Managing credit risk in today’s environment

Financial institutions are under a significant amount of pressure. They’re constantly working to balance risks and opportunities in order to manage their portfolios and drive future growth.

Below, we highlight the increased risks in the leveraged lending market and suggest activities that can help financial institutions ensure they’re managing their risks effectively.

Leveraged lending market

The leveraged lending market has seen increased stress over the past year, with significant impact from the effects of COVID-19 and new concerns still emerging. Leveraged lending refers to a transaction where the borrower’s post-financing leverage, when measured by debt-to-assets, debt-to-equity, cash flow-to-total debt, or other such standards unique to a specific industry, significantly exceed industry norms for leverage.

Increasing market stress

The U.S. leveraged loan default rate is expected to increase to 4.76% by the end of 2021 from its current level of 3.89%. The default rate peak is expected at less than 6%, but the default cycle could extend for another one to two years. Balance sheet maneuvers, specifically covenant waivers and extensions, are expected to remain elevated.

For industry sectors, market participants expect relative performance to be better for the technology, healthcare, communication services, and consumer discretionary sectors. Conversely, higher risks are seen in the retail, oil and gas, and leisure/lodging sectors.

Growing risk for leveraged lending

As a result of various economic and market issues, banks and other financial institutions have seen an increase in defaults within their leveraged loan portfolios. This has led to a tightening of credit within the leveraged lending market.

Financial institutions that take the time to strengthen their monitoring of higher risk borrowers will be better able to decrease the likelihood of future losses occurring.

This is somewhat of a reversal from a year or two ago when community banks were looking to get into leveraged lending. Now, financial institutions are pumping the brakes — tightening up credit underwriting and suggesting that the market may experience a downturn in the short term.

What can financial institutions do to mitigate leveraged lending risks?

For financial institutions with leveraged lending portfolios, mitigating risk will become a major factor in success, particularly if market stress continues well into 2021. In order to manage risks more proactively, financial institutions should monitor their borrowers’ financial performance more closely. This could include activities, such as:

• Reviewing financials more frequently than in the past, such as reviewing a borrower’s financial results quarterly rather than annually.
• Increasing scrutiny with accounts receivables, inventory and fixed asset capitalizations are monitored effectively to ensure credit quality is maintained, and that losses and delinquencies do not mount.
• Monitoring accounts payables listings to ensure the borrower is not extending terms with vendor relationships.
• Conducting more frequent meetings or site visits (i.e. biannually rather than annually or every 18 months) with borrowers to ensure the institution fully understands the customers business, any new business ventures that the customer is expending cash on not included in the lending relationship that could place stress on the balance sheet, as well as further understanding the key and their actions to mitigate risks related to their line of business.
• Financial institutions that take the time to strengthen their monitoring of higher risk borrowers will be better able to manage more volatile market conditions and decrease the likelihood of future losses occurring.

Managing your risks to create new opportunities

We’ve worked with numerous banks and credit unions to manage and evaluate credit risks. If you’d like more information on leveraged lending concerns or additional credit risks, please contact your local Plante Moran business advisor.