How Falling Consumer Discretionary Spending Impacts Bank C&I Books

Historically, when economies contract and weaken, consumers often earn less and limit their spending on essential products and services. These include rent or mortgage payments, groceries, household bills, transport and medical costs, to name a few. For example, during the 2007-09 financial recession, consumer spending experienced its most severe decline since World War II.

From conversations with our customers, as well as the experience of our own sizeable commercial and industrial loan book at OakNorth Bank in the UK, we know that many boards and regulators are trying to figure out how falling consumer discretionary spending may impact bank C&I books, and what can be done to mitigate this risk.

Consumer spending on entertainment, dining out, holidays, and luxury items means many businesses within more discretionary spending sectors, such as hotels, restaurants, bars and retail may be more vulnerable to economic downturns. However, it’s essential that commercial banks don’t make broad-brush assumptions about entire sectors. During economic downturns, consumer preferences can change. Some may opt for lower-cost alternatives, generic brands or items that offer better value for their money, negatively impacting the sales of premium or luxury retail, but positively impacting budget and low-cost retail. The same logic can be applied to other areas of discretionary spending: consumers may opt for a low-cost staycation such as camping or cycling, or a package holiday rather than flying abroad or staying in a hotel.

It’s important to note that the impact on consumer discretionary spending can also vary depending on the specific circumstances of each downturn. Government policies, shifts in consumer behavior and the overall structure of the economy play significant roles in shaping these trends. For instance, the Covid-19 pandemic led to a unique situation where some segments of consumer discretionary spending, such as travel and hospitality, were severely impacted due to lockdowns and travel restrictions. In contrast, others such as e-commerce and home entertainment saw increases as people shifted their spending patterns. These shifts in consumer behavior seen throughout the pandemic provide clear evidence of the need for a borrower-level understanding of risk.

Managing the risk in a C&I book during an economic downturn, especially when borrowers are vulnerable to decreases in consumer discretionary spending, requires a proactive and strategic approach. To mitigate these challenges, commercial lenders can look to take the following measures:

• Assessment of borrower viability. Conduct a thorough assessment of borrowers’ financial health and ability to weather economic challenges. This should include reviewing borrowers’ financial statements, cash flow projections and other relevant information to gauge their resilience to decreased consumer discretionary spending.
• Strengthen underwriting standards. Strengthening underwriting standards to ensure new loans are granted only to borrowers with solid creditworthiness and the ability to withstand economic pressures will improve the performance of a lender’s C&I loan book in a downturn.
• Stress testing. Lenders can perform stress tests on their C&I loan portfolios to assess and model the potential impact of various economic scenarios, including significant decreases in consumer discretionary spending. Furthermore, they can analyze how different economic conditions could affect borrowers’ repayment capabilities and the overall health of their loan book.
• Regular monitoring. Proactive monitoring and setting early warning indicators, can help commercial banks identify risk sooner, and take the necessary steps to mitigate it.