When thinking of the root causes of the recent financial crisis, clearly the unsustainable path of credit creation stands out as the central problem plaguing the financial sector. Due to the taming of inflation post-1982 and a secular decline of interest rates accelerated by changed aggregate savings processes in emerging economies, the price of credit has been very low for nearly two-and-a-half decades. This phenomenon, dubbed the Great Moderation stood, alongside the introduction of the Euro behind a very rapid growth of credit in many countries. Following the calamities of 2008, this bubble has burst with spectacular side-effects, among which are new efforts to regulate the banking industry. Basel III is set to yield higher capital and liquidity levels across the globe and thus make banking both safer and less profitable, as high-yielding credit is set to be partially replaced, at the same time, by low-yielding liquidity, all the while capital requirements are set rise drastically.

As a consequence, someone has to shoulder the burden. There are two candidates for this: shareholders or clients. Shareholders may have to face decreasing returns on their investments, whereas clients may have to pay more for credit. Whereas the former means lower growth of credit, the latter on top of this implies an element of adverse selection, since dearer credit attracts potentially higher credit risk . The reasoning behind this is simple: paying a higher loan rate invariably means the creditor have to get a higher return out of their projects, hence potentially riskier projects are attracted. Or , by the same token, higher credit costs hamper clients’ cash flows, thus worsening their credit risk. Banks’ reduced risk appetites and efforts to “save” capital combined with record-low interest rates, have also led many businesses to get credit through the financial market directly rather than through their banks. Last but not least, in a bid to stem the tide next time around, regulators may invoke novelty credit and balance sheet size restrictions in what is commonly called macroprudential policy, injecting uncertainty into the future composition of balance sheets.

So, no matter who pays for the increasing burden of regulation, banks will face fewer, riskier and more volatile loans. In order to stay competitive in such a landscape, banks can improve their lending processes both from an efficiency and a decision-making standpoint. Efficiency-wise,  by upgrading their core credit-decision technology using automation, valuable staff time can be freed up to do more analytical work and thereby put more emphasis on managing credit portfolios rather than handling single exposures. Decision-wise, having credit decisions based on client profitability both ex-ante and ex-post, banks are able to improve the economic profit from lending decisions, i.e. avoid the pitfalls from adverse selection while continuing to lend to economically ‘good’ risks. Furthermore, growth processes in a world of scarcer credit can be more effectively managed by setting the right incentives. By employing such enhanced profitability management on both new business and existing loans, banks can give regulators a thorough insight into their lending practices, which, given the likely continuation of the current episode of low interest rates, are bound to get more attention going forward.