between profit and loss. If nothing else, it can help investors limit the financial ramifications of backing a failed investment. A prime example of this is Deutsche Bank. The German company avoided losses thrice last year by paying close attention to red flags.
As soon as warning signs emerged on Wirecard AG and Greensill Capital, two of their big financial service investments, Deutsche Bank cut down their exposure to these entities significantly. This allowed them to sidestep a potentially debilitating financial hit. The bank also acted swiftly when red flags around Archegos (the now-defunct asset management company) popped up.
To counteract what they saw as an increasingly risky association, Deutsche Bank first increased its loan collateral with Archegos. Then, when it became clear that there would be no turning around, the bank’s risk managers quickly and quietly liquidated its Archegos assets. In this way, the German bank recovered all its money and even got some collateral to boot. In contrast, their Swiss rival, Credit Suisse, failed to read the signs correctly and ended up with over $5 billion in losses.
4 Important red flags every credit portfolio manager should watch out for
As such, there are 4 red flags that every credit portfolio manager should always be on the lookout for. Finding any of these should concern and alert you of future risk. More importantly, it should warrant a deeper investigation of your borrower’s financials.
1. Increased debt-to-equity ratio
This classic financial metric is often a good indicator of default risk. Businesses need funds to operate and grow. However, if most of those funds come from creditors, it can create a mountain too big for your borrower to scale. As a rule of thumb, your borrower’s debt-to-equity ratio should never go above the industry average.
In addition, a sudden increase in a borrower’s debt-to-equity ratio can also be a precursor to financial instability. Managers should watch out for activities such as over-ambitious expansion plans. Aggressive fund-raising activities that have an ambiguous motive should raise a red flag too. These can point to a tipping of the scales to the debt side of the equation.
An infamous example of this is the Royal Bank of Scotland’s reckless expansion bid in the early 2000s that saw it nearly collapse. The bank aggressively acquired assets without rhyme or reason, incurring serious debt that it couldn't pay back in the process. Only a bailout by the British government to the tune of around £45 billion saved it from complete closure. Aside from the reputational hit it caused, the bailout also forced the bank to lose 81% of its ownership stake.
2. Cash flow and other financial irregularities
A consistent cash flow is reflective of your borrower’s capacity to manage finances and sustain profits. This in turn points to their ability or inability to make credit repayments. Sudden, humongous spikes and dips in profit margins are, therefore, something to keep an eye out for. A dip in revenue is an obvious concern since it means your borrower may not have the necessary resources to pay you back.
Conversely, an abrupt and unexplained increase in cash flow also needs to be scrutinized to ensure there is no financial hanky-panky going on to fudge margins. Last year, Wirecard AG, a German payment processing and financial services provider, filed for insolvency after around £1.8 billion of its supposed profits went ‘missing’. Auditors discovered that Wirecard’s impressive numbers were the result of some serious window dressing and not actual profit margins, something they should have discovered much earlier had they looked more closely.
Other financial and accounting irregularities such as a sudden increase in asset values, surge in legal fees, complex financial transactions, or excess inventory could all be signs of potential trouble.
3. Negative public sentiment
In today’s hyper-connected society, public sentiment carries a lot of weight. Recently, Portugal footballer Christiano Ronaldo caused Coca-Cola share values to drop by $4 billion just by snubbing the drink at a press conference! So, it makes sense to monitor the public’s sentiment towards your investments as they could be a sign of things to come. Of course, with all the excess of opinions out there, being able to extract the red signals from within this noise is what makes tracking this particular red flag a tricky expedition (read our blog on sentiment analysis for more details on that).
But, as they say, there’s no smoke without fire. In the case of Wirecard, while the company’s fraud was only discovered last year, it has had skeptics who raised alarms as far back as 2008. These negative whispers were raised by German shareholders, eagle-eyed short-sellers, and internal employees. However, Ernst & Young, the firm’s auditors, chose to ignore all these sentiments.
4. Actions of other involved parties
Along with monitoring financial metrics and public sentiment, keeping an eye on the actions of involved parties such as regulators, auditors, insurers, and other investors is a wise move. That’s because their actions can sometimes speak much louder than all the words and numbers on a financial statement or annual report. It could also be that they are privy to information that you do not have.
This is something Credit Suisse should have done to avoid taking a $140 million hit due to the Greensill Capital collapse last year. Months before Greensill imploded, other investors such as SoftBank and GAM suspended their ties with it. In addition, BaFin (a German regulatory body) flagged the company for financial irregularities. All this flurry of negative activity around their client should have raised red flags for the bank.
Why credit portfolio managers miss out on red flags
Given that catching red flags is one of the best ways to mitigate risk, how is it that credit risk managers sometimes miss them? To be sure, it's not from a lack of trying. Here are some possible reasons for that:
1. It’s hard work
At the end of the day, red flags are metaphorical in nature. They don’t just highlight themselves in red with an accompanying neon flashing light on your borrower’s financial statements. You have to take the time needed to read the data, analyze it, perform some calculations, and then measure the results against industry standards before finally deciding if it is a red flag or not. So, there is a little bit of financial forensic analysis, digging around, and looking under the hood that is involved. Catching red flags is, therefore, not child’s play. Conversely, it is something that requires patience and a good analytical accounting brain.
2. Too much data, too little time
Today’s managers have a mountain of data at their disposal. Apart from historical data and myriad financial metrics, managers also have alternate information such as a company’s digital footprint at their fingertips. This means that they can get a more well-balanced view of their borrower. Unfortunately, it also means there is just too much ground to cover sometimes. As a result, a lot of important red flags fall through the cracks. In addition, it can take days to sift through all the data and perform the in-depth analysis needed to discover a red flag. This could mean that managers make the discovery too late and there isn't enough time to make any meaningful changes.
3. Valuing relationships over data
It is good to value relationships, especially the ones that go back years. But, in financial circles, where preserving and improving your investor’s profit margins is the end goal, cold hard facts should take precedence over close ties. Despite their decades’ old association with Wirecard, Deutsche Bank took the hard call of severing ties with it once they saw all the data-backed red flags. This is sometimes hard for financiers to do as they often want something to show for all the hard work they’ve put into an account.
An easier way to catch red flags
As you can see, catching default-indicating red flags is not an easy task. So, it's no wonder then that it features atop the list of biggest fears for a credit risk manager. The process of identifying red flags is quite subjective. We would go so far as saying that there are as many methods for identifying red flags as there are credit risk managers! Whatever the process, it is sure to be a meticulous, research-filled, and time-heavy one, if done manually.
One alternative to that is using AI-augmented systems such as TRaiCE that does all the heavy lifting for you. It can comb through vast datasets that contain trillions of parameters to produce data-backed, default-indicating red flags. Since its parameters are fluid, you also have the freedom to configure your own investment guardrails with the industry standards or data metrics you think are pivotal to catching red flags. It just makes for an easier, more efficient, and fool-proof way of doing things. And this way, you have one less thing to worry about!
Check out part 2 of this blog for a deeper dive into fears #2 and #3 - False results and inability to predict future risk.