The Return of the Credit Cycle

It has been like waiting for the second shoe to fall.

The first shoe was the Covid-19 pandemic, which forced the U.S. economy into lockdown mode in March 2020. Many banks prepared for an expected credit apocalypse by setting up big reserves for future loan losses — and those anticipated losses were the second shoe. Sure enough, the economy shrank 31.4% in the second quarter of 2020 as the lockdown took hold, but the expected loan losses never materialized. The economy quickly rebounded the following quarter – growing an astonishing 38% — and the feared economic apocalypse never occurred.

In fact, two and a half years later, that second shoe still hasn’t dropped. To this day, the industry’s credit performance since the beginning of the pandemic has been uncommonly good. According to data from S&P Global Market Intelligence, net charge-offs (which is the difference between gross charge-offs and any subsequent recoveries) for the entire industry were an average of 23 basis points for 2021. Through the first six months of 2022, net charge-offs were just 10 basis points.

Surprisingly, the industry’s credit quality has remained strong even though U.S. economic growth was slightly negative in the first and second quarters of 2022. The Bureau of Economic Analysis, which tracks changes in the country’s gross domestic product, had yet to release a preliminary third quarter number when this article published. However, using its own proprietary model, the Federal Reserve Bank of Atlanta estimated in early October that U.S. GDP in the third quarter would come in at 2.9%.

This would suggest that the industry’s strong credit performance will continue for the foreseeable future. But an increasing number of economists are anticipating that the U.S. economy will enter a recession in 2023 as a series of aggressive rate increases this year by the Federal Reserve to lower inflation will eventually lead to an economic downturn. And this could render a significant change in the industry’s credit outlook, leading to what many analysts refer to as a “normalization of credit.”

So why has bank loan quality remained so good for so long, despite a bumpy economy in 2022? And when it finally comes, what would the normalization of credit look like?

Answering the first question is easy. The federal government responded to the pandemic with two major stimulus programs – the $2.2 trillion CARES Act during President Donald Trump’s administration, which included the Paycheck Protection Program, and the $1.9 trillion American Rescue Plan Act during President Joe Biden’s administration — both which pumped a massive amount of liquidity into the U.S. economy.

At the same time, the Federal Reserve’s Federal Open Market Committee cut the federal funds rate from 1.58% in February 2020 to 0.05% in April, and also launched its quantitative easing policy, which injected even more liquidity into the economy through an enormous bond buying program. Combined, these measures left both households and businesses in excellent shape when the U.S. economy rebounded strongly in the third quarter of 2020.

“You had on one hand, just a spectacularly strong policy response that flooded the economy with money,” says R. Scott Siefers, a managing director and senior research analyst at the investment bank Piper Sandler & Co. “But No. 2, the economy really evolved very quickly on its own, such that businesses and individuals were able to adapt and change to circumstances [with the pandemic] very quickly. When you combine those two factors together, not only did we not see the kind of losses that one might expect when you take the economy offline for some period of time, we actually created these massive cushions of savings and liquidity for both individuals and businesses.”

The second question — what would a normalized credit environment look like? — is harder to answer. Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities, says the bank’s economists are forecasting that the U.S. economy will enter a relatively mild recession in 2023 from the cumulative effects of four rate increases by the Federal Reserve — including three successive hikes of 75 basis points each, bringing the target rate in September to 3.25%. The federal funds rate could hit 4.4% by year-end if inflation remains high, and 4.6% by the end of 2023, based on internal projections by the Federal Reserve.

“There’s obviously a lot of debate around the [likelihood of a] recession today, but generally our view is that we will gradually start seeing [a] normalization and higher credit losses next year, even if it were not for an outright recession,” Poonawala says. While a normalized loss rate would vary from bank to bank depending on the composition of its loan portfolio, Poonawala says a reasonable expectation for the industry’s annualized net charge-off rate would be somewhere between 40 and 50 basis points.

That would be in line with the six-year period from 2014 through 2020, when annual net charge-offs for the industry never rose above 49 basis points. And while loan quality has been exceptional coming out of the pandemic, that six-year stretch was also remarkably good — and remarkably stable. And it’s no coincidence that it coincides with a period when interest rates were at historically low levels. For example, the federal funds rate in January 2014 was just 7 basis points, according to the Federal Reserve Bank of St. Louis’ FRED online database. The rate would eventually peak at 2.4% in July 2019 before dropping back to 1.55% in December of that year when the Federal Reserve began cutting rates to juice a sagging economy. And yet by historical standards, a federal funds rate of even 2.4% is low.

Did this sustained low interest rate environment help keep loan losses low during that six-year run? Siefers believes so. “I don’t think there’s any question that cheap borrowing costs were, and have been, a major factor,” he says.

If interest rates do approach 4.6% in 2023 — which would raise the debt service costs for many commercial borrowers — and if the economy does tip into a mild recession, the industry’s loan losses could well exceed the recent high point of 49 basis points.

“There is a case to be made that a recession could look a bit more like the 2001-02 [downturn] in the aftermath of the dot-com bubble [bursting],” says Poonawala. “You saw losses, but it was an earnings hit for the banks. It wasn’t a capital event.”

That recession lasted just eight months and the decline in GDP from peak to trough was just 0.3%, according to the National Bureau of Economic Research. The industry’s net charge-off ratio rose to an average of 107 basis points in 2002 before dropping to 86 basis points in 2003, 59 basis points in 2004 and bottoming out at 39 basis points in 2006.

This same cyclical pattern repeated itself in 2008 — the first year of the financial crisis – when the average net charge-off rate was 1.30%. The rate would peak at 2.67% in 2010 before declining to 68 basis points in 2013 as the economy gradually recovered.

When we talk about the normalization of credit, what we’re really talking about is the return of the normal credit cycle, where loan losses rise and fall with the cyclical contraction and expansion of the economy. Banks have experienced something akin to a credit nirvana since 2014, but it looks like the credit cycle will reappear in 2023 — aided and abetted by higher interest rates and an economic downturn.

Strengthening Relationships With Credit Score Monitoring

Customers want to improve their financial wellbeing and save money. Banks want to create sticky digital relationships.

Here’s something that can help both groups: credit monitoring.

Having a safe and easy way to keep an eye on their credit enhances consumer financial wellbeing in a variety of ways:

  • Makes it easier to find and stop fraud. According to the Federal Trade Commission, American consumers lost more than $5.8 billion to fraud in 2021, which was a 70% increase over 2020. When customers have a safe, convenient way to monitor their credit, they’re more likely to uncover and recover from fraud more quickly.
  • Helps uncover and correct credit report mistakes. Credit report errors are much more common than many people realize. According to a 2021 Consumer Report investigation, more than a third of consumers who participated in a voluntary credit report check found errors. And these errors are more than a nuisance. Negative impacts can include being uncorrectly charged higher interest rates on a loan or credit card or being turned down for a job or a place to live. 
  • Can improve credit scores and consumer financial wellbeing. Based on internal research SavvyMoney has conducted with partner financial institutions, we’ve found that consumers who monitor their credit data see strong improvements in their credit scores. Across all score ranges (except the 750 to 850 range), there was a 30% improvement in six months and a 39% improvement in 12 months. In the 300 to 649 score range, the improvements were even more dramatic: 32% in six months and 41% in 12 months.

Score improvement can mean significant savings for bank customers. Most importantly, consumers who improve their score can see a stark difference in interest costs on their loans. According to a study from LendingTree, borrowers with “fair” credit scores, which range between 580 and 669, could end up paying over twice as much interest on personal, auto and student loans, and 97% more on their credit cards.

Most consumers don’t currently monitor their credit. But that could change if they monitor it through your institution. Because credit monitoring is a soft pull, customers can check their credit data as often as they want without any impact to their credit score. That can help them get a better handle on their current financial health and areas where they could improve. And banks can add in personalized education and loan offers based on their score, creating a virtuous cycle of better credit, better lending rates and improved overall financial wellbeing.

Unfortunately, most people don’t monitor their credit. According to LendingTree’s annual customer survey, only a third of American consumers take that step. A big reason why: Consumers are understandably reluctant to provide their personal information.

This is where giving customers access to credit monitoring helps your financial institution too.

Consumers’ reluctance aligns with a key finding from SavvyMoney’s financial institution partners: 75% of users want to be able to check their credit score from inside their trusted financial institution. If their credit data is available through a single sign-on through your financial institution’s online or digital banking, they won’t have to.

Use a credit monitoring service that updates credit files more frequently — the best offer the option of daily updates — allows customers to track if they’ve moved into a new range and be alerted when their most up-to-date score qualifies them for lower rates.

Look for companies with solutions that integrate with your digital banking platform. That allows your customers to safely and easily monitor their credit score right from your online or mobile banking, driving engagement with your website or app. As the chart below captures, that additional engagement can drive an uptick in a wide variety of products and services, including checking penetration, which is often seen as a proxy for primary financial institution status.

Source: SavvyMoney partner case study

Credit monitoring is good for both your customers and your bank. If your financial institution isn’t currently making it easy for customers to check their credit with you, it’s a service worth investigating.

Rethinking the FICO Score


FICO-6-20-18.pngFor decades, pre-dating many banking careers today, the tried and true method to evaluate credit applications from individual consumers was their FICO score. More than 10 billion credit scores were purchased in 2013 alone, a clear indicator of how important they are to lenders. But is it time for the banking industry to reconsider its use of this metric?

The FICO score, produced by Fair Isaac Corp. using information from the three major credit bureaus—Equifax, TransUnion and Experian—has been considered the gold standard for evaluating consumer credit worthiness. It focuses squarely on the concentration of credit, payment history and the timeliness of those payments. FICO scores have generally proven to be a reliable indicator for banks and other lenders, but in an age operating at light speed, in which many purchases can be made in seconds, a score that can fluctuate in a matter of days might be heading toward obsolescence.

Some believe a person’s credit score should be considered only in parity with other, more current indicators of consumer behavior. A study released in April by the National Bureau of Economic Research says even whether people choose an Apple or Samsung phone “is equivalent to the difference in default rates between a median FICO score and the 80th percentile of the FICO score.”

Consider the following example. A consumer pays off an auto loan, resulting in a reduction in their FICO score. This is largely due to the reduced amount of credit extended. That reduced score could become a deciding factor if the customer has applied for, but not yet closed, a mortgage 60 or so days before paying off the vehicle and could affect the interest rate of the applicant.

That leaves a bitter taste for anyone with average or above average credit who has demonstrated financial responsibility and, it could be reasonably argued, would be a much better candidate for credit extension than someone with the same score who doesn’t give two flips about the regular ebbs and flows in their credit.

For all its inherent benefits to the industry, the traditional credit score isn’t perfect. Banks could be using their own troves of customer data to evaluate their credit applications more accurately, more fairly or more often. This could be a boon for institutions hoping to grow their deposit base or enhance their loan portfolios. Some regulators have indicated their attention to this approach as well. The Federal Deposit Insurance Corp.’s Winter 2017 Supervisory Insights suggests data could be a helpful indicator of risk and encouraged member institutions to be more “forward-thinking” in their credit risk management.

“As new risks emerge, an effective credit [management information system] program is sufficiently flexible to expand or develop new reporting to assess the effect those risks may have on the institution’s operations,” the agency said.

That suggests the FICO score banks are currently using might not tell the full story about how responsible credit applicants might be.

“My personal opinion is that among most people, if you have someone who thinks about [their digital footprint and credit], you’re already talking about people who are financially quite sophisticated,” Tobias Berg, the lead author of the NBER study and an associate professor at Frankfurt School of Finance & Management, told Wired Magazine recently. The study examined a number of data points that go far beyond what is incorporated in a FICO score.

That certainly has value for banks. The data they already collect about their customers could be used to determine credit worthiness, but there’s a counter argument to be made. Digital footprints are much easier to manipulate more quickly over time by changing usernames, search history, devices and the like. Using an Android over a more expensive iPhone could be a negative in the study’s findings, for example, which might not reflect the customer’s true credit profile.

But FICO scores are not reviewed as regularly as they could be, and a swing of a couple dozen points from one moment to another can significantly sway some credit applications.

For now, fully abandoning the FICO score isn’t a likely or manageable option for banks, nor one that’s favored by regulators, but the inclusion of digital data in credit applications is something that could be adapted and be beneficial to both the bank and customers eager to expand that relationship with their institution.

Giving Small Business Borrowers ’True’ Credit


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Small business owners and entrepreneurs are the engine that fuel the global economy. Lending to small businesses has been the heartbeat of the over 5,500 community banks, and it’s also how many of the nations largest banks have prospered.

Yet the market for these loans has become commoditized—or as highly accomplished venture capitalist Marc Andreessen has said, have been “eaten by software.”Why? Because banks still treat small businesses and entrepreneurs like they are individuals applying for a personal loan and not a commercial entity with real economic value.

The problem is the current business data and credit scoring infrastructure that most banks use to underwrite loans was not made for the entrepreneur. It was made for the consumer and does not acknowledge the value of the actual business itself to the entrepreneur.

When entrepreneurs go to a bank for a loan, they are always asked two questions.

What is their credit score?

What is their current income or salary?

Simple credit scoring and current income verification is not enough as it does not fully value the entrepreneur and the businesses’ capacity.

Seventy percent of a business owner’s net worth is tied up in their business, but few banks look at anything beyond the value of the real estate, their credit score and their current income. Sixty-seven percent of all private companies are funded at levels that are actually less than they should be because the value of the underlying business has historically been overlooked.

This traditional approach to small business lending is out of date. Today, because of technology and an infinite amount of data, business owners can plug in information about their company and match it against similar businesses to find out what their business is worth, and then leverage that data for loans, insurance coverage or other financial planning matters. Banks like Univest Corp., insurance companies like Penn Mutual and credit bureaus like Equifax and Experian are starting to use and offer online databases to measure a business’ value not just for loans, but for financial planning and risk scoring.

If you are bank, take advantage of new advancements in big data and apply them to your actual core business. Focus your efforts on what used to be your bread-and-butter customer—the small business owner. But be aware that today’s entrepreneurs know that the lending process has now become democratized and they are only a browser away from a better deal. Change the game. Go further. Inspire the next great wave in lending by giving entrepreneurs and small business owners true credit.