Mitigating Lending Risk Amid Slowdown Fears

Recessions are difficult to predict, but several indicators show the U.S. economy cooling after a historic, decade-long expansion. So, it’s prudent for lenders to prepare for a recession and adjust lending practices in order to continue to thrive.

Businesses and consumers are understandably anxious — not just to anticipate when the next recession hits but to determine what form it takes and how it may impact their businesses and portfolios. It’s important for lenders to sidestep the fears that dampened lending in the wake of the Great Recession and take steps to avoid repeating that vicious cycle.

Economic Worries Mount

There’s no question a recession is looming; it’s just a matter of time. While US gross domestic product (GDP) has been fairly steady despite the ongoing trade war with China, cracks are emerging.

Third quarter GDP was recently revised downward from 2% to 1.9%. The Fed cut rates for a third consecutive time, taking a more cautious view of US prospects. Business investment continues to decline. Last, our Small Business Lending Index fell 5.4% in November and is now 1.9% below its year-ago level. Global political worries are growing too – from Brexit to Hong Kong.

Prepare, Prepare, Prepare

What, then, should banks be doing right now to mitigate lending risk in a slowing economy? The best defense is preparation. The first step for lenders is to run their portfolios through recession scenarios. Stress test loans to analyze their ability to weather unfavorable economic environments — from a progressive slowdown to a worst-case scenario similar to the Great Recession. To be effective, these tests shouldn’t happen in a vacuum.

Lenders should run custom scenarios that take into consideration the uniqueness of their geographies and industries. Here are two worth considering:

Forward-Looking Risk Ratings: To truly be ready for a slowdown, use risk ratings that project probabilities of default (PD) over the next several years. For example, looking at statistical estimates of defaults for each business borrower in a lender’s portfolio can give you a sense of the resiliency of your portfolio over time.

Tailored Testing: Creating scenarios appropriate to the geographic location and local economy of your borrowers is essential to this process. An industrial company in the Midwest has a very different financial makeup and outlook than a retailer in the Southeast, for example. Generating scenario-based probability of default predictions at the individual obligor level provides a much more accurate reading to manage your risks and opportunities.

We’re in a healthy, consumer-driven economy at the moment but there are mixed signals about the economic outlook. The trade war and 2020 elections are looming large in the minds of business leaders, weakening confidence and business investment. Now’s the time to be proactive and invest in resources and technologies that will bolster your operations against the effects of a slowdown. By taking the time to prepare, lenders can better focus their energies not merely on staying alive in a downturn but on keeping the capital flowing when businesses need it most.

William Phelen is the SVP and General Manager at PayNet Inc., an Equifax company that provides commercial lending data on small and medium sized enterprises.