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    The Economics of Wholesale Credit

    The Economics of Wholesale Credit

    Traditionally, corporate trade credit limits have been set based on customer size, an internal or external credit score, and a qualitative sense of risk appetite. These limits have been effective in minimizing write-offs, principally because they are conservative.

    If robust, more precise, probabilities of default can be obtained, those credit limits can be adjusted to yield higher margins and extend credit where economically justified. The result can drive higher volumes to some existing customers and new sales to customers previously denied credit.

    To do so, the credit limit setting process must focus on net value added, rather than on loss minimization. One side benefit of the approach is the ability to credit-adjust the pricing of a given transaction. This way, the cost of credit is explicit and can be added to the required margins.

    Forgone margins and growth
    More than $500 billion dollars in unsecured trade credit are currently extended in the United States by wholesale sellers, marketers, or traders. The average is roughly $200 million in Accounts Receivables (AR) per firm.1 Many of the mid-size to larger marketing entities hold AR books larger than regional banks. Yet they manage these AR positions with the primary goal of limiting write-offs.

    Inevitably, firms turn away profitable customers, and sales to non-investment grade counterparties are highly restricted. The seller’s return on capital becomes limited, and total sales and profits suffer, all needlessly. Rethinking how credit limit tables are constructed can alleviate these restrictions for many customers, directly increasing both sales margins and revenues.

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    In the current economic crisis, lending institutions are faced with a new world in which they must understand credit risk with often limited data available. "We have seen that credit-relevant events can happen suddenly; the best-prepared clients will be those who have automated the gathering of their analytics," says Nihil Patel, managing director at Moody's Analytics. "Our clients need to make credit decisions quickly, which means they need to process many different pieces of information. To inform those decisions, they're looking for a 360-degree view of their customers, comprising payments, financials, and other relevant information, and that allows them to conduct fast but comprehensive reviews."

    Moody's Analytics has been helping clients automate the processes that generate these real-time analytics by further enhancing its existing RiskCalc offering, designed to enable firms to evaluate default and recovery rates using specialized models that generate risk calculations and analysis. Moody's Analytics and Numerix, with its OneView platform, have traded this award back and forth over the years, and Moody's Analytics returns to the winners' circle in 2020 after Numerix won the category last year.

    Patel says Moody's Analytics efforts over the past year were largely focused on delivering clients with comprehensive views of their portfolios. "To that end, we added new alternative data resources and other metrics to the RiskCalc solution. We also integrated the Moody's Analytics Credit Sentiment Score tool, which uses natural-language processing and text analytics of news media to identify signals of credit impairment in companies. This tool helps clients assess credit-related news more efficiently and have an earlier and deeper understanding of the impact of these events," he says.

    Currently, Moody's Analytics is enhancing the early warning system within the RiskCalc solution, combining multiple metrics produced by multiple Moody's Analytics products into one aggregate risk score. "Being able to view their portfolios' most important credit metrics in one dashboard will allow clients to shift their focus from manually aggregating data to risk management," Patel says.

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    Twenty-one Moody’s Analytics experts share their views on what will drive markets and risk management strategies in 2021.

    Twenty-one Moody’s Analytics experts share their views on what will drive markets and risk management strategies in 2021.

    Keys to 2021 Recovery
    Rising COVID-19 infection rates across the US and EMEA and continued pressure on governments to provide additional stimulus raise concerns for the global economic path of recovery. As we move into 2021, which factors will weigh most heavily?

    Interest rates: Pressure on the Fed for a rapid return to full employment
    The Federal Reserve’s adoption of average inflation targeting and desire to return the economy to full employment quickly has raised the bar for the first rate hike. We forecast the first rate hike to occur in 2023, and believe that the pace of tightening will likely be less aggressive than in past cycles with the Fed having learned from its past errors. — Ryan Sweet, Head of Monetary Policy Research at Moody’s Analytics

    The removal of the COVID-19 premium will be wrung out of the bond market next year, pushing long-term US Treasury yields next year higher. The 10-year Treasury yield is forecast to end next year at 1.37% but the increase won’t be significant enough to weigh on the economy.

    US economic recovery to slow before accelerating
    The US economy is expected to slow in the first half of 2021, with still-rising COVID-19 infections taking a toll on jobs, spending, and investment. The second half of the year should be brighter though, as widely available vaccines lead to fewer infections, higher confidence, and a self-sustaining recovery. However, risk of rising inflation and record-high government debt remain.

    Despite good news on the vaccine front, the US economy will face an uphill climb in replacing 10 million lost jobs in 2021. One other bright spot on the horizon is the unprecedented level of interest in starting new businesses; according to our research this sentiment is particularly prevalent among some minority groups. Still, the short-term dislocations caused by the 2020 recession need to be addressed quickly to avoid permanent damage. — Cris deRitis, Deputy Chief Economist at Moody’s Analytics

    Richly valued US equity market may rise by only 5% in 2021
    Following the 12.6% average annualized increase over the last three years, the market value of US common stock is expected to rise by 5% over the course of 2021. Higher US Treasury and corporate bond yields will subtract somewhat from the relative attractiveness of equities.

    We expect 2021 to be an above-average year for US business activity. However, while the fuller utilization of resources favors a greater-than-10% annual increase by recurring profits, a less risky business outlook and firmer inflation expectations favor higher Treasury bond yields. The latter warns of higher corporate bond yields (meaning slightly lower corporate bond prices). The upside for 2021 has already been reduced by the preemptive pricing-in of good news regarding 2021 corporate earnings. Moreover, a significant amount of 2021’s prospective corporate bond issuance was brought forward into 2020. — John Lonski, Markets Economist at Moody’s Analytics

    2021’s corporate bond offerings will drop from 2020’s record highs
    Though up from recent levels, 2021’s corporate borrowing costs should remain historically attractive, especially in the context of expectations of continued growth in corporate earnings. Compared to historical trends, high-yield borrowing costs may be relatively more attractive than investment grade.

    Thus, 2021’s expected declines of corporate bond issuance should be comparatively deeper for investment-grade bond offerings. Following 2020’s prospective surges for US$-denominated corporate bond issuance of 53% for investment grade and 28% for high yield, the two broad ratings categories are expected to incur yearlong 2021 declines of -25% for investment grade and -15% for high yield. Despite possible double-digit percent declines, 2021’s bond offerings for both categories will be second only to their respective record highs of 2020. — John Lonski, Markets Economist at Moody’s Analytics

    Limited fiscal space and Brexit uncertainty for EMEA
    Fiscal stimulus will be key for 2021 recovery. Within Europe, Italy and Spain in particular will struggle with their large numbers of COVID-19 cases and limited fiscal space. Similarly, for many African countries constrained public spending will likely drag down their recovery. Meanwhile, for Russia and GCC countries, low oil prices have significantly reduced those governments’ coffers.

    In the UK there is still a lot of Brexit uncertainty. In the case of a Hard Brexit, the recovery over the next 2-3 years will be subdued. Because of that, we forecast that UK output level would reach pre-pandemic levels two years later than in the case of at least a limited trade deal. EU countries would also experience some fallout from Hard Brexit, especially Germany and France, although this impact would be smaller than that felt by the UK. — Anna Zabrodzka, Chief EMEA Economist at Moody’s Analytics

    Artificial Intelligence and the superpower effect
    In 2020 we saw organizations increasingly adopt artificial intelligence (AI) and automation tools. In 2021 AI-powered workflows will become the norm, not the exception. We don’t see AI replacing jobs or making business decisions by itself, but it can dramatically improve processes to allow employees to focus on high-value analytical work. AI is reaching a maturation point where organizations can implement it at scale to gain real efficiencies and improve productivity.

    Until now, many firms have evaluated AI with cautious optimism. We predict a demonstrable shift in 2021, as those firms clamor to embrace AI and ensure they capitalize on its “superpower effect.” — Ashit Talukder, Head of Artificial Intelligence at Moody’s Analytics

    Global Insurance Themes in 2021
    Navigating the pandemic, addressing new accounting standards, and managing climate risk will all drive change for insurers in the year ahead.

    Industrialization of technology to support ESG investment
    In 2020 we saw a real groundswell of interest in ESG investments and digitization. We believe this will continue through 2021 but—importantly—accompanied by a leap forward in the maturity and capability of the supporting solutions.

    In a 2020 survey we conducted, 71% of asset managers said they were unable to view the performance attribution of ESG investment factors. Solutions that provide an accurate view of the performance of both ESG and traditional investment factors will be key as ESG moves towards its more standardized future. This “industrialization” of the technology infrastructure that supports ESG investments is critical to enable the industry to meet the needs of investors. — Matthew Seymour, Head of Buy-side Solutions, Enterprise Risk Solutions at Moody’s Analytics

    Investment strategy and financial reporting will drive actuarial transformation
    In 2021, insurers will continue modernizing their actuarial systems and processes. As a consequence of persistent low interest rates we see an increasing need for firms to transition to actuarial systems offering asset liability management capabilities, to optimize asset allocation.

    This need is further exacerbated by regulators asking insurers, in their actuarial projections, to use investment returns that accurately reflect underlying assets, in particular for insurance products with minimum guarantees. For other insurers, actuarial modernization will be driven by the implementation of the IFRS 17 accounting standard, which requires projections at finer granularity with faster and more frequent computations. — Alexis Bailly, Senior Strategist at Moody’s Analytics

    A wave of change for financial reporting
    The impact of regulation and accounting standards changes will continue to weigh on insurers in 2021, as they balance the impacts of the coronavirus and climate change with changing accounting requirements, from IFRS 17 and IFRS 9 to long duration targeted improvements (LDTI) in the US.

    For finance teams at insurers implementing IFRS 17 (which for the first time brings consistent and comparable reporting across the world), defining KPIs under the new standard—and figuring out whether current metrics need recalibrating—will be a prime concern. How to communicate effectively with investors will require some deliberation, given how the standard will affect insurers’ liability measurement and profit recognition. — Barbara Jaworek, Director at Moody’s Analytics

    Stress tests and scenarios
    Climate change risk and the related uncertainty will continue to be a growing concern for insurers in 2021. Globally, many insurers are focusing on integrating climate risk into their risk modeling and embedding climate risk into their strategic asset allocations decisions, typically through the use of climate scenarios. In the UK, the Bank of England will mandate detailed climate stress tests for all insurers and banks in 2021. Consequently, insurers will need to prioritize climate risk modeling by committing significant resources and investment. — Nick Jessop, Senior Director of Research at Moody’s Analytics

    The rise of climate risk in financial reporting
    Many insurers will continue to observe developments in sustainability reporting to assess the impact on their financial reporting in 2021, and beyond. While many already include climate risk in their disclosures in response to the Task Force on Climate-Related Financial Disclosures, questions around climate risk in financial reporting still remain. For example, will there be industry convergence on what metrics to use to effectively communicate climate-related and other emerging risks? What data, processes, and systems will be required for insurers to produce specific but comparable disclosures on climate-related and other emerging risks in their financial statements?

    While many insurers have already started to incorporate these risks, it is still early days, so insurers will be watching and contributing to developments in sustainability reporting carefully. — Cassandra Hannibal, Director of Research at Moody’s Analytics

    What Banks Can Expect in 2021
    Banks of all sizes will continue to face unprecedented challenges. From rock-bottom interest rates to increased default rates to rising competition to pressure to cut costs, lenders will have to remain flexible to succeed in the post-COVID-19 world.

    Banks: Build, hold, or release?
    Banks navigated the first part of the crisis by ramping up reserves ahead of materialized losses as extended closures put businesses under stress. We expect banks to keep reserve levels high given the ongoing rise in coronavirus infections. Moody’s Investors Service (the credit rating agency and sister company of Moody’s Analytics) sees a worst-case peak of approximately 15% in corporate defaults for Q1 2021. So, we anticipate losses to start increasing and to appear on banks’ books in Q2. In the first quarter of 2021, the key focus will be the timing of losses and their scale, given the Federal Reserve’s economic support action and the latest stimulus package. — Laurent Birade, Senior Director at Moody’s Analytics

    Community banks: Embracing automation
    Ongoing margin compression, depressed loan growth, and increased reserve builds will make 2021 an extremely challenging time for community banks to make money. As the pandemic progresses, we expect these institutions to continue embracing automation as a means to deliver ever-improving efficiency ratios. — Robby Holditch, Director at Moody’s Analytics

    Credit unions: Pushing to preserve membership
    With increased competition from fintech companies and ongoing low interest rates, many credit unions will find it very difficult to boost returns for their members in 2021. As the economic slowdown caused by COVID-19 continues, we expect these lenders to try to find new ways to preserve their membership base, especially by offering new products and services. — Robby Holditch, Director at Moody’s Analytics

    Lending: Difficult cost-efficiency decisions ahead
    The rollout of the Paycheck Protection Program (PPP) in 2020 assisted US banks to help existing customers struggling during the pandemic. PPP also generated new customers for banks. The onboarding of these new relationships has been swiftly performed to distribute PPP assistance expeditiously. These new customers resulted in new bank deposits, giving these lenders additional opportunities for growth. Before banks can realize these new opportunities, however, Know Your Customer (KYC) compliance and credit risk assessment considerations must be taken to protect bank portfolios that remain subject to loan defaults and delinquent payments as the pandemic continues.

    In 2021, the banking industry will be challenged by low interest rates, continuing loan forbearance program pressures, and increasing default rates across portfolios. Banks will be faced with difficult cost-efficiency decisions as they expedite branch closings while transitioning to digital platforms. Banks that embed and leverage data, analytics, and technology will be best positioned to reshape their operating costs while seizing growth opportunities in the post-pandemic environment. — John Baer, Managing Director at Moody’s Analytics

    KYC and Compliance Risk Continues to Evolve
    As risks become more intertwined and regulation in the KYC space continues to evolve, companies will be required to know more about their customers than ever before. Risk and compliance programs will need to combine data, software, and analytical insight for a holistic view of who they are doing business with.

    Deeper due diligence using AI
    The risk detection industry has come a long way in being able to help banks and corporations achieve the due diligence depth required to comply with new regulations. However, the obligations of the EU’s Sixth Anti-Money Laundering Directive (which organizations must comply with by June 2021) sets an even more prescriptive framework that will require compliance teams to go much deeper in their due diligence as part of their anti-money laundering process. And using history as a guide, these requirements will likely spread to all regulatory due diligence in the near future.

    Given the vast amounts of disparate data that must be absorbed and analyzed as part of the screening process, the deployment of AI technology for more effective customer screening will be pervasive in 2021. This will mean fusing human expertise with AI-based screening technology for more effective verification checks, sophisticated name matching, and materiality guidance to qualify matches. — Bill Hauserman, Senior Director of Compliance Solutions at Bureau van Dijk, a Moody’s Analytics company

    Beyond regulation: reputation risk management
    While reputation risk management falls outside traditional regulatory compliance, knowing whether your counterparty is associated with any adverse media is going to be a ubiquitous concern in 2021. We expect increasing demand for adverse media screening tools that deliver a curated list of risk-relevant information on an individual or entity—and the people, events, and companies they are connected to. — Alex Zuck, Head of Compliance Products at Bureau van Dijk, a Moody’s Analytics company

    Managing an evolving sanctions landscape
    The evolution of sanctions compliance will continue to challenge conventional due diligence programs, requiring organizations to revisit existing frameworks in order to comply with new and existing sanctions screening requirements. Ownership-related sanctions violations in particular are one risk factor that financial institutions and multi-national corporates cannot ignore, or solve, with traditional screening technologies. To truly understand the ultimate beneficial ownership of customers and third parties, an effective sanctions compliance program in 2021 and beyond must be powered by comprehensive and accurate entity data. — Ted Datta, Director of Compliance Solutions at Bureau van Dijk, a Moody’s Analytics company

    Adopting technology to manage supplier risk
    The coronavirus pandemic has prompted organizations to expand their supply chains, creating an urgent need to quickly evaluate the credibility of new vendors, identify any bad actors, and better understand their supplier ecosystem. In practical terms this means understanding your supplier’s ownership structure, who they are doing business with, their commercial viability, and any associated adverse media. It is about looking at your suppliers’ suppliers, and potentially their suppliers, to gain a holistic view of the supply chain. — Alex Zuck, Head of Compliance Products at Bureau van Dijk, a Moody’s Analytics company

    A winding recovery for the US CRE and Structured Finance Markets
    After a difficult 2020, the commercial real estate and structured finance markets face an uphill climb in the year ahead. Though some property sales are expected to return to a more normal sales transaction volume, the expiration of cash flow supports for the CRE market raises a red flag.

    US CRE: A two-pronged recovery
    We’re looking at a two-pronged situation in 2021, as the pandemic will continue to weigh down some sectors even as optimism and a shift in platforms herald increased economic activity in others.

    A sharp recovery is in store for some properties and markets (multifamily, industrial—even some hotels) but others (retail, office) will continue to deteriorate. Within property types there will be stark differences as well: Student Housing may continue to lag; Senior Housing may well have turned the corner after bottoming out severely; Affordable Housing will shine. Within geographies it is an open question as to whether dense urban areas will truly suffer an outflow of households and employers—and if so, which geographies will benefit? Nearby suburban areas, or other states entirely? —Victor Calanog, Head of CRE Economics at Moody’s Analytics

    US Structured Finance: Overcoming credit hurdles
    As we move into 2021, commercial real estate cash flow supports of forbearance and non-foreclosure are expiring and there is uncertainty around a potential new stimulus. In the new normal, not all properties will be able to meet credit hurdles with nuanced shifts in lodging, retail, and office space.

    As we return to a more normal sales transaction volume, we anticipate a quicker realization of CMBS losses than in past recoveries. This should provide opportunities for attractive values that will permit transitioning of properties to more competitive stances involving updating and possibly a change in purpose, as seen in the proposals to convert some Midtown Manhattan office space into multifamily units. CMBS new issuance volume will be as steady or greater than 2020 as a greater availability of information on post-pandemic property and loan performance supports lending. We also see an opportunity for larger CRE CLO-type transactions in 2021 involving the transition of properties that will require short-dated financing. — David Salz, Director of Structured Finance Solutions at Moody’s Analytics