SIX STRATEGIES TO NAVIGATE CREDIT STRESS By Dennis Falk, SVP & Regional Manager, PCBB Between the pandemic and rising inflation and interest rates, the last two years have taken community banks on a wild ride. Rising inflation and the higher interest rates designed to bring inflation back to earth have influenced cash flow and the cost of goods, which can create financial stress for borrowers. Financial stress can lead to credit stress, a problem for community banks and their customers. Multiple Challenges in Credit Risk The problem isn’t just that economic circumstances may push some borrowers towards payment tardiness or default. Community banks are seeing: • Varying credit quality by market sectors and subsectors. The pandemic, rising inflation, and/or higher interest rates have hit some business areas hard. Other sectors, like those deemed essential businesses, have remained remarkably unscathed. • Difficulty discerning the creditworthiness of different potential borrowers in those sectors and subsectors. For instance, businesses in travel and tourism found pandemic-related lockdowns in 2020 and 2021 very challenging. Some of those businesses have rebounded since then, such as cruise ship traveling, which saw share prices jump after pandemic safety protocols were removed earlier this summer. Other travel-related industries haven’t been as lucky, such as the hotel sector with lingering staff shortages that caused some hotels to close or leave a portion of rooms unsold. The challenge is determining which individual businesses are good credit risks. A firm’s business sector matters, but it isn’t necessarily the last word on whether a bank should lend to it. How can your bank assess risk in ways that encourage safe growth during a volatile economic time? Here are six strategies to help: 1. Notice the industry concentrations already in your loan portfolio. Use real-world observation and what-if analysis to determine the effects of rising interest rates on the sectors and subsectors where your bank is invested. Don’t forget the importance of factors such as region and business size. Commercial real estate companies in New York, for instance, might be experiencing different conditions than commercial real estate companies in Chicago while still having long-term tenant contracts in common. 2. Collect current financial information from borrowers more frequently — at least every six months. Annual updates are no longer sufficient. Consider all your possible information sources, which might include credit scores, payment history, debt-to-income ratio, net cash flow variables derived from customer-level income, utilities, rental payments, and other debt servicing. Some financial institutions are even moving toward using real-time data to get the clearest, most upto-date picture of a customer’s financial standing. 3. Analyze sectors and subsectors of industries to anticipate economic patterns. For instance, 20 The CommunityBanker
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