a challenge for credit risk managers

In addition to the negative impact it has on the economy as a whole, inflation and its repercussions are also a headache for risk managers, particularly in credit risk.

So what are the consequences of such an economic storm on credit and what are the associated risks?

A fragile economic and political context

With rich and turbulent news in recent years, banking and financial institutions have been challenged on many occasions.

The COVID-19 crisis, the ever-increasing demand, the fragile supply chains that give rise to certain shortages, or even the war in Ukraine … This combination of events has a major impact on the global economy.

As a result, the inflation rates of most of the world’s economies believe at levels not reached for several decades for some, including Europe: European countries such as Latvia experienced record inflation of over 25% in August 2022.

Recall that the target set by the European Central Bank (ECB) is 2%, allowing for lasting price stability and therefore a healthier economy.

Faced with such an environment, regulators are forced to take drastic measures to stop the rampant growth of inflation: raise key rates.

While this is expected to have a beneficial effect on the current crisis (returns on savings will be higher and loans more onerous), this mechanism also has significant consequences on the lending activity of major banks and financial institutions.

Inflation as rising interest rates: a credit risk to consider

While rate hikes appear to be the miraculous solution to this inflationary spiral, it also has implications for credit risk that risk managers must anticipate.

First, inflation has detrimental effects on credit activity and in particular on the solvency of counterparties committed to banks if wages are not raised.

A rise in prices, in fact, considerably reduces the financial well-being of households and businesses, causing further difficulties in repaying loans.

This can also prompt them to want to contract others, which then deteriorates their financial situation and adds additional risk to creditors.

It also becomes problematic if wages rise with inflation.

Indeed, counterparties may be tempted to repay their loans earlier, resulting in reduced payments and a financial loss for financial institutions.

At the same time, an increase in regulatory rates should also be considered in a risk management policy.

Although the primary objective of this policy is to stabilize prices at lower levels, the economic slowdown could cause the resurgence of non-performing loans, representing a significant potential loss for banks.

Also, even though fixed rate loans weren’t impacted by a rate hike, floating rate loans can be real time bombs. The interest expense of the affected counterparties could significantly increase, placing them in a complex financial situation.

This could have significant consequences, particularly in terms of over-indebtedness, reminiscent of the devastating subprime mortgage crisis.

A new context for risk managers and modeling teams

With inflation over 10.7% in October for Europe and fears of a potential recession, banking operators are faced with a literally historic situation.

While bank balance sheet resilience has been studied frequently during macroeconomic shocks through the regular stress tests * of the EBA (European Bank Agency) for several years, in recent years credit risk policies have essentially been built to a relatively low price environment compared to current levels.

The decision-making rules then become more complex, especially since the main internal models (in particular the IRB rating models) are calibrated over periods that do not take into account these levels of inflation.

Moreover, these events remain difficult to predict from a statistical point of view given their singularity and above all with causes that appear at first sight as isolated events (the recent shortage of semiconductors is an example).

All of this can then cause more situations where models underestimate or overestimate the true level of counterparty risk in a context like this, leading to more overrides ** and complex situations for credit analysts.

This can therefore represent a much higher potential cost of regulatory capital for banking institutions.

Consequently, and as in any crisis, this becomes an additional problem for banking regulators and audit teams, who must check the soundness of internal models in such a context, but also be careful not to damage too much the prudential balance sheet of the banks. financial institutions. in order to contain the systemic risk.

We can therefore easily conclude that inflation is a complex issue in credit risk.

However, banking operators are also confronted with the prudential policies of regulators, which appear to be a miraculous solution but in reality give financial institutions a hard time, having to develop a risk hedging strategy in a volatile and changing economic environment.

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A stress test allows you to assess the resistance of a financial institution to an external shock that can be of various types: macroeconomic, climatic, … (**)