Credit Risk Management during an Ongoing Pandemic
Joe Sergienko and Michael Whalen discuss the enormous impact the COVID-19 pandemic has had on normal economic activity, as well as contributing factors. Mr. Sergienko provides insights on what credit risk professionals are seeing and are likely to see as the pandemic plays out.
TRANSCRIPT
MW 00:10 [music] Welcome to BRG's ThinkSet Podcast. I'm your host, Michael Whalen. BRG is a global consulting firm. We help organizations in disputes and investigations, corporate finance, and performance improvement and advisory. We're a multidisciplinary group of experts, industry leaders, academics, data scientists, and professionals. Around the world, BRG delivers the inspired insights and practical strengths our clients need to stay ahead of what's next. For more information about BRG, please visit thinkbrg.com.
The global response to the COVID-19 pandemic has unquestionably had enormous impact on normal economic activity. And when economic activity is disrupted so severely, borrowers become stressed in their ability to meet their obligations to their lenders and debt holders. But the widespread defaults and bankruptcies that many expected at the beginning of the pandemic didn't seem to materialize as badly as many had feared. Did the government interventions into the economy prevent a downward credit cycle, or is it possible that pressure on creditors has just been delayed? Are other forces at play in reducing risk during COVID?
Joe Sergienko from BRG is here to give us some context of what credit risk professionals are seeing and are likely to see as the pandemic plays out. Joe is a managing director in BRG's Financial Services practice, with more than twenty years of experience in assisting clients with risk management and capital planning. He's an expert in complex risk assessment, regulatory compliance, and the planning and implementation of capital and liquidity projects.
Joe, welcome to the BRG ThinkSet Podcast.
JS 01:48 Thanks very much, Michael.
MW 01:49 Joe, we're recording this close to the anniversary of the imposition of the US lockdowns, and I don't know about you, but it certainly, to me, felt like the world was ending, or at least the economic world was coming to a bit of a screeching halt. And I suspect everybody in the credit risk world was breaking the seal on their worst-case scenario contingency plans. But it seems to have played out a little bit differently. What happened?
JS 02:12 I think we all got ready for the worst and thought, with such a significant decline in GDP, that we were headed for another meltdown. However, I think everybody learned lessons from the Great Recession and took a little bit of a different approach on how do we address the pains of the economic shutdown. I think the government response certainly helped. I think banks helped as well by allowing credit to continue to move. I certainly don't believe that we're fully out of the woods yet, however, but we certainly are seeing it play out much differently than if we were to have discussed this back in March or April of last year. I would have been raising alarm bells pretty loudly because such a significant lockdown meant the economy was going to come to a halt. And that meant that borrowers were not going to repay their lenders as quickly as they normally would. But banks and government response have certainly helped in the process.
MW 03:16 We saw the government obviously pump a lot of money into the economy through some of the successive stimulus plans, a new one which has just passed this week, and monetary authorities have been keeping their foot on the gas by maintaining or even further easing overall monetary conditions. Is this all that the government did, or are there other things they did to help the credit markets?
JS 03:36 No. There are other things that they did to help the credit markets. And quite frankly, some of it was lessons learned from the Great Recession, but also new tools that they implemented to accommodate what otherwise would have happened in such a drastic halt of economic activity. So, we saw regulators giving regulatory capital relief and relief on accounting measures that, otherwise, if banks did not receive funds on time, they would have had to take accounting hits, which probably would have caused banks to shrink their balance sheets quite quickly and start to constrict credit. Instead, they were able to keep the doors open, as it were, and allow funds to move, even though, technically, they had borrowers that were delinquent or would otherwise have been in default.
JS 04:26 In accounting terms, we had a lot of the banks implementing the Current Expected Credit Loss, otherwise known as CECL, enhancements. And rather than just allow that to play out—which in normal times or less-severe times, the regulators probably would have just allowed the accounting to stand, as it were—we saw the regulators say, "Hey, look, we understand this is a new accounting methodology that you would have implemented. We need to be thoughtful here and not cause alarm. So, we're going to defer certain elements of this at the bank's discretion, of course." But I think that they understood, at the end of the day, that there could be widespread issues if they allowed some of the accounting rules and capital rules to be implemented as written given the timing that we were in.
MW 05:17 Were the rules consistent with what we see with some of the revisions which have occurred since the great financial crisis in terms of trying to let market inputs influence book accounting entries, as opposed to management judgment, or are these sort of market-to-market issues that they deferred?
JS 05:34 No. This is the accounting changes bringing in some of the market factors and the macroeconomic environment factors as opposed to the qualitative judgment, management judgment that you would have seen pre-CECL.
MW 05:48 So what is the outlook among credit risk professionals right now? Is the view that this is pain denied, or is it just pain deferred?
JS 05:54 I think it's a mix of both, to be honest. As you talk to some bankers, they are seeing it as pain denied. They'll get through it. They know their borrowers. They feel quite comfortable with their borrowers and how they anticipate seeing some of the funds start to flow back in as the reopenings occur. I think there are some elements of the banking community that think we've skirted the most harsh elements of the process.
However, there are some that certainly do see that as pain deferred. Some of that is just down to, quite frankly, uncertainty as to what reopening really means for people and how that plays out over time. And so you think about commercial real estate as a great example, with everybody working from home and feeling generally quite comfortable with the process. Do you need as much of a footprint in your commercial real estate space? And so, do you have some entities saying, "Hey, let's cut back on our footprint," and how does that impact asset valuations?
Furthermore, as you bring people back into work, how many people are coming back to work, and how does that impact the infrastructure around the offices? So think about the delis and the lunch places that we all like to frequent when we're in the office. If we're still not in the office, how many of those are going to come back? So I think there's an element here of wait and see as to how long the reopening process takes and what it actually looks like, and have the fundamentals of the economy changed as we start to do the reopening, and then we can decide more definitively if it's pain denied or pain deferred.
MW 07:35 Was the economy broadly affected as a result of COVID-19, or was the impact confined to specific segments of the market economy? For example, commercial real estate and the energy sector had well-publicized issues for energy. Certainly, at the beginning of the crisis, there were substantially low oil prices and concerns about oil demand, and commercial real estate had the issues that you described earlier. How does this contrast with the experiences during the global financial crisis, when it might have seemed that all segments of the economy were affected?
JS 08:13 I actually think it was broader than the '08/'09 crisis to some extent. I think it has played out selectively over time. But at the end of the day, I believe that everybody has been impacted in some way from a financial credit market perspective with this crisis, whereas if I think back to '08/'09, yeah, it was certainly broad, and it was certainly very damaging for many people, but I don't think it was as targeted in different points in time. '08 and '09 felt a little bit more like everything was happening all at once, whereas if you look at now—and to use your example around the crude oil prices—you had that sudden drop for a little while, and then it's come back up. But now we still have issues in things like commercial real estate and housing that are going to take a little bit longer to sort themselves out. If I were to graph the thing, I'd probably say that there's an uptick in certain elements, and then there's downticks in other elements, that is really, quite frankly, I think, different than what we saw in '08 and '09.
MW 09:25 What was the strategy that banks had for provisioning for credit loss when the pandemic hit? And given what's happened subsequently to that, have they reduced those provisions?
JS 09:37 Yeah. So at the beginning of the pandemic—and it was a little bit of a timing issue, because as you pointed out at the beginning of the podcast, the shutdown started in March, and that meant at quarter end. So banks had to really quickly figure out what they were going to do. And it was a well-thought-out process, I think, for most banks that they would increase their provision substantially. And they wanted to articulate to regulators and the markets that they were taking this thing seriously, although they didn't know specifically how severe or how long the lockdown would be and how it would impact their credit books. But they wanted to demonstrate that, "Hey, there is uncertainty in the market, and we need to be prepared for that," which is, I think, one of the key lessons the banks learned coming out of the financial crisis of '08 and '09.
Now that we sit here, and we've seen significant release of those reserves and that provisioning, we've seen banks say, "We think we are going to be made whole on many of the loans that we originally were holding some of those reserves for," and I tend to think that there's some optimism coming from the banking sector around those loans as you see different parts of the economy reopen, and they have discussions with some of their borrowers around repayment plans and things such as that.
MW 11:04 Joe, you touched on it in your previous response, but there was a lot of time spent after the global financial crisis trying to figure out how to avoid a similar market catastrophe. And it's often said that generals and possibly regulators often fight the last war as opposed to the current war. But what measures were put into place as a result of the 2008 and 2009 crisis that actually did prove to be helpful in this current COVID crisis?
JS 11:35 I think some of the things that the regulators put in place in response to '08 and '09 were things like the liquidity measures, the Main Street Lending Program, the immediate elements that they could backstop the banks. And that was part of what came out of Dodd-Frank and that regulatory regime post-financial crisis that said, "Hey, let's make sure that these banks have access to the funds they need when the going gets tough.” So things like the liquidity market measures and even—we'll get to in a minute—but even the PPP loans, those were certainly elements that, I think, came out of the financial crisis of '08/'09 that had immediate impact and really helped stabilize markets in uncertain conditions.
MW 12:23 Was there anything that didn't seem to work that well?
JS 12:27 I don't think that the measures that were put in place in '08 and '09 were exactly right for this crisis, which kind of gets to your original question of: you're fighting the last war, right, where the last crisis was indeed a banking crisis. It was banks were having to write off loans, and they were taking losses, and there were capital hits all over the place; whereas this crisis, that isn't how it started. This crisis started with a pandemic. This crisis started with people going on unemployment pretty quickly and the world shutting down from an economic perspective that I don't think that the measures that the regulators immediately had in place were prepared to answer those questions.
And so I touched on PPP, the Payment Protection Plan, as an example earlier. That didn't really exist. It was an idea, but it was not a functioning program. And so it took a little bit of time to get those efforts up and running, get it through Congress, and then get it implemented at banks. And even at banks, it wasn't immediately clear how it was going to work. So the regulators had to give guidance, and it took a while to get everybody comfortable. And I think it caused a little bit of pain and anguish in the Main Street community of: how can I keep my business up and running, and how can I keep people employed so that there aren't further knock-on effects to the economy?
We were just looking at it from a different perspective. 2008 and 2009 was a Wall Street banking sort of crisis, and that's really where it started. Obviously, there's fundamentals underneath that, but that's really where it started having a problem; whereas this one, it started on Main Street where people could not go to work. So we had to respond differently.
MW 14:23 You talked about bank resiliency. And there were a number of stress-test mechanics that were imposed on banks as a result of the Great Recession. Did those stress tests bear any relation to the stress experienced by banks during the current pandemic?
JS 14:38 So the short answer is no. I don't think so. I think the stress tests that the banks have been doing since the Great Recession have a different use than planning for a pandemic-like stress. The stress tests that the banks tend to do are relatively macro in nature. And as we've seen in some of the macroeconomic forecasts, there's some disconnect between unemployment numbers and GDP and stock market indices.
However, that being said, I do think what we got out of the stress test that the regulators have imposed on banks is a level of capability to assess what is going on and react from a bank perspective. So there's an element of governance that was imposed by those stress tests that I think has borne fruit in this downturn. I also think that those stress tests and the initial reason for those stress tests were to inform other lenders and market participants about bank resiliency and capability to withstand the stress. So I think they do allow for the banks to say, "Hey, look, we are good. We shouldn't have a run on the bank or anything like that. You instead focus on getting credit to customers dealing with those sorts of issues." So I think it helps in one sense, but didn't necessarily really help from a financial impact in assessing those risks in the system for the banks.
MW 16:10 Now, you touched on this a little bit, but how did we manage to avoid the credit market liquidity crises that we experienced in the global financial crisis? How did we manage to avoid this in this particular crisis?
JS 16:24 First, the government programs definitely helped, right? Knowing that there were backstops, I think, helped market participants calm down a little bit. And I think most people in the markets see this as a one-time pandemic. There will be light at the end of the tunnel; so, not to use very technical term, freak out, and start to pull back on credit there in liquidity. They know things will reopen. For the most part, they're involved with other market participants that they've known for years.
If you think back to '08 and '09, you had a little bit of—you didn't know where the next shoe was going to drop. And so one minute, you're talking about Lehman, the next you're talking about Bear Stearns, and all of these sorts of issues that were going on, and everybody's looking over their shoulder as to who's next. And in this case, I don't think we did that. I think we paused and said, "Okay. Everybody's got to work from home or work remotely, but we can still keep things moving, and we can still have conversations." And so maybe that's another lesson that we learned from that crisis, that we don't have to react to immediate news all the time, and what are the fundamentals that are driving some of the performance.
MW 17:44 You talked about the sector variability on bank and credit market reactions to the COVID crisis in the lockdown responses, but lockdown wasn't applied consistently across the US by region, and it wasn't even consistent around the world in terms of the measures governments took to try and mitigate the effects of the COVID virus. Have we seen variability in credit performances by region in the US?
JS 18:14 Yeah. I think we've seen those that were more open probably have a little bit less of an immediate impact on their financials. However, I do think even in those locations, you've seen them reserving appropriately and safely, considering that they don't know if there's going to be another lockdown for them. And then those that did lock down more severely or stringently, there's a feeling that there's a harsher credit cycle coming for those sort of regions, particularly as the reopening process occurs. And you see what's still standing, who's able to reopen, and who's able to repay their loans, and how long is that going to take.
And I think it goes back to something I said earlier around uncertainty. And nobody wants to make the call today about the differences between the northeast or the southeast or what have you. But I think time will tell as those reopenings occur and who's able to come out of it less scathed than [others], quite frankly, I think most people agree that the less-stringent locked-down areas probably have the more likelihood of coming back less scathed than others.
MW 19:29 When I talk with clients, I tell them that, on a historical basis, if you look at the credit markets, that risk is pretty cheap on a historical basis. Risk spreads are extraordinary historical deals. Do you expect that to continue, or is there something that could change this current construct where the market is on risk and risk is relatively cheap?
JS 19:53 I think the reopening process and seeing some of the impacts on those sectors and regions… will help reprice risk more effectively. I think there's a lot of unknowns, and the markets love to speculate. And that's part of what goes on. But I think most have been reluctant to speculate that ABC company or DEF company is going to have issues. I think that's a little bit of a transparency in the market that is driving some of the risk pricing going on. But as some of that transparency goes back to normal, I think we're going to have some clarity and some shifts in the risk paradigm there.
MW 20:35 So during the global financial crisis, we had certain financial instruments that were pegged as disguising credit risk. We had a lot of criticism of derivative products such as CDOs and CLOs and those instruments, in fact, being a symptom of there being too much heat in the credit markets. We've seen leveraged loans and no covenant high-yield bonds have similar criticism. Now, I know this is an equity market discussion regarding SPACs, which are special purpose acquisition companies, and those aren't credit markets. But what are regulators looking out for as a sign of, to use the oft-quoted expression, irrational exuberance in the marketplace?
JS 21:15 I think they are paying attention to the equity markets a little bit. I think there's a question as to the investment process, particularly from individuals, and how that might be impacting individual deposits and their investments into markets, and does that potentially create some level of risk in the credit markets as individuals aren't able to repay loans because they have money tied up into these SPACs and other market instruments that seem to be going gangbusters compared to what they were back in the day. I also think that the regulators are looking at some of the banking fundamentals around the release of reserves. And is that implying that everything is looking up? And I'm not sure the regulators generally feel that everything is looking up. I think they just see it as a potential for a new challenge, and releasing reserves too quickly could tell us that we're being overly optimistic.
I also think that they are looking at customer deposits and the fact that those have grown, and then looking at the other side of the balance sheet and seeing that loans to customers have increased. And does that imply that, soon enough, borrowers are going to be overextending themselves and have too much outstanding at banks, and they're not using the cash, which could imply that they're saving it up for a rainy day, but they may be creating their own rainy day? So I think there's a couple of elements that the regulators are looking at right now that may indicate some overexuberance from a customer perspective that could have impacts on banks.
MW 23:00 There's been a big drive in both the equity markets and the credit markets, and this includes bank lending toward ESG-focused activities. And that is those investments and credit instruments that are aligned with environmental, social, and governance objectives. That someone myself, who works in the project finance markets, I know that lenders have told me that if they get an ESG-linked deal on their desk, they'll give it two or three looks to see if they can make it work, whereas on another transaction, they might not spend as much time and effort to try and figure out a way to make a transaction like that work. Does this have any credit risk implications that possibly are understated?
JS 23:43 Yes. I think the way to assess credit risk, on average, is based on somewhat on historical performance and how a particular credit or project performed in the past to inform some level of the future performance, or how likely is this borrower going to be able to pay me back? And ESG projects, on average, don't have as long of a historical repayment effort because they are so new. So there is an element of some additional credit risk that you're not really looking at. Hopefully, from a bank perspective, they are pricing that risk into any loans.
However, we also have to keep in mind, and appropriately so, that there is a big push from the administration and others to do ESG sort of projects. And so being one of the lenders that is involved in an ESG project also buys you some reputational benefit and potentially some goodwill with regulators and other investors. So I think that it could impact credit, and hopefully, the banks have priced some of that risk in. But there is also an important element here to make sure that those projects are getting funded and helping the movement along as it gets going here in a real way.
MW 25:04 That's wonderful. Thank you very much for joining us here on the ThinkSet Podcast.
JS 25:07 Sounds great. Thanks so much, Michael.
MW 25:11 [music] This ThinkSet Podcast is brought to you by BRG. You can subscribe to the podcast and access other content from ThinkSet magazine by going to thinksetmag.com. Don't forget to rate and review this show on iTunes as well. I'm Michael Whalen. Thanks for listening.
The views and opinions expressed in this podcast are those of the participants and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group or its other employees and affiliates.
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