Prepare for Recession, Plan for Growth

Recession Ready, Commercial Credit, Small Business Credit, Enterprise Risk Management

As one of the world’s original Renaissance men, Founding Father Benjamin Franklin cultivated an interest in and talent for a multitude of pursuits—in politics, diplomacy, science, writing, innovation, to name a few. As he experienced numerous—and notable—successes and failures across these fields, he identified a critical element of success that was no doubt applicable to all his endeavors: “By failing to prepare, you are preparing to fail,” he wrote. 

His words hold resounding significance for commercial lenders today, who are all too aware that we are coming down from a boom year in 2018. As growth has slowed in 2019, lenders with a vivid memory of the Great Recession are increasingly on the lookout for the next one. This article will not debate how worried we should be about a recession; it is a question of when it will arrive, rather than if it will arrive. “Historically, the best that forecasters have been able to do consistently is recognize that we’re in a recession once we’re in one,” George Washington University economist Tara Sinclair commented in The New York Times. The best that lenders can do is heed Benjamin Franklin’s advice and prepare for that day to come by packing their recession readiness kits with tools such as forward-looking risk ratings, alternative lending data, and automation. Otherwise, they may find themselves out in the cold scrambling for firewood.

From Blaze to Ember

To be sure, economic conditions have not quite gotten to “sound the alarm” stage yet. GDP exceeded economists’ expectations and rose 2.1% in the second quarter, continuing the streak of the record-long economic expansion. Growth was driven almost entirely by strong consumer spending and a surge in government spending, while business investment decreased for the first time in three years. Most measures of Main Street sentiment remain elevated, including the Conference Board Consumer Confidence Index (which rebounded strongly in July), the NFIB Small Business Optimism Index (which ticked down due to rising business uncertainty but remains near all-time highs), and the PayNet Small Business Lending Index (SBLI). However, the manufacturing sector has weakened, and the slowing global economy is likely to keep the pressure on U.S. exporters. Moreover, U.S. farmers continue to battle headwinds caused by trade disputes, and PayNet data indicate that agricultural lending declined at the fastest monthly rate in nearly three years in June. Overall, Main Street appears to be in good shape for the remainder of 2019, but small business lending activity may well have peaked earlier in the year.

Originations Slowing

The latest quarterly data shows small business lending rising once more. As illustrated in Figure 1, small business lending rose again in Q2 versus the prior quarter. Growth thus far in 2019 was driven by the large and surprising jump in April, and this year appears to be following a similar pattern to 2017 and 2012. In each of those years, Main Street businesses pulled back on borrowing and investing after strong growth in the prior year. If this pattern holds, we can say with some amount of confidence that 2019 marks a pause to digest the heavy investments that were made in 2018. This pause remains the most likely explanation given the still low credit risk.

Figure 1

The PayNet SBLI fell nearly 23 points (14.5%) to 135.0 in June — its sharpest monthly decline on record and lowest point since December — and is now 6.8% below year-ago levels. The SBLI 3-month moving average fell 1.1% compared to last month but remains positive on a year-over-year basis.

Figure 2

In June, lending decreased from the prior month’s levels in each of the ten largest states, with the most pronounced dips affecting Illinois (-1.4% M/M) and Ohio (-1.3% M/M). SBLI levels in each state nevertheless remain at or near the top quarter of historical readings. However, compared to 12 months ago, eight of the largest ten states saw lending expand, led by Pennsylvania (+9.4%). It is worth noting that six of the ten largest states have experienced at least 18 consecutive months of annual lending growth.

All private-sector industries saw lending shrink on a monthly basis in June. Mining, Quarrying, and Oil and Gas Extraction (-6.1% M/M) experienced its largest month-on-month decline in a decade, while Manufacturing (-1.9% M/M) saw lending hit its lowest level in more than four years. On an annual basis, most industry lending activity fell, including double-digit declines in Accommodation and Food Services (-13.1% Y/Y), which experienced its sixteenth consecutive month of year-over-year declines, and Public Administration (-10.7% Y/Y).

Delinquencies Steadily Climbing

The PayNet Small Business Delinquency Index (SBDI) 31–90 Days Past Due increased 3 basis points in June to 1.55%, its highest point since early 2012. It is now up 14 basis points from a year ago. The SBDI 91–180 Days Past Due was unchanged in June but is up 2 basis points on a year-over-year basis.

Figure 3

Half of the ten largest states experienced delinquency growth in June, including Illinois (+8bp M/M), for which delinquencies rose for the eighth consecutive month and reached their highest point since 2012. Georgia (-9bp M/M) and Florida (-10 bp M/M), on the other hand, each saw sizable delinquency declines. On a year-over-year basis, most large states had increased delinquencies, though SBDI readings are generally below historical medians. Regarding defaults, most large states experienced higher default rates compared to last year, led by Georgia (+75bp Y/Y) and North Carolina (+30bp Y/Y).

Delinquencies went up on a monthly basis in most major industries in June, including Transportation (+13 bp M/M) and Construction (+3bp M/M), which each reached new multi-year highs. Delinquencies also rose on an annual basis across major industries, led once again by increases in Transportation (+64 bp Y/Y). Notably, Construction has now experienced 43 consecutive months of year-over-year delinquency growth. Regarding defaults, nearly every industry experienced higher annual default rates, with notable increases in Construction (+29bp Y/Y) and Retail (+27bp Y/Y).

Where Is Risk Going?

Even as Main Street continues to be an area of relative strength in the U.S. economy, financial stress is slowly and steadily building. ADP and Moody’s estimated that small businesses shed jobs on net in June, while the NFIB Small Business Jobs Report continues to show that small business owners are having a hard time finding qualified employees. These difficulties help to drive wages higher, as seen in the Paychex | IHS Markit Small Business Employment Watch, which showed hourly earnings growth for small businesses reach a 1.5-year high in July. While wage gains are clearly a positive development for employees, they also add financial pressure on small businesses. Small businesses’ financial footing remains relatively strong overall and should remain healthy in the near term given current levels of consumer spending, and the Fed’s recent decision to cut rates may also alleviate some of the financial pressure felt by Main Street businesses.

The slow, almost imperceptible, monthly increases in loan delinquencies remain below the long-term average for small business loans. These below average loan delinquencies have generated below average business defaults, as we see in Table 1.

Table 1

However, the rising delinquencies combined with rising interest rates and higher GDP translate into elevated default forecasts of 2.1% in 2019 and 2.4% in 2020. Note these forecasts have decreased from 2.2% and 2.5%, which were our forecasted rates at the end of 2018.

As with the last recession, a slowing economy will mean a more challenging environment for small business survival. The key is to find the low point in the slowdown so businesses can be prepared. PayNet has run various scenarios using the PayNet AbsolutePD® Stress Test Simulator (Table 2), which shows business defaults rising from 2.6% to as high as 3.1% in the next business cycle. The stress test shows construction, retail, and transportation would be affected the most.

Table 2

Armed with this data, banks should embark on preparations now—before these scenarios become reality rather than projections. Costs will go up along with stress, and efficiency will be the name of the game.

Your Recession Readiness Kit

As a result of the financial crisis in 2008, large banks substantially pulled back from lending, and small and medium-sized banks as well as fintechs were unable to entirely fill the credit gap. This resulted in fewer loans to private businesses— in fact, the national average for bank originations was down 24 percent while local GDP was up 20 percent since 2008. 

This time, we will look to the past as well as the future in order to survive the next recession. History will be our guide of what to do—and not to do—and we now have access to critical data and technologies that should be part of your recession survival kit:

  1. Forward-Looking Risk Ratings

Commercial lenders must ensure they are ready for a slowdown by using risk ratings that project probabilities of default over the next several years. Typical risk ratings are backward-looking, which result from pool-based analyses that require at least 18 months of seasoning before providing conclusive direction on defaults. Risk ratings based on credit scores suffer from the same backward-looking problem. Historical default rates from the credit score development sample are typically years old, and they miss the current macroeconomic conditions, thus compounding the backward-looking problem. Historical defaults from credit scoring models are commonly mistaken for “probabilities of default” when in fact they are the default rates that existed when the model development sample was created. This assumption generally causes lenders to over-lend in the recession and under-lend in recovery periods, as their risk ratings lag the current economy by at least 18 months.

  1. Stress Test Your Portfolio

An advantage to point to from the Dodd-Frank laws is the use of new tools to understand credit risk. While stress testing requirements have been rolled back as a regulatory requirement, they can be particularly effective as a tool to provide measurable views of credit risk through economic cycles. Various methods to stress test can be used from expert “rule of thumb” to empirical systems. Rule of thumb uses a broadly accurate guide or principle, based on experience or practice. Empirical systems use data and historical relationships to arrive at estimates of future risk. The 16 Federal Reserve System (FRS) macroeconomic variables remain a dependable way to apply recession scenarios to your portfolio. Creating scenarios that are appropriate to your geographic location and the economic make-up of the local economies in which you operate remain the recommended approach. Estimates of defaults under both FRS adverse, baseline and user defined scenarios for each of the nine quarter forecast periods prescribed by the regulatory agencies are best suited to provide valuable insights to the risk of your commercial portfolio under stressed conditions.

  1. Automation

Time is a lender’s most valuable asset—and manual processes can take up far too much of it. Automation is an essential addition to the lending process which can transform turnaround time from weeks of work into days. Automation enables an organization to use a digital-lending portal to gather applicable demographics to identify prospective borrowers. Rather than having to wait until later in the process to uncover this critical information, they can immediately identify whether to pursue this lead and quickly move on. They then use a credit-decision engine to gather and analyze the applicable borrower data. The lender can use this tool to determine terms and conditions, credit structure, purpose of credit facility, pricing, relationship models and cross-sell strategies. Finally, the organization’s credit policy and process integrate with its credit-decision engine to enable an automated review of a loan application, including compliance checks, terms and conditions and credit structure. Since the data gathering and analysis has already taken place and automatically factored into the decision, there is no need to review all those pieces, as would be required with a manual process. Not only can the organization grow in a shortened time period; it can do so without adding any risk. If a recession does hit, automation will enable your bank to ride out the storm. The lower costs afforded by automation may be the difference to help your bank remain independent after the next downturn.

Prepare for the Inevitable

There’s no question a recession is coming. While no one can predict when it will arrive, we can predict the likely fate of businesses that have not prepared for it. Now is the time for commercial lenders to be proactive and invest in the resources and technologies that will bolster them against the potential effects of a recession. As Benjamin Franklin put it, “You may delay, but time will not.”

By taking the time to prepare and pack their readiness kits ahead of a recession, lenders can better focus their energies during a recession not merely on staying alive but on growing their relationships and—by extension—their organizations and communities. When Main Street thrives, we all thrive. It’s just a matter of ensuring we have the tools needed to get us through the winter and beyond.

A version of this article appeared in the October 2019 issue of The RMA Journal and can be found here.