Recent government support programmes have helped many through the current situation, but as lockdown is phased out, there will be an increase in non-performing loans. Paul Garbutt looks at meeting these obligations while maintaining compliance, treating customers fairly and keeping financial strength.
Over the last few months, banks have granted essential loans to businesses and offered forbearance for borrowers. These are vital lifelines and withdrawing funding will exacerbate macro-economic weaknesses. With a long road to recovery and an impending recession, there will be an increase in non-performing loans, both pre-existing and coronavirus-related. Government guarantees will cover the majority of the COVID-19 loan losses, but not all of them, and the schemes will not subsidise losses from pre-existing loans.
The outlook for non-performing loans
As the furlough scheme comes to an end, retail banks face challenges over how to end support and achieve the right outcomes for their customers. This will be no mean feat, with a quarter of all UK workers on furlough or other government-backed schemes, as of early June.
Our discussions suggest typical bank portfolios have 12-15% of secured and unsecured lending in some sort of forbearance, although specialist lenders are seeing up to twice that amount. Commercial bankers estimate 60% of new coronavirus scheme loans will default or suffer other repayment issues that will drive previously unseen levels of non-performing loans. Some estimate the situation to be: a third performing as expected (most likely because the business is simply building up cash buffers), a third defaulting and a third in some form of difficulty (imminent or technical default).
The road to recovery
Economic recovery depends on banks continuing to do the right thing, which in turn, relies on them remaining financially viable. The risk of reduced net interest margins, combined with possible negative rates; uncertainty due to Brexit; ongoing preparations for the LIBOR transition; and pre-existing regulatory agendas, put increased pressure on lenders.
It’s a tough balancing act and one that demands careful management of the lending transaction lifecycle, from origination through to collection, recovery and handling bad debts. Banks already have frameworks in place to manage these elements, but with the flurry of activity in the last few months, the focus has been on loan origination. Reviewing the operating model for the entire lending lifecycle will help mitigate these risks in the medium term.
Banks face similar challenges when it comes to overseeing the lending journey:
The biggest issue for corporate lenders was initially the sheer volume of applications under the Coronavirus Business Interruption Loan Scheme (CBILS) and the Bounce Back Loan Scheme (BBLS). This increases the risk of fraud going undetected and makes it harder to maintain compliance with the British Business Bank’s funding criteria. Limited time to implement the schemes has left many banks on the back foot, creating a tailored risk-assurance framework as they go.
Retail lenders face similar challenges, with an overwhelming volume of applications for repayment holidays and lending. Treating customers fairly depends on an appropriate affordability agenda, with consistently applied lending criteria. Stretched resources may have an impact on quality, increasing conduct risk and the potential for 'mis-selling', which is also a key concern for corporate lenders.
Mitigating the risks:
A surge in applicants means a surge in data, and digitising the customer journey from the off can help manage the risks through each stage of the lending lifecycle. Data analytics can identify if any customers have been wrongfully excluded and detect suspicious activity or duplicate applications, but this relies on data being collected in the right format.
Drawing on additional resource, through outsourced personnel or re-training existing teams, allows for greater scrutiny over the applications and can support the wider assurance framework. Care needs to be taken as collections is a specialist area. The necessary expertise is always in short supply and the design of beefed-up operations needs to ensure that expertise is there for the vulnerable customers in particular.
Back book and initial period
Managing the front and back books is about effective monitoring throughout the loan repayment period, including maintaining regulatory and scheme-specific compliance. Much of this monitoring can be automated and the data can be assessed using data analytics, while raising red flags for potentially fraudulent activities.
Data analytics can also identify customers who may default on their loans, and help banks prepare for the anticipated losses. Retail customers may miss payments, most likely by agreement, but corporate borrowers may not be in a position to make many, if any repayments and provision of restructuring assistance will be key.
Mitigating the risks:
Lenders should review their recovery and collections policies and prepare for increased activity in this area. Greater and more-timely communication between the various organisational elements of collections, credit risk and reporting is key. Taking lessons learned from the data in this current period can improve the future operating model to manage the volume of non-performing loans.
Getting the right repayment hierarchies in place where customers have multiple products and the need for an accurate and timely Single Customer View (SCV) can be challenging. Corporate lenders may also consider coaching programmes for small and medium enterprises, to help the lenders build their brand and reduce the potential for non-performing loans in the future.
Banks should prepare for an increased number of defaults, and lenders to the corporate sector should have scale arrangements in place for covenant monitoring and independent borrower reviews. Data analytics can identify borrowers who are experiencing problems and also help value collateral.
Mitigating the risks:
Corporate lenders for CBILS and BBLS must document their decision-making processes in line with BBB expectations, and have processes in place to access government guarantees. Both corporate and retail lenders may consider resource augmentation to support recoveries or collection practices. Gaining independent assurance over these activities, and compliance with government initiatives, may reduce regulatory risks in the long term.
Borrower at failure
Recovery or work-out processes are challenging for both retail and corporate lenders. Investigations, including forensic recovery and asset tracing, can be resource-heavy and difficult to conduct on a large scale. The same applies to recovery and collection activities and managing applications for BBB guarantees.
Mitigating the risks:
Lenders may consider creating a virtual ‘bad bank’ to separately manage the volume of non-performing loans. This can offer greater regulatory assurance; generate significant efficiencies and cost saving; and reduce the potential for costly remediation exercises further down the line.
Maintaining good conduct
The anticipated demand for experienced recoveries and collections teams will probably outweigh the current supply. Many firms are re-allocating resources from compliance, risk and operations, but without adequate training, this could increase conduct risk, with greater potential for poor customer outcomes.
Mitigating the risks:
Preparation is key and retail banks are currently ahead of commercial lenders, as, for retail, initial forbearance arrangements may be stopping at the end of June. Corporate lenders will need to balance re-allocation of staff, to make sure they do not put added pressure on compliance and risk teams, who need to provide assurance over government schemes.
Planning standby resourcing now, with enough time for the necessary training, will support fair treatment of customers and promote good customer outcomes. New customer journeys and operating models within the institutions will be required, however. It’s not enough to try to scale up with inexperienced resources. Where possible, firms should automate collection processes to support self-service, check their SCV and review the current operating model to meet future volumes.
What to do next
In the current macro-economic environment, a larger volume of non-performing loans is inevitable. At every stage of the loan lifecycle, loans should be closely monitored to identify the potential for default and to allow the bank to plan accordingly and provide appropriate help to customers in difficulty. Senior management should have appropriate assurance that the financial, regulatory and conduct risks are adequately managed and mitigated with a robust information audit trail in place.
For help managing non-performing loans, contact Paul Garbutt.
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