How to Protect Against the Downside, Prepare for the Upside

“If you’re left in a situation where you’re defending, where you’re shrinking your balance sheet, where you’re worried about your capital, where you’re continually cajoling shareholders, or clients to stick with you — you’re not focused on growing.”

Those are wise words from William Demchak, chief executive officer of PNC Financial Services Group. PNC is one of the largest banks in the U.S. and an OakNorth customer.

He said this in an interview with the Financial Times in May 2020 — a couple of months after the country had gone into lockdown under full force of the coronavirus pandemic. At the time, he was discussing PNC’s rationale for selling its stake in asset manager BlackRock, which was prompted in part by increasing concerns about the U.S. economy as a result of the Covid-19 pandemic.

But fast forward the clock two and a half years, and he could just as easily be speaking about the economic situation in the U.S. today. Increasing economic uncertainty and interest rates at their highest point since 2008, many commercial bankers are focused on protecting their downside risk. As a result, many are likely missing the upside opportunity.

Protecting Against Downside Risk

1. Granular data. Most banks tend to lump their borrowers into one of a dozen or so broad sectors: all restaurants, bars, hotels, golf clubs and spas, for example, will be classified as “hospitality and leisure.” This classification approach misses the fundamental differences between how these businesses operate and how their capital and operational expenditures may be impacted by changes in the economy. In order to quickly identify where the most vulnerable credits lie in their portfolio, banks need to get to much more granular industry view — even going as far down as 6-digit NAICS codes — in their analysis.

2. Forward-looking scenario analysis. Banks need to be able to run multiple macroeconomic scenarios on their loan book using forward-looking scenarios to explore how a borrower would perform at different financial and credit metric level. This gives them the ability to plan ahead for market changes such as rate rises and house price fluctuation by formulating targeted risk mitigation strategies that can reduce defaults and charge-offs and better manage capital requirements.

3. Proactive monitoring. Banks need to be able to identify potential credit issues faster and earlier, so they can take proactive steps to reduce the chances of negative outcomes during a downturn.

Effectively Navigating Upside Opportunities

1. Granular data. in an economic downturn, there are always winners and losers that emerge; more often than not, it’s specific businesses or sub-sectors rather than entire industries. As consumer confidence wanes and inflation tightens purse strings, it’s likely that budget retailers and discount stores will see increased demand while their high-end alternatives experience the opposite. Both are classified as “retail” but will have dramatically different experiences in an economic downturn. Banks need the right data and tools to identify businesses that may need additional capital to make it through the economic cycle from the businesses that need additional investment capital to pursue potential growth opportunities arising in it.

2. Forward-looking scenario analysis. Banks need to be able to create configurable scenarios that reflect their internal economic outlook by adjusting macroeconomic variables, such as interest rates and inflation, among others. This means they can make more informed decisions about high risk, high opportunity industries and borrowers in their loan book and adjust their activities accordingly.

3. Proactive monitoring. In times of turmoil, most banks tend to segment their portfolio from highest to lowest exposure, starting with their largest and working their way down. Not only is this approach incredibly time consuming, it also means a lot of team time is spent running analysis on credits that don’t end up presenting a credit issue. Banks need to be able to segment credits on a high to low risk spectrum within a matter of hours, so they can identify the credits that require intensive versus light touch reviews, freeing up resources to pursue new loan origination.