Collateral is one of the more underutilised credit risk mitigation tools available to banks, and likely to become more important as loan losses mount in the year ahead.
Jack Ma recently offered a critique of bank regulation, one which has led to the suspension of what was supposed to be the world’s largest ever IPO from Ant Group. At a conference in September, Ma argued that traditional banks act like “pawnshops”, requiring collateral and guarantees from borrowers, and outlined a future in which data plays a far more pivotal role in determining creditworthiness.
Many would argue that Ma failed to distinguish between credit assessment and credit risk mitigation, though his comments correctly drew attention to the growing importance of data in the lending process, particularly at a time of extraordinary uncertainty for banks amid the Covid-19 pandemic.
Fortunately, banks were on a much stronger footing at the outset of the pandemic than they were at the start of the 2008 financial crisis, in part due to the higher capital and liquidity requirements imposed by regulators. They were also quick to build up loan loss provisions early in the year using forward-looking accounting standards based on expected credit loss (ECL), while regulatory measures to conserve bank capital were also being introduced (e.g. dividend restrictions).
Credit risks mount
These actions appear to have helped avoid what could have been a disastrous financial system meltdown, allowing banks to continue to lend to customers – albeit cautiously – and support the global economy. And most regulators have expectations for banks to continue to provide credit to businesses and households.
Yet, recurring waves of Covid-19 infections have jeopardised early hopes of a speedy economic recovery. The ongoing economic impact to already-struggling households and businesses will eventually translate into NPLs (non-performing loans) on bank balance sheets, as governments start to wind down support that has so far been provided to businesses and households.
Rating agencies S&P and Moody’s have both recently stated that credit losses will surge and bank earnings will fall over the next 12 months. Compounded by negative ratings actions, most banking systems in Asia Pacific are not expected to stage a full recovery until 2023, both agencies say.
Banks should have little doubt that regulatory scrutiny of their capital and liquidity levels will be unrelenting for as long as the recovery lasts. Additionally, they are likely to encounter much stronger regulatory interest in their credit risk management and mitigation practices during this period, particularly as defaults continue to mount.
Outside of periods of distress, it is easy to overlook the integral relationship between good credit risk management and bank capital management. This relationship exists principally due to the fact that capital requirements are determined to a large extent by a bank’s own assessment of borrower risk, as well as the quantum of available risk mitigation, often in the form of guarantees and collateral.
Collateral is one of the more underutilised credit risk mitigation tools available to banks. Before the pandemic, MAS (Monetary Authority of Singapore) and APRA (Australian Prudential Regulation Authority) had set out more stringent requirements for bank lending, dealing specifically with collateral management and valuation practices.
In August 2019, following a review of bank collateral management standards and practices used in corporate lending, MAS issued an information paper setting out its expectations for how credit risk exposures should be managed. In particular, the paper highlighted the “direct impact” collateral valuation standards and practices have on loan loss allowances, which have a direct bearing on bank capital.
MAS said it expects banks to have “timely, accurate and comprehensive information on credit exposures and collateral portfolios” to facilitate proactive and prompt credit risk monitoring and oversight, and that processes should be in place to ensure the integrity of the credit and collateral data that form the basis for credit monitoring and decisions.
Banks were also asked to value collateral at its net realisable value, based on reasonable and prudent assumptions, and to revalue collateral on a regular basis – more frequently for problem loans. Valuations, the paper said, should be independently sourced, reliable and reflective of market conditions.
Similarly, in a revised prudential standard on credit risk management issued in December 2019, APRA set out requirements aimed at enhancing banks’ credit standards and the ongoing monitoring and management of their credit portfolios over the full credit life cycle, through better collateral management and valuation practices.
The new prudential standard – now due to take effect in January 2022 following a Covid-19 related extension – will require independent valuation of collateral, where such valuations should take into account the time taken for collateral to be realised, with consideration for the potential impact of external events, such as drought or flood (or a pandemic, one would assume).
While MAS and APRA have not placed a great deal of emphasis on loan collateral and valuation practices since the pandemic began, the benefits of adopting good practices in these areas has become abundantly clear in the face of mounting loan losses, particularly if banks are to mitigate some of the risks associated with continuing to provide credit to support the recovery.
Many banks are unfortunately not currently set up in a way that allows them to easily enhance their collateral management and valuation practices, in part due to the patchwork of legacy systems they use for loan origination and maintenance. The result of this is that critical workflows for the entire loan life cycle are not able to ingest the volumes of data that are available to verify, assess, and monitor collateral.
Arguably, this results in loan processing errors, uncertainty over loan security and inaccurate collateral valuations that persist throughout the life of a loan, ultimately contributing to a lack of visibility around credit exposures, unused capital allowances and operational inefficiencies.
Besides the troves of valuable data currently residing within their own systems, banks need to be thoughtful about the use of external datasets that can support credit decisions, risk mitigation and better visibility of collateral in the banking book, says Luke Nestor, founder of Rockall Technologies, which was recently acquired by Broadridge.
“There is no doubt that regulation is forcing banks to become more digitised and data-oriented in terms of their loan operations and systems,” he says. “In Europe, banks have already been trending towards adopting stand-alone collateral systems that can deliver accurate loan data that can be aggregated and is fully usable across their credit systems.”
This approach has allowed banks to manage collateral and all of its relationships and data points through the life of the loan, all the while ensuring that the collateral is correctly valued on a continuous basis from origination to release, Nestor says. “In Asia, such systems will be needed for banks to answer incoming regulatory demands for high-quality credit data and lineage, while also allowing them to establish a foundation for a more analytics-based approach to credit risk.”
“Banks that can leverage data and analytics in their loan systems will find themselves better able to handle incoming credit losses in the year ahead.”
To learn more about sound credit decision-making and collateral management practices, join this webinar.