Despite government guarantees for loans allocated to manage the public health crisis, banks may be forced to use their own equity in the future. The crisis is continuing to endanger increasing numbers of small businesses and offers an opportunity to reinvent ratings systems while granting credit to avoid discriminating against modest and already fragile companies.
Whether they opt for an extra year’s extension on their payments or not, businesses that took out a government-backed loan (GBL) will soon be faced with additional costs. The system introduced by the French government last March enabled many small and medium-sized businesses to survive by providing them with cashflow advances. But with repayment dates just around the corner, banks will have to adapt their assessment procedures.
Among the 300 billion dollars allocated by the French government, some 120 billion dollars were distributed by banks, prioritizing small and medium-sized businesses who received 78 percent of this portion. For some companies, these loans were viewed as cashflow assistance to be used when needed. Others have not yet touched their loans. This latter category presents very little risk to banks. However, businesses that find themselves unable to honor repayments, coupled with the vast quantity of files to be processed, will pose a problem in the coming months.
An ill-adapted ratings system
Companies currently provide annual official balance sheets which are used by banks to define ratings. Those using internal systems in line with Basel regulatory reforms calculate their equity based on this rating. With the repayment of the GBLs, three difficulties will emerge:
- Internal ratings will no longer represent the company’s health in light of the crisis! How can an exact rating be defined based on tax returns from 2019 and 2020 while the rules governing GBLs are subject to change and the crisis is still developing? What’s more, the financial rating in valuation systems represents 80 percent of their counterparty rating. As current financial factors are difficult to interpret, these two indicators are losing their meaning and banks’ equity may no longer be accurately reflected. It should be noted that four out of five companies that received a GBL (30 percent of all GBLs for a total of €35 billion in outstanding sums) have no Banque de France credit rating.
- Internal ratings are set to deteriorate, which will see an increase in equity needs for the smooth operation of banks. As a result, the attribution and cost of credit will change. Banks will insist on reducing their risk by increasing the cost of credit or limiting its allocation. In both cases, this threatens to worsen the situation for companies that are already struggling. Only the most solid organizations may be granted loans, to the detriment of those that need them the most to rebuild themselves.
- Banking institutions that provided GBLs are facing the greatest customer risk. The government guarantee does not cover the whole loan, and the banks are responsible for at least 10 percent of the overall sum. Despite the small (or even non-existent) margins and costly recovery processes due in part to the number of files to process (currently more than 585,000!), banks will have to absorb the human resources, technical and financial costs needed to effectively manage the situation. What’s more, this risk will apply not only to the GBLs but to the entire counterparty. It will therefore be necessary to have an overall risk perspective including other credits, the situation of guarantees and positions in other institutions.
Increasing analysis and ratings frequency
Annual financial data is insufficient in the current context as many companies will be threatened with bankruptcy in the coming months. The extra-financial criteria (qualitative, behavioral, etc.) taken into account in ratings procedures should therefore be significantly increased. In order to increase flexibility and precision, ratings should also be calculated more often to closely monitor company health. This implies identifying more data sources and being able to process them quickly. Ideally, company accounts should be viewable and obtainable more frequently, but this objective is hampered by a specific constraint: the cost for companies and banks, which would also have to be capable of providing and processing such a mass of information.
Extending financial forecasts
Many companies benefit from several different assistance programs. This will lead to a backlog of costs when these sums are due for repayment and before business revenue has returned to normal.
Financial forecasting should be carried out over several years to assess whether the company has long-term viability and when it is in danger of defaulting on payments. This implies the introduction of a credit score. Instead of using counterparty ratings based on past financial factors, banks must also take present and future factors into account.
Potential strategies include adapting surveillance plans, modifying ratings systems by taking into account forecasts and qualitative factors, and seriously increasing analysis and ratings frequency. However, this all requires adapted software that is quick and easy to configure in order to adapt working methods to unique situations. This connection with multiple information sources will eventually foster the prevention of defaulted payments and will be carried out automatically.