The ongoing economic effects of the pandemic, including supply chain issues, combined with inflation make this an especially complex business lending environment. These issues will influence how community banks manage portfolio risk, as conventional approaches to risk management are more reactive than proactive.
To avoid delinquencies and loan losses, banks should look for early indications of challenges before they pose a real threat. Banks must have a solid understanding of where potential problems may arise before they negatively impact portfolio performance and the best way to spot red flags early is by looking at behavioral changes among borrowers. There are several behavioral changes bankers should watch for and incorporate into their risk management strategies.
Historically, banks have managed portfolio risk by focusing on lagging indicators of financial trouble among their borrowers, often in the form of missed or late payments. However, once these problems are noticed, it can be too late to fix. Instead, banks can get ahead of potential problems by looking at leading indicators.
Meaningful examples of leading indicators include cash flow and deposits. By monitoring for changes in deposits at scale, financial institutions can determine which businesses’ revenues are falling – this may signal future issues with loan repayments, which can enable a proactive adjustment in loan terms to keep these borrowers on track.
Another area to monitor is overdraft frequency – more overdrafts is a sign that a business is having issues with cash flow, whether due to unexpected expenses or less revenue. Identifying accounts with an uptick in overdrafts will allow your bank to intervene before a business customer can’t make a loan payment.
High credit-line utilization is another leading indicator that will show the financial stress faced by a business customer long before a loan is 90 days past due. If revolving line balances remain high, this could indicate a business is facing challenges and requires attention. Determining which business customers are maintaining high line utilization and reaching out to understand why they are consistently tapped can help your bank navigate the best path forward.
Assessing the above factors cannot be done manually. Say your bank has 10,000 business loan accounts and 15,000 business deposit accounts – a single person or team cannot monitor deposits, overdrafts, high credit-line utilization and more for all of those accounts each day.
For this level of monitoring to be scalable, banks must leverage data, both from their core system and external systems. With their existing data and today’s technology, banks can create automated triggers that alert the right team members when there are signs of trouble with a loan.
Alerts can be set up based on deposit account balances, increased overdraft activity, updated credit scores and more. Banks can establish parameters around these data points to determine when an alert should be sent to their team for closer review.
For example, if your team is monitoring deposit accounts, you can create a rule to compare the account balance as it stands today to how it was 30 days ago. You could then set a trigger threshold, such as 25 percent. This would trigger an automatic alert if the deposit balance dropped 25 percent lower than it was 30 days prior.
Setting up alerts for multiple factors can be even more effective, as banks can see at once when a customer has lower deposits, multiple overdrafts and high credit-line utilization. This provides your team with a comprehensive view of vulnerabilities within the loan portfolio.
This approach can also be applied to marketing and cross-sell opportunities. For example, consider deposit accounts with higher balances. Your bank could set up a rule to look for accounts that have 25 percent more money than the month before. This could trigger a cross-sell offer for a new product, like a certificate of deposit.
By incorporating behavioral changes into your risk-monitoring processes, your bank – regardless of size – can more proactively address potential threats before they negatively impact portfolio performance in today’s rising rate environment.
Bryan Peckinpaugh is senior vice president at Baker Hill.
