The Pandemic Impacts Credit Margins: This Is How Banks Can Prepare Now


Many banks in Europe were already in a challenging environment before the Corona crisis. There is strong competition in addition to the cost increases caused by regulatory requirements and the pressure to modernize the range of services as well as the system landscape. This situation is exacerbated by the Corona crisis as other factors, such as loan defaults, will have an impact on the per se tense profitability of financial institutions. The economic impact of the pandemic will primarily affect banks' portfolio management.

More and more companies are in financial difficulties due to the crisis triggered by COVID-19 and are dependent on liquidity measures. For banks, this results in a steep increase in administrative work. The flood of loan applications is only the first of a series of challenges that financial institutions will have to face now and in the coming months. Across industries such as trade, catering or tourism – many companies are currently suffering from a massive loss of earnings and will no longer be able to service existing loans in compliance with their contracts, in the coming weeks and months. This means that rising risk costs for loan defaults will put a strain on the already low net income of many banks in the lending business in Europe.

As a result, credit institutions must now build up reserves and review critical processes accordingly. Among other things, this will require a shift of focus to analysis and monitoring of portfolio management. A consistent adjustment of the digital agenda will be crucial to best deal with defaults in credits.

Credit Risks Threaten the Stability of the Portfolio

In the current economic crisis, banks do much more than process Corona aid applications: by taking measures to improve liquidity and avoid bankruptcy scenarios, they secure the existence of many companies in the short term. These risk-relevant measures include waiving non-compliance with essential contractual obligations from existing credit contracts, for example, by suspending repayments or not exercising termination rights. Ultimately, however, these initiatives also lead to a delay in the repayment of loans and an increase in the debt ratio of companies in need.

As a result, credit risks increase, requiring financial institutions to monitor their portfolios much more actively and to work out non-performing loans in a targeted manner. Bundesbank board member Joachim Wuermeling also warned in an interview with the Handelsblatt about credit risks and their delayed effects on bank balance sheets. He anticipates a significant increase in burdens in the third and fourth quarters of this year.

With regard to this burden, a key success factor for banks will be to allocate the available resources to the material risks in the portfolio. Now, it is important for them to decisively focus on critical commitments and processes in order to meet the challenges as best as possible and to ensure the profitability of their own business. There are three main fields of interest for financial institutions now and in the near future:

  • Earnings contribution from the lending business
  • Transparency and control
  • Resource commitment and allocation

Effects on Earnings Contribution: How Corona Affects Banks' Credit Margins

Even before the crisis, the adjusted net income of many financial institutions was already below the equity capital costs. According to the management consultancy Bain & Company, in the first half of 2019, for the first time since the financial crisis, German banks were unable to generate their equity capital costs of currently 7 to 10 percent in corporate banking. The Bain Corporate Banking Index shows that the return on equity fell to 7 percent. This downward trend has been showing for the past five years; the experts' sobering conclusion is that yields have remained low and profitability keeps falling.

Many financial institutions unwittingly force price competition by expanding further into the supposedly promising corporate business. They try to counteract low profitability by extending credit volumes to position themselves as a house bank, increase their share of wallet, and be able to carry out targeted cross-selling. The result: the credit volume is at a record high, but the credit margin itself has fallen as a statistical average.

In addition, there are other serious effects on the earnings contribution in the lending business, which will have a growing impact on the credit margin as a result of the Corona crisis, such as risks due to loan defaults, additional efforts for analysis and monitoring, rising capital costs, non-risk adequate pricing, lack of cross-selling or increasing liquidity needs. Our white paper 'Banks after Corona: Implications in portfolio management' provides detailed information on these effects and how they can be countered.

Regulations and Stakeholders: Increasing Requirements for Transparency and Control

In the face of the COVID-19 crisis, banks were initially relieved of regulatory obligations. Some regulatory requirements and capital regulations were eased in order to relieve the burden on financial institutions and to keep lending going. For example, bank supervisors have already postponed the implementation of Basel IV by one year; it will no longer enter into force on January 1, 2022 as originally planned, but only on January 1, 2023.

There are also discussions about sustainably supporting the banks as systemically important units. In view of the crisis, Hans-Walter Peters, President of the Association of German Banks (Bundesverband der deutschen Banken, BdB), is demanding additional help for banks from the ECB. “In view of the economic situation in Europe, there is an urgent need to suspend negative interest rates immediately,” Peters emphasizes in an interview with the Handelsblatt. By suspending negative interest rates, banks would be able to strengthen their equity with the aim of continuing to be able to provide their customers with loans. Peters also demands that the bank levy be temporarily suspended. Since 2011, as a result of the financial crisis, institutions have had to pay this levy, which in the event of an emergency finances stabilization measures by European banks. “At the moment, the banks need all of their financial strength to support the entire economic system,” Peters explains.

In the medium and long term, however, it will be equally of interest and obligation for supervisory authorities to bring transparency to risk situations and any hidden burdens to banks. An increased need for information might go hand in hand with new regulatory aspects. In any case, stress tests and loan reviews will also be essential in addition to the annual audit. This means additional effort, particularly in the analysis units, with regard to the aggregation of information or the requirement to be able to provide information ad-hoc. In reality, this often entails manual processes and analog cross-departmental coordination, despite technical progress in banks through digital and regulatory initiatives.

New call-to-actionThe need for information will also grow among the various stakeholders. For reporting, it is important to prepare figures and forecasts and to answer inquiries from control bodies, management, and supervision. This is additional workload for the back office, on top of the operational tasks of analysts in portfolio management.

Front and Back Office: Significant Growth in the Need for Analysis Leads to Resource Bottlenecks

As already discussed, additional or more intensive activities will significantly increase the burden on credit experts in the future. Due to the market turmoil and corresponding effects on borrowers, a large number of measures will have to be accentuated, which have been made more flexible in the past few years through process simplifications or credit business guidelines. This includes, among other things, suitable steps for early risk detection and more intensive monitoring of existing commitments by front and back office in different granularity. As a result, analysts will incur significantly more work related to portfolio management.

The following areas will become particularly important due to the current crisis:

  • Checking risk-relevant parameters: Risk-relevant violations of obligations from the loan agreements must be assessed and approved if the risk increases.
  • Checking the ability to repay: The liquidity made available in this crisis is credit that needs to be paid back (given the currently very unclear sales development). Under significant time pressure and with currently unstable repayment forecasts, analysts have to critically examine whether the loan funds can be repaid at all and monitor the increase in corporate debt very closely.
  • Consideration of the correlations between asset classes: The crisis not only affects traditional corporate customer financing, but – possibly with some delay – also specialist financing such as aircraft, ships and real estate (including commercial real estate). Universal banks are usually represented in many or all of these asset classes. Since such financing is usually structured without recourse, major challenges arise on the analysis side in the syndication or transfer of assets.

All of these tasks require systemic front and back office support for critical and risk-relevant decisions within financial institutions. For example, standard processes should be automated and thus accelerated, so that market and analysis experts are relieved from routine activities.

Conclusion: Adjust Priorities of the Digital Agenda

Not only the provision of liquidity that is necessary due to the real-economic effects of COVID-19 and the corresponding acceleration of application processes are currently key issues, but also the preparation for the 'wave' of credit-related implications in portfolio management. All the areas mentioned so far will trigger an intensification of the analysis and approval requirements in the course of the Corona crisis. That means extra work, especially for the analysts.

It will be important to systematically support the experts in their work so that they can devote themselves to tasks with a high level of criticality and risk relevance. In order to keep the risk in the portfolio transparent and to ensure a focus on critical commitments, it is important to relieve the experts in the long term. By automating non-critical processes, routine tasks can be eliminated so that experts can concentrate on the essential tasks. Increasing automation is also an important aspect in achieving overhead cost effects.

Banks therefore need to rethink their digital agenda. Existing digitization initiatives, which are very much tailored to an optimization of customer experience, should also be checked with regard to user experience in the understanding of the internal expert and should be adjusted accordingly.

Our detailed whitepaper on the implications for portfolio management is now available for download as PDF. Here you can find out in detail which influencing factors financial institutions should keep in mind in order to avoid erosion of the net credit margin in the impending economic crisis.

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Image Source: Teaser: fizkes – 1188857007 – iStock.

Written by -Torsten Spörl-

Torsten is Chief Revenue Officer and responsible for the 'Customer Tribe' of knowis AG. At the beginning of his professional career, Torsten worked in transaction consulting in the financial services sector at two of the 'big four' management consultancies. He then led various units in the banking sector, focusing on corporate customer business and project financing.

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