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    Managing a Credit Portfolio Through COVID-19

    As the world grapples with the tragic loss of human lives, and as scientists work toward understanding how to flatten the curve of COVID-19 spread, economists are struggling to measure its potentially profound impact on economic activity as markets attempt to find their footing. Financial institutions are grappling with the immediate cash and liquidity demands. For those that withstand the short-term impacts, the widening spreads are foreshadowing the medium- to long-term challenge: mounting credit losses. The first credit defaults have already occurred with Valeritas Holdings, a medical company, filing for Chapter 11 on February 10th, citing supply chain disruptions linked to the Coronavirus (COVID-19). They highlight unanticipated downstream impacts: weak credits felled by supply chain disruptions caused by Coronavirus. What does this mean for credit portfolios, and what are the implications for banks and their ability to navigate through these tumultuous times?

    Our experience through the great recession provides a partial sense for what to expect from first quarter earnings, which will be reported under CECL by some SEC filers in mid-April. The great recession provides an important benchmark in actual losses, but not in balance sheet reactions to changing loss expectations. At that time, banks reported allowance under the less reactive incurred model that is inherently backward looking. Adoption of CECL is intended to allow expected changes in the credit environment to immediately impact reserves, thereby increasing the ‘cushion’ for future credit losses. If the CECL model works as intended, many banks and other financial institutions will experience pronounced increases in allowance as forward-looking models that feed into CECL react to the expected credit environment deterioration. This will ultimately lead to reduction in earnings, prior to the manifestation of credit events.

    With this in mind, it is also important to consider the cross-sectional impact of COVID-19 outbreak. Consider impact on businesses that rely on physical proximity of their customers like hotels, restaurants and transportation segments, and impact of reduction in tourism and business travel with airline passenger travel ground to a halt. Supply chain disruptions are impacting operations, in particular those that rely heavily on China, Italy and now Spain and France. And, of course, luxury brands are taking a hit as consumers pull back on discretionary spending. Energy, and oil segments have been hit, with a drop in oil prices reinforced by Saudi Arabia’s move to further cut prices. These dynamics will naturally have negative reverberations in their relevant commercial real estate markets. But, performance is not all negative, with expectations of segments such as pharmaceuticals, food and beverage, and medical services are reasonably resilient to recent events.

    Recognizing the wide cross-sectional variation across credit market segments, banks and other credit market participants can experience wildly different earnings impacts in the coming quarters as COVID- 19 plays out. Banks must now incorporate their forward looking indicators into CECL models, and are incented to increase required rates on assets that attract a higher level of allowance under the CECL lifetime expected credit loss models. In some cases, they may pull out of deteriorating lending segments altogether.

    This is the first materially deteriorated credit environment since CECL adoption. While signs point to a pullback, Federal Reserve action and Federal and State stimulus will offset some of the impact; the speed at which banks react is yet to be seen. Importantly, CECL standard is principles based (as was incurred loss), and the ways in which economic forecasts translated into credit loss allowance under CECL will differ from firm to firm. But with organizations managing their portfolios to numbers the market ultimately judges them against – allowance, earnings, and their volatility – it is likely that banks will shy away from, or more aggressively price, deteriorated segments than in previous downturns. This is reassuring as it can ultimately contribute to a more stable financial system. After all, the CECL measures can be used to inform and improve lending standards. For organizations that actively monitor cross-sectional dynamics, and manage credit portfolio diversification, these measures can facilitate in steering their portfolios to minimize volatility in expected credit losses. Therefore, CECL adoption has the potential of mitigating a credit crisis seen during the great recession partially caused by continued investment in segments who’s credit has deteriorated.

    Market dislocations caused by COVID-19 will serve as the first real test of the CECL allowance model. Q1 and Q2 results from lending institutions will highlight the changing credit environment, largely driven by the COVID-19 impact on the economy. However, we still don’t know the extent to which CECL will impact lending, potentially resulting in a pullback in the short-run, and possibly accelerate entry of new players in the credit market down the road. There are also many levers that are being discussed now that need to be monitored more carefully by policymakers as the Q1 and Q2 numbers are released. Programs designed to bolster the functioning of credit markets in segments of greatest need — like those of the Small Business Administration and Federal Housing Finance Agency — will need to be reassessed and perhaps, reinforced as the market works through the transition.

    The Coronavirus (COVID-19) pandemic has disrupted society in ways that seemed unfathomable a few weeks ago. What short-term and long-term impact will it have on society and business? Past epidemics and disasters have often resulted in widespread, long-term, permanent changes in society. New technologies, such as the cloud, artificial intelligence (AI), automation, and robotics are all being used as part of the response to COVID-19 and to keep businesses going. Catalyzed by global disruption, these technologies, that were previously adopted sporadically, are likely to drive long-term technological changes in workplaces across industries and enable human workers to do better, higher quality tasks.

    We have been quicker to adopt cloud services in our personal and social lives than the business world, mostly because the data that companies use to run and grow their businesses is highly sensitive. It's taken a while for companies to transition from in-house data and systems management to cloud computing, but that too is changing—and expected to change even more rapidly due to COVID-19.

    Businesses have been forced to shut down offices across the globe and many office-based employees are working from home. Cloud-enabled businesses have rapidly transitioned to telework models with minimal disruptions so far. Technologies using mobile communication and videoconferencing are now being put to test, and being proven to work effectively (most of the time!).

    Past crises and tragedies have resulted in accelerated testing of “risky” novel technologies. In the days following 9/11, researchers from i-Robot, Carnegie Mellon, USF, and other robotics labs rapidly deployed their research ground robots for search and rescue efforts at the site. These ground robots, previously used for basic research, were able to traverse vast debris fields and venture into areas too dangerous for humans and dogs. In that crisis, they demonstrated indisputably that they weren't merely expensive research curiosities but viable autonomous systems capable of standing in for humans in dangerous situations.

    Robots have been used for search and rescue in the aftermath of many subsequent disasters, such as hurricanes, building collapses, even the 2011 nuclear plant meltdown at Fukushima.

    In the COVID-19 crisis, advanced experimental technologies are again being used in dangerous situations. The contagiousness of the virus makes human-to-human interactions very risky; this has cleared the way for robots and lots of other automated technologies to help out in many ways.
    Long standoff infrared scanners that measure a human’s temperature at a distance were previously used only experimentally; now they are being used in the field to assess patients’ conditions from far away. Experimental humanoid service robots are being used to disinfect rooms, communicate with isolated people, take vital information, and deliver medications.

    In Washington state, a robot helped doctors treat an infected patient and communicate with medical staff while limiting their own exposure to the illness. In China, robots are disinfecting patient rooms using ultraviolet light to kill viruses and bacteria, transporting food, and picking up litter from patients. Self-driving vehicles are delivering supplies to medical workers in Wuhan and making retail deliveries on e-commerce orders, while drones are being used to patrol public places, spray disinfectant, and conduct thermal imaging.

    Artificial intelligence is being used to track and predict the spread of Coronavirus, helping spot COVID-19 faster than humans from CT scans, and search for possible treatments using AI-powered drug discovery platforms. AI solutions are being aggressively deployed by e-commerce firms to predict demand and improve supply, even as global supply chains falter. Organizations are also using AI to ensure business continuity as more workers telework, leveraging and expanding automation solutions that allow machines and humans to work together.

    The initial successes of advanced technologies such as robotics and AI will spur their adoption and acceptance going forward. One can envision a future where teleconferencing is used more widely, in favor of reduced business travel; autonomous vehicles and drones gain the trust of a wider swath of society; and robots are used for manually repetitive or dangerous tasks at work and at home. Online learning may become more prevalent after educational institutions conduct e-learning on a massive scale during this crisis, and AI will make global supply chains more resilient even as human-machine collaborative systems ease the burden on human workers. Most importantly, technology can improve the safety and quality of life for human workers, and thereby enable us to improve productivity and utilize our full potential.

    The coronavirus outbreak is one of many environmental, social, and health crises businesses and people will face in the coming decades. Adopting AI-enabled automation, robotics, and other cutting-edge technologies will help us be more prepared to overcome them.

    Like everyone else, I’ve been cycling through the five stages of grief these past few weeks, saddened by the human tragedy unfolding across the world and the loss of a way of life that already seems like a distant memory.

    Every crisis is different and this one is certainly unprecedented in post-war history, given its geographic breadth. And yet I can’t help but compare it to the 9/11 attacks.

    I was living in Washington DC, having graduated from school just nine months prior. I learned of the news while at work as chaos broke out. Parents rushed to their cars to retrieve their children from schools and daycare centers, only to be stuck in a massive traffic jam. I sprinted back to my apartment while jets scrambled overhead. Every delivery truck that passed was suspicious as rumors of a dirty bomb spread.

    I spent the next three days cooped up in my apartment, watching the news nonstop and preparing for the next wave of attacks that thankfully never came. Like today, the lack of information in that moment led to speculation and panic. Unlike today, that threat subsided relatively quickly, even if it took months for me to get back on an airplane and for life to get back to normal, albeit a new normal.

    Today, we see the threat coming days in advance just by examining the epidemiological curves. But there is nowhere to run to, nowhere to hide. The best course of action is to sit in isolation, breathe deeply, and try to remain calm. The best we can hope for is that no other major outbreaks occur. By isolating ourselves and taking preventative measures today, we minimize the number of future infections. The challenge is the silence of the infection’s spread—the lag of just a few days between infection and symptoms is enough for one person to spread the disease to potentially hundreds of others.

    In this sense, the work of our public health officials is much like the work of risk managers in the finance or insurance industries. We too operate with a lag, though it is often months or years between the time we make an underwriting decision and observe the outcome. Through our actions, the outcome we hope for is that nothing happens. Bills are paid. No one loses a job. Life moves on.

    No one throws a party for losses avoided or crises averted. In the best-case scenario, our managers might turn to us and say, “See I told you nothing would happen. You made me buy all that insurance and upgrade all my models and systems for nothing!” Such is the paradox of risk.

    To be successful, and perhaps to stay sane, risk managers need to cultivate a sense of internal satisfaction and validation. Just think of the countless lives that epidemiologists and other public officials have saved through targeted vaccinations and disease control efforts. They are truly our unsung heroes.

    Maybe Superman is really out there in space smashing up asteroids before they impact the Earth and wipe out all life. But we just know him as quiet unassuming Clark Kent. Is Dr. Fauci all that different?

    Now maybe you aren’t involved in public health risk management where people’s lives are directly on the line. Maybe you just manage the credit risk of mortgages, auto loans, or small business loans. Sure, your decisions help your institution avoid financial losses. But that’s small potatoes, right?

    Don’t sell yourself short. Those decisions can have enormous consequences on the financial health of individuals and their families. It can mean the difference between someone growing up in a stable home or being able to go to work or to employ others in a small business. Even your loan denials may make the difference between someone taking on too much debt and someone who is able to achieve economic security.

    Your skills and talents are going to be needed more than ever after the Coronavirus (COVID-19) pandemic subsides. We will be looking to not only put the economy back together, but to create an economy that is more resilient, more vigilant, and better adapted to the future challenges we will face. And make no mistake: there will be future challenges.

    Perhaps even more importantly than our day-to-day work, the principles of risk management can help everyone live happier, more productive, and more serene lives. As a life philosophy, risk management helps us to prioritize, plan for the future, and control our anxieties.

    It’s important to recognize that risk management does not mean risk avoidance. Bad things will still happen. The difference is how we react to the situations that are presented. Will we remain calm and collected, as we take the playbook we’ve written for such occasions off the shelf? Or will we panic and allow our emotions to drive us to make precisely the wrong decisions at precisely the wrong time?

    If you need any evidence that most of our friends and neighbors are not following risk management principles, simply look to the recent run on toilet paper in the face of a pandemic. Who knew so many households were operating under a “just in time” framework? More importantly, not only were these excessive paper purchases futile, they may have inadvertently contributed to the spread of the virus as thousands of people rushed to their local retailers. Again, the wrong decision at the wrong time.

    As risk management practitioners, our greatest societal contribution may be to simply talk to our families, friends and neighbors about risk. Perhaps we should start with the foundational principles of risk management: identify, measure, mitigate, prioritize.

    The first step in any successful risk management project is to identify the potential risks. While none of us identified COVID-19 as a potential threat back in 2019, we should have been aware of our current health status and the risk that we could contract an illness at any time. We should all be taking stock of our financial health regularly and recognizing the chance of being laid off or losing the value of our wealth.

    After identifying the risks, the next step is measurement. What is the likelihood of the various risks we face? What’s the severity of a shock if we are unfortunate enough to experience it? Can we quantify—even in rough terms—a range of probabilities and severities?

    Finally, there are the mitigation and prioritization steps. What actions can I take today to prepare for these possible outcomes? Of course, mitigation comes at a cost so the size of our mitigation steps should be proportionate to the risk.

    This is perhaps where many of us fall short if, we don’t apply some discipline to our analysis. We may assign too much weight to a high-severity but low-probability outcome, and not enough weight to a much more likely risk. No, we didn’t see COVID-19 coming but some disruption due to illness or job loss is not uncommon. How much better off would we all be confronting the pandemic if we had at least three months’ worth of living expenses saved up?

    Unfortunately, according to the Federal Reserve only about 40% of US families have liquid savings equivalent to at least three months of expenses. Less than 30% of families have liquid savings equivalent to at least six months of expenses.

    Obviously, we are living in a time of crisis and we need to take swift, direct actions now to protect public health and save our families and businesses with financial support. The latest Moody’s Analytics baseline economic scenario released March 27 calls for an unprecedented collapse in output and a sharp spike in unemployment in the months ahead (see charts). If we don’t act immediately, then these principles will be of limited value in the devastating aftermath of an economic depression.

    We must do whatever it takes.

    Simultaneously, we must start preparing for future risks just as we are dealing with the current situation. Spreading the gospel of risk management will help us to better confront whatever the future has in store for us individually and as a global community.