Working Through the Cycle: Modern Credit Managers Adapt to Constant Change
by Rita E. Garwood January/February 2017
After wrapping up a stable year, political power has shifted in Washington, and delinquency is on the rise. Four credit managers weigh in on positive and negative trends that may be in store for 2017, emphasizing the importance of ongoing vigilance and prudence in their never-ending quest to balance risk and reward.
Although The New York Times 2016 Year in Pictures called it “unexpected” and “tumultuous,” 2016 was a stable year from a credit manager’s perspective. Scott McCann, senior credit manager of Bank Channels for Wells Fargo Equipment Finance says it was largely a continuation of 2015, marked by low growth due to strong competition and tight spreads with a slight slip in portfolio quality that was primarily due to the oil and gas industry.
Kevin Prykull, senior vice president and credit underwriting executive at PNC Equipment Finance, agrees. “Credit metrics for 2016 were quite good,” he says. “Early on we identified companies within the coal, oil and gas sectors that exhibited stress. We have been managing down that exposure during the past year. Absent those select sectors, the overall portfolio remains well within our desired risk appetite and within our established risk tolerance limits. We are solidly positioned in our credit measures as we enter 2017.”
Michael Mount, senior vice president, credit and portfolio review department head of U.S. Bank Equipment Finance says stress in certain industries during 2016 had a ripple effect, which created some additional challenges. “The industry is at the point in the cycle where the lending environment is highly competitive, resulting in pricing pressures and requests for some loosening of credit standards and structures,” he says.
“As for new business, activity was brisk for the first half of the year, but we noticed a slowdown in activity between Labor Day and Election Day,” McCann adds. “It now feels like companies are waiting to see what the new administration’s economic policies will be before making major CAPEX decisions.”
“In retrospect, 2016 was good and a fairly stable year, but signs of stress are becoming evident,” says Craig Rondos, vice president and chief risk officer at DLL. “I would not be surprised to see some level of deterioration in the new year. There are still some unknown variables, such as the longer-term impact of the presidential election, changing regulations and oil and commodity prices, which can have an impact one way or the other. As prudent risk managers, we must be prepared for all eventualities.”
Preparing for a Power Shift
The National Association of Credit Management noted the difficulty in predicting the economic ramifications of the presidential election in its December 2016 report. The market turmoil anticipated after the election of Donald Trump did not occur. In fact, the Credit Managers’ Index jumped in December from 52.9 to 54.1, the third-highest reading seen in 2016.
As the dust of the election year settles, will businesses drop their wait-and-see approach to replacing equipment? Our credit managers see both positive and negative possibilities ahead.
“Only time will tell which campaign promises and regulatory changes can be implemented, but it appears so far that some changes are coming — hopefully positive changes,” Mount says. “The markets seem to be encouraged with the upcoming leadership change in Washington, and this seems to be a positive sign for 2017. With the amount of capital chasing finance opportunities, I think we will continue to experience pricing pressure and competition pushing for credit structures, which are more aggressive.”
“Change often causes uncertainty, and the presidential election was no exception. But as companies have time to rationalize the outcome and adjust to the change, most should return to business as usual,” Rondos says. “The new administration’s stance on U.S. economic development may also encourage businesses to consider new equipment acquisition. Conversely, the potential repeal of at least portions of the Affordable Care Act may result in the deferral of larger healthcare equipment purchases.”
“Media reports are signaling that Trump’s priorities are lower taxes and more infrastructure spending, which should be good for capital investment,” McCann says. “Changes to international trade deals, such as NAFTA and TPP, could have major implications, some of which could offset the positives of certain pro-growth initiatives.”
With Republicans in control, regulatory cutbacks are at the top of the Congressional agenda. According to Reuters, the House passed the Regulatory Accountability Act on January 12, 2017, the first of many pieces of legislation designed to reform federal regulation. Despite this push, our panelists agree that financial industry regulations are here to stay.
“Government regulation of the financial services industry is not going away anytime soon,” Prykull says. “In fact, some regulation can be positive as it provides oversight and governance to the financial services industry as a whole. We’ve made changes to our policies, procedures and organizational structure to comply with the heightened standards and implemented the three lines of defense within our bank. With a change in Washington, D.C., we look forward to clear, concise and consistent guidance and oversight from our regulators as it applies to all financial services providers, not just the banks.”
“Although there is some possibility of deregulation, such changes are unlikely to take effect in the short term,” Rondos says. “The use of common sense and sound lending practices, such as KYC, CDD and EDD should, of course, continue, so I am not anticipating widespread changes.”
“Less financial regulation would be positive for our industry, especially bank-owned finance companies,” McCann says. “The hope would be that regulations that are not key to protecting our financial system could be lightened. If so, more resources could be utilized to manage risks that directly impact the safety and soundness of the banking system, including credit risk.”
Rondos cautions that credit managers must continue to be vigilant when dealing with regulators.
“If it isn’t documented, it didn’t happen, so proper recordkeeping is critical,” he says. “As regulations have become increasingly far-reaching, the line between risk and compliance has become slightly blurred, so credit managers must work in very close cooperation with their compliance counterparts.”
The FASB issued the final current expected credit loss (CECL) standard in June. To prepare for implementation, Mount advises credit managers become familiar with the differences between the existing incurred loss accounting model and CECL’s expected loss model. “The lender’s leadership team also needs to understand the differences in the models, as capital costs may be higher under CECL, which may impact the types of financing and the terms being offered which the lender wishes to pursue,” he says. “Depending on the lender, the standard will become effective in 2020 or 2021, which will come up as an unwelcome surprise for lenders not preparing in advance.”
Rondos believes CECL will present initial challenges for many equipment lessors. He suggests establishing a multi-disciplined team, including credit/risk, finance and modeling, to ensure a well-rounded approach to addressing CECL requirements. He says lessors will also want to consult with external auditors to understand the implications fully.
“Moving from the incurred loss methodology to an expected loss methodology could accelerate the need to provision for riskier deals,” Rondos says. “It is conceivable that a deal booked under the incurred loss methodology would not require a provision, but that the same deal booked under CECL would require an immediate provision. At a high level, this could impact capital requirements and leverage, which could lead to an impact on pricing. Credit managers should be familiar with the CECL guidelines to avoid unexpected consequences.”
Last year, the Thompson Reuters/PayNet Small Business Delinquency Index increased slightly in both the 31 to 90 day and 91 to 180 day categories. However, this uptick followed a two- to three-year period of very low delinquency. What does this mean for equipment finance?
McCann says the industry is still quite healthy, although it has probably peaked. He expects delinquency to increase in 2017.
“Many businesses are not necessarily continuing to enjoy the success of recent years, and some are beginning to experience signs of stress,” Rondos says. “Delinquency has been somewhat erratic, but the overall trend likely points toward an increase in 2017. More severe cases may be concentrated in certain market segments, but few sectors will be immune.”
Mount sees the increasing delinquency as a return to normality. “I think the industry remains healthy, and the delinquency numbers are a return to ‘normal’ after years of very low delinquency levels,” he says.
“Delinquency rates have been favorable for so long that any uptick gets viewed with a great deal of negativity,” Prykull says. “In many cases, we are just getting back to normal and should react accordingly.”
What approach should a credit manager take in an environment with delinquency on the rise?
“Credit managers should stick to basic blocking and tackling,” Rondos says. “Underwriters should not be overly influenced by short-term cycles, but instead should be looking ‘through the cycle.’ It can be tempting to relax underwriting standards when times are good. But deals that are approved today are the ones that can become delinquent tomorrow when times are not as good, so basic and prudent underwriting should be used at all times. Risks should be acknowledged and mitigated, but risks that cannot be sufficiently mitigated should be avoided.”
“We should be as prudent and judicious as possible,” Prykull says. “It is time to focus our collections activities on aggressive and active management of the portfolio.”
Mount recommends reviewing existing collections staffing levels. “Many collections departments reduced staffing levels during the period of very low delinquency levels, and those departments may not be properly staffed for current levels,” he says. “To keep delinquency in check, contact customers as soon as they become delinquent to determine if there is a problem. Additionally, enforce prudent lending standards and review projections on new opportunities with the goal of avoiding further increases in delinquency.”
Given the ongoing low spread environment, McCann issues a reminder to avoid stretching credit standards too far and to structure transactions in a way that limits downside risk, utilizing shorter terms, down payments and well-supported residuals.
No matter the state of the economy, stressed sectors always exist. “Oil and gas continues to be stressed, but we are seeing some improvements in this sector as oil prices have recovered from their prior lows,” Mount says.
“It feels like the decline in oil and gas has settled, but at an extremely low level which continues to present challenges from a portfolio perspective,” McCann says. “The industry still has significant capacity, and companies are for the most part not investing in new equipment.” Meanwhile, the transportation and commodities sectors have entered shaky ground.
“A noticed softening in the transportation and transportation-related industries is occurring and may have some credit impact during 2017,” Prykull says. “We plan to be very proactive in managing these sector risks within our portfolio.”
“We also are seeing some over-capacity in certain transportation sectors, which is having a negative impact on their revenues and profit margins,” Mount adds. “Commodity businesses are challenging, primarily due to oversupplies in some commodities and the strong U.S. dollar.”
“We are seeing some weakness in trucking in some regions/segments, and it appears that the auto industry’s recovery has peaked since the Great Recession,” says McCann. “Other commodities, such as metals and food, are also under stress, so we are trying to pick our spots when making decisions on new financing requests.”
Although a number of industry sectors have experienced challenges in recent times, Rondos says reducing exposure to these industries is not always necessary. “It can also be an opportunity for lessors to differentiate themselves by employing sound underwriting practices, using creativity to mitigate risks and working in conjunction with equipment vendors toward common goals.”
Prykull believes portfolio management is an ongoing process, regardless of fluctuations in certain sectors. “As a general bank lessor, we are highly diversified with respect to industry, geography, segments, products and asset classes — having said that, we constantly prune and tend to our portfolio like a skilled arborist,” he says.
New Year’s Resolutions
January is the time to set goals and anticipate challenges that we may face during the year ahead. What are the credit manager’s equivalents to logging in hours at the gym or losing that extra 10 pounds?
“Maintaining portfolio quality and growing the business, of course,” McCann says. “But in addition, early talent development is becoming a larger priority for our team. As our workforce ages, we need to train our leaders of tomorrow, including our risk managers, so that they will be ready to move into key management positions when the time comes.”
Mount agrees: “With the increasing regulatory requirements, I would like to devote more energy towards training. Additionally, we will continue to focus on efficiency improvements in order to reduce credit decision turnaround times. In terms of challenges, I think we will have to continue to focus on the changing regulatory environment and address it appropriately as it evolves.”
“My goal for the PNC Equipment Finance Credit Products Group is to balance growth opportunities within an appropriate risk appetite framework and deliver exceptional service to our clients while maintaining our solid credit metrics — no small feat,” Prykull says, adding that talent management is always important. “With the graying of our credit experts within the industry, developing and retaining solid underwriting and credit talent is essential for our future. Talent management matters not only for our entry-level staff, but also for our mid-career level employees.”
“Refreshing our Risk Appetite Statement (RAS) is high on the list of priorities,” Rondos says. “The RAS should realistically define thresholds for a wide variety of risks, not just credit risk. We need to recognize changing times, new collateral types and evolving regulatory issues. But having a well-prepared RAS is only effective if the business stays within the boundaries of the document. As competition remains strong, there can be temptation to accept higher risk, often without a corresponding increase in reward. Working to maintain the appropriate balance between risk and reward, while achieving company objectives, is an ever-present challenge.”
Prykull agrees that maintaining the risk/reward balance will always be an ongoing challenge for credit managers. “Despite some deterioration in 2016, the overall credit metrics of our leasing portfolio have been good for so long that one must stay on guard and resist becoming complacent. Balancing risk with selective growth while focusing on what matters is the final litmus test. We need to constantly ask the questions: What are we missing in our credit analysis and portfolio assessments? Are there any systemic issues at play in the portfolio that could have very unfavorable ramifications? Ongoing vigilance and prudence are essential.”
“Customer needs are changing,” Rondos says. “There is a shift toward less conventional (and riskier) assets and structures, and the equipment leasing industry must find ways to adapt. But lessors should approach these changes with prudence and eyes wide open. New asset types, such as software, software subscriptions, cloud-based collateral and vendor-dependent structures such as managed equipment services place increased emphasis on the creditworthiness of the borrower. Credit managers must be aware of the risks and ensure adequate mitigation. And the fact that another lessor is willing to do something is not mitigation. Lessors do not want to become a victim of the ‘greater fool syndrome.’”
“We live in a world of seemingly constant change and yet the industry has continued to adapt accordingly,” Mount says. “What we do is challenging, but that is exactly what keeps it exciting.”