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Credit Risk in pandemic time

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions.

In the early days of the pandemic in 2020, with global supply chains breaking and millions of people suddenly getting pink slips, bank credit models flashed red. Risk managers were warned that the surge in unemployment would lead to a wave of consumer defaults – but this did not happen.
Typically, credit models are designed to predict much higher defaults when unemployment rises snappishly. But something happened to derail that normally reliable if/then scenario. Government support program kicked off and changed the scenario.
There are understated distinction models weren’t trained to incorporate: people don’t default due to job losses, but because their income drops impulsively. Historically, changes in employment and income track very closely. And since macro employment data is readily available, credit models are programmed to project increasing defaults based on plunging employment.

In the US only, roughly 26 million people lost their jobs over a period of five weeks in the months of March and April last year. As a result, the US and state governments implemented massive support programs – including weekly payments to the newly unemployed and one-time payments to many businesses and most individuals. For low-wage workers, unemployment benefits often exceeded their normal income. As a result, the expected wave of defaults didn’t kick off.

In the EU, the credit support programs can be largely classified into two big types. Mostly for firms, there are government-based guarantees for commercial loans, while consumers (and smaller firms) were supported by law-based payment moratoria periods, not only for mortgages, but also for other types of credit. Additionally, bankruptcy laws were temporarily adjusted to allow firms to be protected against creditors. EBA has put in place temporary guidelines for support programs, effectively blurring the reporting situation (no default or forbearance for clients using support programs) and currently there is a mess of still running moratoria expiring in few month (cliff effect looming) combined with new forbearance still needed, but no longer supported by EBA guidelines.

According to the Financial Times, the largest US and European banks had set aside a combined $139 billion in loan-loss provisions. As per Mr. Cris deRitis, deputy chief economist at Moody’s Analytics, insists banks are just being prudent. They recognize how support programs have temporarily distorted the picture and want to make sure they’re prepared for a possible increase in defaults.
The rescue packages and unemployment benefits flowed through the banking system. That may help to increase the banking activity and to keep the financial system activity during these difficult months.

Now, 2021 will be extremely interesting as now a large part of defaults and forbearance events, even those that would take place without COVID-19 crisis, are postponed.


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