By Sean Hunter, CIO at OakNorth
Banks have historically lent to CRE because it’s straight forward to evaluate a property vs. the complexities of a particular business and sector
Many lenders in the US have had a lot of success with Commercial Real Estate (CRE) lending and place far less effort on lending to trading businesses (often called “Commercial and Industrial” or “C&I” lending). The primary reason this has historically been the case is that analyzing the prospects of a business is clearly more difficult than valuing a property. The lender needs to take into account the prospects for the overall sector alongside considering how the particular business is likely to fare in the future. Because there may not be the same level or types of assets to provide collateral for the loan (especially for the sorts of services businesses that dominate the new economy where assets can be more intangible such as intellectual property), there appears to be greater uncertainty and more downside risk.
COVID-19 has radically changed this picture
The trend towards more flexible and remote work has accelerated. No one really knows how this will play out in the long term, but the current indications are that remote work will play a much greater part in the mix from now on. Furthermore, many consumers have changed habits and now do an even greater proportion of their spending online than before, lessening the desirability of in-store retail premises. Brick and mortar retail is likely to bounce back somewhat as confidence grows and lockdowns ease, but the convenience and instant gratification of online shopping means that we will probably never see things go back entirely to where they were pre-crisis.
These factors contribute to an uncertain future for CRE, making diversification more important than ever. Not only can banks avoid the risk of softening of CRE, but they can catch the wave of growth as businesses recover from the crisis and the need for debt finance expands.
ON Portfolio Insights can give banks the confidence to do more C&I lending
ON Portfolio Insights does a “bottom-up” evaluation of your entire loan book, assigning each business a vulnerability rating based on a subsector-specific, forward-looking credit scenario taking liquidity, debt capacity and profitability into account. This gives two significant benefits, first it allows a bank to identify risk in its book 6-12 months earlier than they otherwise would and secondly it creates tremendous operational efficiency by allowing them to focus their attention on the loans which present the highest risk of future credit deterioration. Catching problems early means they are easier to solve as well as leading to lower losses overall. Loans without high-quality or tangible collateral require much closer monitoring – the forward-looking capabilities of ON Portfolio Insights enable lenders to manage those loans much more efficiently.
The power of early risk identification and mitigation
A major US lender which performed an extended proof of concept test of ON Portfolio Insights, saw its internal risk ratings migrate towards our vulnerability scores over the length of a 6-month trial. Relationships that the bank had as a marginal pass, but that our software showed as high risk, tended to become sub-standard loans the next time they collected financials. We have seen a similar experience in the UK in our own bank, where out of 7bn USD lent, we have only had 10 defaults since inception, with 100% recovery on 6 of those and over 95% anticipated recovery on the remainder. This is the power of being able to identify borrowers at risk and begin mitigation efforts far earlier than other lenders – before the borrower has even yet defaulted.
ON Portfolio Insights makes it simple to create operational efficiency by targeting effort at the relationships where this will have the greatest impact
Once the COVID-related lockdowns started, it was clear we were in uncharted waters for the economy and therefore historical risk ratings became totally redundant. This meant banks could only prioritize activity based on exposure. By looking at the vulnerability score in combination with the exposure on the loan, our software allows lenders to prioritize activities (review, doc collection, renewals, etc.) far more effectively. Because our forward-looking vulnerabilities don't become obsolete in a market shift, they update, and your priorities update accordingly. This more dynamic view of risk is still valuable in a more stable economy because we can update risk inside a lender’s review cycles, allowing them to triage their loan book and maintain constant focus on the items of highest impact.
By providing a dynamic, forward-looking view of the vulnerability of borrowers, ON Portfolio Insights can help lenders diversify into C&I lending with confidence that they will find risk 6-12 months earlier (when they can hopefully take action to address it) and create operational efficiency by targeting their efforts on the areas where they will have the most impact. This is all part of our mission to help lenders empower the Missing Middle.