Managing through Recessions: From Surviving to Thriving

Justin Basini, Michael Woodburn, Stephen Smyth

Covid-19 is likely to trigger an immediate global recession. If the recession is not to become a prolonged depression, banks and financial institutions have a critical role to play in keeping credit flowing in the economy and especially to consumers. To do this, they need to navigate a series of challenges in the coming weeks and months ahead; making decisions with urgency on limited or confusing data.

Justin Basini, the CEO and Co-founder of ClearScore, convened a panel of experts to discuss how lenders can mitigate the risks and take advantage of the opportunities that become available during a recession. The panel includes the Co-founder of Capital One and Managing Partner of QED Investors Nigel Morris and other executives who collectively have over 100 years of experience through several recessions driven by different situations across multiple countries.

What is clear is that most banks and lenders will radically reduce consumer lending during the recession and certainly in its early stages when data is scant and medium term trajectory difficult to read. There are many reasons for this; uncertainty, fear, lack of capital and know-how. These are good reasons to be cautious on lending. The chart below shows how supply for credit card lending fell over 50% during the last recession in the US and had still not fully recovered 10 years later.

Total Credit Limits issued on New Credit Cards in the US ($bn, source CFPB)

Our core message is that managing credit through a recession is as much an opportunity as a risk. To harness this opportunity, you need to succeed in three areas: decisive leadership, understand your constraints and get margin right.

Decisive Leadership: Act quickly, but don’t over-react

“A recession is about leadership. Most organisations dig in: they will build a moat around their business, shut down creativity and just try to survive. But you’re not powerless; there are many things you can do. Stay in the game and keep originating so you can see the situation evolve.” Nigel Morris, co-founder of Capital One and Managing Partner of QED investors

“Don’t make the cure worse than the disease” Bill Cilluffo, QED Partner and former CEO, Capital One Canada

A mistake we have made in the past is to over-analyse. Every week is important at the start of a recession. In the last weeks, 10 million people have signed on for unemployment in the US. An unprecedented number. It is critical to act quickly.

Acting quickly but effectively is best done by triaging what actions must be taken now, which can be delayed, and which ones need to be thought about more deeply. First, some actions are no regrets. Engage with your lenders. Plan for ramping up capacity for collections and recoveries — operations are often the heroes in recessions. Tighten lending criteria. Cut non-essential costs such as travel (easy in the current climate) or ask for extended payment terms.

“There are difficult trade-offs. Generally being aggressive and moving quickly is important. But if you just take blunt instruments and do the same thing to everybody that doesn’t always work. For example, with Credit Limit Decreases in Credit Cards. Doing that to everyone in a portfolio is something I have never seen work. The best people leave really quickly and you may not get the protection you want. Or in collections, if you try to call everyone 5 times you might have a negative impact on your best customers. Really slope the energy to where it makes sense” Bill Cilluffo, QED partner & former CEO, Capital One Canada

Second, some actions should be put aside for now but revisited later such as those that are more complicated and time-consuming initiatives that can be done later. The critical thing is to stem the bleeding, the reconstructive surgery can take place later. Up to 80% of the current projects you are working on (IT enhancements, UX improvements) should be stopped and the energy redirected to actions that have impact quickly.

Included in this ‘put aside for now list’ is a set of measures we would classify as over-reaction. Pulling out of the market entirely may dangerously limit your ability to gather crucial data on the evolving market and state of consumer finances in different populations. Rushing into laying off large numbers of people to save costs may distract you from more important levers that give you options as the situation evolves.

Finally, you need to devote attention to complicated and high impacting initiatives that are not levers that can be pulled instantly. Often these are actions that will have the biggest impact on your ability to survive the recession but require deeper analysis. Funding and capital access are hugely significant second order impacts of recessions. You need to engage creditors early and consider the critical constraints that you need to drive your action plan over time– see the following section. Margin is the other big category here; only by revisiting how much you charge consumers and protecting margin can you continue to successfully lend credit in a way that is optimal for customers and your own business.

Credit Risk models will not slope profitability as well during a recession leading to bad lending decisions for your consumers and profits

Understand the second order impacts that will hurt you

“Credit Hurts. Liquidity kills” Miles Reidy, QED Partner and former CFO Capital One Cards

“One of the mistakes we see companies make frequently, is that they focus all their effort on credit risk and don’t get to capital markets until they see a problem. I’m not saying you’d ignore credit risk, but I’d put 80% of your effort on capital markets first. Having early and frequent conversations with your lenders pays dividends down the road” Bill Cilluffo, QED Partner and former CEO, Capital One Canada

The increased credit losses of a recession clearly hurt consuming lending businesses but it is the second order impacts that can kill them. This might be as simple as the fact that recession triggers more consumers to miss payments on the credit cards or loans. This spike in delinquencies might overwhelm the call centres that engage people who have missed payments. With fewer people being called, the efficiency of collections will deteriorate making credit losses go from bad to worse.

This will be different for every company and their particular constraint — being clear on your critical constraint is key. As credit worsens, the issue for one company might be liquidity, cash trapping or capital issues. It is important to work all the way through what the knock-on impacts are of credit worsening. This is particularly hard as you will be bombarded by your organisation and your board with questions about what is happening, how bad it will be and what you will do about it. With so many options you can take and so much uncertainty, this can be overwhelming. By being crystal clear on the constraint that will end the business, you can prioritise your response.

The important thing is to make assumptions and form a plan quickly and against these priorities; communicate to your creditors, your regulators, your organisation. Frame the discussion and own the process. Do not wait until you have specific answers to all the parts of the equation. If you do, it may well be too late.

“There will be a tendency for people to tell you why you can’t do what you want to do. The world has now changed. The regulatory, compliance and operational constraints may be different. Ask yourself ‘Now what can we do (that we wouldn’t have considered before)?’. Nigel Morris, Managing Partner of QED investors and co-founder of Capital One

Having understood or made assumptions on the second order impacts and the pain points, the recession will create an opportunity to address these issues in ways that may not have been possible in normal times. In normal times, regulators may have rules for consumer lending that cap interest rates; this seems consumer friendly but may actually stop someone getting a loan they need desperately. With the recession, the emphasis of regulators may now be different, and they will be focused on keeping credit flowing to consumers and the small businesses that need it. They might be more open to considering changes to regulation such as increasing interest rate caps in order to free up lending.

Another example might be around your liquidity providers. Covenants might be up for negotiation and this can alleviate stress on your funding position. However, there may be many people trying to renegotiate simultaneously. It is important to start such processes early, understand what creditors need, build credibility with them and help them sell the solutions internally before it is too late.

Getting to the ‘right’ margin: Use margin levers in conjunction with credit levers

“There are no prizes for being too smart in the short-term. Focus on resilience and margin. Don’t over finesse” Michael Woodburn, Chief Data Officer ClearScore, former CEO of Oakbrook Finance

The worst reaction to a recession is to carry on as before, but the second worse is to “go blind” and pull out completely. As credit losses rise and second order impacts kick in, profits will come down and the outcome can be severe.

Most credit risk professionals in consumer lending institutions will, in the face of rising losses, instinctively try to protect their company by pulling the levers in their area of expertise. They will want to slow down originations of new lending by tightening criteria for lending and arguing for reduction of marketing spend. This approach may help the organisation initially but “cuts the nose off to spite the face” for the long term as the reduction in lending will lead to a smaller book with lower long-term revenue.

You cannot get out of a recession crisis just by pulling credit risk levers. The underlying reason for this is that your credit risk strategy will no longer work as well because it does not have good enough data about the new reality. Credit risk models are only as good as the data they are built on. When a recession hits, the environment can change so much that the models cannot predict risk as well. For example in the lead up to the 2007–2009 recession, the debt to income ratio of individuals did not tell you much about whether someone was good or bad for credit risk. When the recession hit, this became the most important variable. Without debt to income in your credit risk models, any action to change a cut-off would not be able to take advantage of this evolving environment.

Your credit risk decisioning can be optimised during a recession by doing three things. First, you need to monitor the performance of your models and how they are degrading by monitoring short-term performance predictions or residual monitoring. Second, continue to test and gather data in the market. Without data, you cannot build a good new model to emerge stronger from the recession. And finally overlay judgment and common-sense. If you know 10 million workers have been made unemployed in the travel and hospitality industries, you may want to consider looking at those employment types more closely.

The best strategy though is to think beyond credit risk and to increase your margins by increasing interest rates. This can create a strategy that is more resilient to increase in losses and enables you to keep booking users through the recession. Although this may sound like a ‘bad thing’ to do to customers who may be facing financial stress, our experience is the opposite. Provided you are transparent with customers and give them options, they will appreciate the choice to still have credit, even at a slightly higher interest rate. You may well also be operating in a market with less price competition. The most harsh judgment and PR challenge to navigate is the judgment typically from people who never use credit except for a mortgage but most of these people simply do not understand what it is like to have no savings and to need small lines of credit. Going back to the chart at the beginning of the article, the economy is better with more credit at a higher interest rate than having more than 50% of credit removed.

A recession is an opportunity to recast your business

There are opportunities through the recession to do more than survive: to build your brand, to position for growth and be a white knight to your customer base. This might be from helping out users with payment holidays if they get into trouble or by investing in new partnerships or ways of doing business. We see a huge opportunity to come out of the recession with a much stronger business. Most lenders will shut down on consumers and re-open later. For the next few months, this gives a substantial opportunity for lenders who stay in the game to book the very best customers and re-calibrate their models.

With many people now working at home, we also believe there will be a golden moment to shift your business to a much more digital and efficient business. At ClearScore, we see a huge opportunity for this crisis to be the coming of age for Open Banking. Open Banking has the ability to give lenders near real-time access to the financial situation of consumers. By identifying credit worthy individuals with appropriately priced products we see opportunities to keep lending going at levels much higher than in the 2007–2009 crisis and this will lead to a much more efficient digital platform for lending in the future.

“The former mayor of Chicago said ‘Never waste a good crisis’. Out of this there is an opportunity to make a better business” Nigel Morris, Managing Partner of QED Investors

April 2020

Authors:

Justin Basini, CEO ClearScore

Stephen Smyth, Head of International at ClearScore

Michael Woodburn, CDO ClearScore

ClearScore is a UK based fintech with operations in the UK, South Africa, India and Australia. We offer free credit reports and scores and help users improve their financial wellbeing by making the process of finding better deals clearer and easier. We have 12 million users worldwide and serve our lending and financial institution partners with the best data, conversion funnels and service.

QED Investors is a leading boutique venture capital firm based in Alexandria, VA. QED Investors are focused on investing in early stage, disruptive financial services companies in the U.S., U.K. and Latin America. QED is dedicated to building great businesses and uses a unique, hands-on approach that leverages our partners’ decades of entrepreneurial and operational experience, helping their companies achieve breakthrough growth. Notable investments include Credit Karma, ClearScore, Nubank, SoFi, Avant, Remitly, GreenSky, Klarna, QuintoAndar, Konfio, Creditas, and Mission Lane.