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Managing a spike in defaults: what are the risks?

Paul Garbutt Paul Garbutt

In the current economic landscape, banks are preparing for a spike in defaults, with an increase in collections and recoveries activity. Paul Garbutt looks at how to mitigate the risks across front- and back-office roles.

Looking at the rest of the year, and ahead to 2021, retail banks are working on the general assumption that 10% of lending currently in forbearance will default by the end of 2020. To put this into context, retail banking books are currently around 13-15% in forbearance.

On the corporate side, banks are expecting 40-60% of Bounce Back Loan Scheme (BBLS) repayers to default, at a value of around £20 billion starting in summer 2021.

This will lead to a surge in collections and recoveries activity, which carries significant risk around conduct, reputation and compliance, among other areas. A number of skilled-person reviews have been instructed over retail collection processes, with a particular focus on treatment of vulnerable customers. As a highly specialised area, it will be a challenge to get the right resources in place within the short timeframe.

What are the key risks across the customer-facing and back-office roles, and how to mitigate them.

Customer facing activity

When managing defaults across customer-facing roles, there are five key areas to consider:

1 Customer information

All communications, terms and conditions must be clear and compliant with the Conduct of Business Sourcebook. This relies on good governance and cross referencing to third-party sources such as the government, British Business Bank (BBB) and professional advisors.

2 Loan issuance

All lending must be compliant with government schemes and firms must be able to meet demand. This relies on appropriate due diligence, fair treatment of customers and robust anti-money laundering screening. Banks can use automation and fraud-detection software, drawing on additional resources as needed.

3 Forbearance

Forbearance in retail and corporate lending must be compliant with government initiatives, with accurate repayments schedules. Capacity can be a problem and many firms may need to retrain individuals, or draw on external expertise, to generate accurate and consistent repayment calculations.

4 Differentiated client offerings

Business development is an ongoing process and there is a risk of missed opportunity, for example through cross selling or post-sales support. This largely depends on suitably skilled relationship managers and further training, combined with effective customer profiling, to support future growth.

5 Collections and recoveries

Fair treatment of customers, particularly offering support to vulnerable ones, is a key concern, recognising that their profile will change over time.

Maintaining data tapes with complete records of customer interactions will help establish a single customer view (SCV) across all products and gain a better picture of the aggregate impact on each customer. But poor data quality can be a barrier, making it difficult to create an SCV, establish a repayment hierarchy or identify vulnerable customers.

With significant conduct risk, BBLS and Coronavirus Business Interruption Loan Scheme (CBILS) could be on a par with PPI misselling in the future, so transparency and demonstrating BBB compliance is paramount.

Conduct risks could manifest in collections from small- and medium-sized enterprises (SMEs) in particular, especially for outsourced activity or sold-on portfolios. Uncertainty over how the FCA and Financial Ombudsman Service (FOS) will respond will compound the issue, but an increase in FOS complaints is likely due to the recent extension to SMEs. This could lead to an increase in compensation payments, in addition to probable losses during recoveries.

The scale of the work ahead, combined with short timeframes and limited resource, add to these challenges and make it difficult to balance tactical and strategic operating models. Banks can review their operating model to identify areas for resource redeployment, automation and use of artificial intelligence. This will streamline collections and recoveries processes and help triage customer cohorts.

Effective use of data analytics can give assurance over key controls and automated processes, helping to mitigate the risks. Many firms may not have the specialisms or resources to do this in-house and making use of external support and outsourced providers can be beneficial.

Non-customer facing activity

Credit risk and IFRS 9 modelling calculations are proving difficult, as the current macro-economic environment is outside the expected parameters for most credit risk and finance models.

New and updated models are under development, but they will take time to build and validate. Closer monitoring and increased frequency of reporting can help manage the interaction between loan defaults and IFRS 9 charges.

There may also be direct and indirect tax risks from the recognition of losses on lending and claims against government guarantees. Specialist expertise may be needed to address these tax risks, with additional resources to validate the work.

While the process to claim government guarantees is still under development, firms will need to demonstrate compliance with the initiatives and significant preparatory work will be needed.

Next steps

With the expected surge in collections and recovery activity, firms need skilled resources and robust assurance over their processes and procedures.

All firms want to treat their customers fairly, protect vulnerable customers and maintain good conduct. All of which will also be under increased public and political scrutiny due to fallout from the financial crisis. Achieving this against a backdrop of cost reduction programmes will be challenging, and requires careful ongoing monitoring, tracking and effective governance.

Contact Paul Garbutt for more information on mitigating the risks and how we can help.

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