Don’t panic, lender portfolio solutions abound

We are in a downturn like no other and recovery, particularly for lenders, is challenging but by no means impossible. This article explores some of the key challenges facing lenders as well as some of the potential solutions.

Lender challenges

Different lenders are grappling with different challenges but there are a few common themes that are impacting lenders across the board.

1) Net interest margin (NIM) opportunities and risks -?Over the last few years, one of the fundamental revenue drivers for lenders continues to be squeezed. Lenders have had limited ability to sustainably increase interest revenue over the last decade due to increased competition in the UK market, particularly from challenger banks and speciality finance lenders who often aim to grow market share through lower cost bases and competitive pricing. Most have been able to survive prior to this year because the base rate over the same period has been relatively low.

Now however, with the political uncertainty; recent mini-budget; and other macro variables driving interest rates up, alongside the expectation that they will continue to rise into 2023, lenders need to carefully manage key margin drivers, including:

• the ability to pass on higher interest rates on variable rate products versus the impact on borrower affordability;
• reviewing the profitability of fixed rate products, particularly where margins are being unsustainably squeezed, and manage risk where possible (e.g. hedging cost of funds);
• how much of the rate increases can be passed onto deposit holders to maintain a lower cost of funds without losing deposits to other higher interest rate accounts; and
• reviewing the amount and cost of increased collections and recovery processes as well as non-performing loan management at a portfolio level.

How well lenders manage the interplay of the key drivers above will dictate the overall NIM impact on their business.??

2) Borrower affordability – will need to be reviewed by lenders in light of increasing costs and a looming recession as predicted by the Bank of England.

Retail customers continue to be squeezed on all fronts which is impacting affordability despite wage inflation in certain sectors. Customer debt is expected to continue to increase as the cost of living pressures bite and the form of that debt may also change with customer behaviours.

Some UK businesses, for example, are already feeling the impact of the “energy crisis” as they have seen their renewed energy tariffs multiply, in some cases, as much as 10 times.

Underlying supply chain inflation also needs to be considered by businesses. Over the past few years, other input costs such as labour and materials have been increasing. The labour market has been tight over the past few years driving up wages, particularly in sectors where it has been difficult to recruit the right people.

In the face of potentially double figure inflation and a looming recession, lenders are already predicting that mortgages, unsecured lending, and business loans will see a jump in defaults over the coming months (Source: Bank of England’s Q2 credit conditions survey).

3) Withdrawal of the UK government’s post-pandemic support – Whilst the governments much needed loan support scheme (CIBLS, BIBLS, RLS etc.) has no doubt saved some businesses, it has arguably delayed the "real" impact of the COVID-19 pandemic and inevitable default for others. The support has been expensive for the government to maintain and cannot continue indefinitely. If businesses or consumers are unable to replace the government support with other suitable solutions at maturity, we may see further stress and additional defaults.

Potential solutions

Predicting corporate recovery at this time is complex but doesn’t mean lenders shouldn’t plan. Planning will depend on the impact of the expected downturn on each portfolio and may take broadly the following forms:

1) Maintain the status quo and trade through - lenders that believe the current environment is temporary and markets will "normalise" in the short-term may choose to hold onto their assets and trade through. To navigate through the uncertainty, management may increase monitoring of current exposures and tighten underwriting or lending volume focus. Key questions to ask are; how long?will it take for markets to "normalise" and what will the new "normal"?look like? Current predictions for recovery range from as little as six months through to a few years – a difficult question to answer at this point. What lenders may be able to do now is understand what the likely range of new "normal" scenarios may look like and make sure their business’ core sectors and products are aligned.

2) Restructure - lenders that believe current product terms are unsustainable, but by re-negotiating certain terms, may become sustainable in the future, may choose to restructure their exposures. Every exposure is different because every borrower is different. The key to going down the restructure path successfully is to work with borrowers to understand if there is a reasonable chance of recovery versus cost to recover. Different restructuring options from a temporary payment moratoria, to a debt for equity swap, to exploring alternative sources of capital, may work for different situations meaning lenders may need to be flexible in their approach.

3) Optimising collections and recovery – as part of the restructure option, lenders may choose to optimise their collections and recovery processes, particularly through the use of technology. Automating repetitive tasks where possible should free up internal resources to focus on more nuanced and complicated borrower cases. If internal resources are still stretched, lenders may choose to weigh up the cost vs. benefit of using an external debt collection agency.

4) Sell the exposures – lenders that don’t go down the hold or restructure paths may choose to sell their performing or non performing loan exposures. This can be for a multitude of reasons (e.g., a certain sector is designated as non-core) and be in the form of a portfolio sale (assets and/or liabilities) or a legal entity (balance sheet carve-out) sale. The key to a successful sales process is knowing the market for:

• Buyers – what is the buyer universe, what are their goals / investment criteria / investment horizon, what are their competitive advantages (e.g., cost of fund), what is their deal track record, etc.?
• Pricing – what a buyer would be willing to pay in the current market comes down to how they value the business and where they see upside.
• Timing – timing the market is difficult, however selling sooner may achieve relative price certainty and allow lenders to focus on core areas and products.?

Lenders should not forget, on the other side, a sale by one business presents opportunity for another – for example, a good business/portfolio with a (temporarily) bad balance sheet.

There are other options available to lenders and as the year rolls on, other opportunities will present themselves. It is important that lenders keep an eye on the market?to understand what is going on around them.

Out of challenge comes opportunity

As well as core focus areas such as customers, digitalisation and managing risk, lenders should look to future-proof the business by looking at how upcoming changes such as Environmental Social and Governance (ESG) and Basel IV may impact their long-term business model.

This is a great time to take stock of exposures and refocus the business to perform in a post-pandemic world.

The EY Financial Services Corporate Finance and Restructuring team advise clients at any stage of the economic cycle and on all aspects of transactions: M&A; Loan Portfolio Solutions; Debt Advisory; Restructuring; Due Diligence and Crisis Management.

Please do not hesitate to get in touch to start your conversation.?