Credit risk in 2021: Prepare for more unknowns | Insights | Bloomberg Professional Services (2024)

This article is based on aRisk.net podcast with David Croen, Head of Credit Risk Product at Bloomberg.

An oil price war, the global COVID-19 pandemic, increased political and trade frictions, and a number of climate-related events certainly made 2020 a year of unprecedented challenges for credit risk managers, who faced a series of high profile defaults and bankruptcies across sectors.

Key credit drivers included industry structure challenges, reduced growth trajectory, impaired operating efficiencies in certain sectors, regulatory focus shifts, reduced CapEx intensity, and limited financing availability. Substantial negative impacts on the energy, travel, leisure and hospitality sectors, while retail store weakness accelerated further in 2020. Many of these defaults resulted in lower recoveries for investors.

Lower oil and natural gas prices, brought on by an oil price war, and exacerbated by lower demand due to the Novel Coronavirus pandemic (COVID-19), adversely impacted energy companies, and market inefficiencies drove oil futures to negative price levels for the first time since records began. The energy sector accounted for nearly one out of five bankruptcies in the US in 2020.

Meanwhile, pandemic-related border closures caused air traffic to drop over 60% year-on-year, forcing the closure of many hotels and restaurants, as travel nearly came to a halt. Several airlines were rescued by their governments, while others failed.

Although central banks continued to provide substantial support to rate markets (over $6tn in 2020), firms still needed to manage their cash flows, and some reports suggest that credit weakness will continue into 2021. Low rates have resulted in near-record borrowing and bond issuance, which may result in a moral hazard for investors. With just over $16.8 tn globally in negative yielding bonds, how should investors target return on capital vs. return of capital?

2021: Clouded prospects and more unknowns

If 2020 proved a challenging year for markets, 2021 may also feature additional unknowns that credit risk managers will need to anticipate. Central banks continue to express concerns about global growth and the potential rate of recovery in 2021. COVID-19 will continue to challenge governments, companies and supply chains. Inflation may become an issue, at least temporarily, but labour slack and some retreating prices may offset pressures. There may continue to be credit events as and when government support programs elapse. Both the U.S. Federal Reserve and the European Central Bank (ECB) have said economic recoveries are losing steam, recommending that central banks and governments together provide additional support to aid economic stability. It seems likely that central banks will continue to provide market support for some time to come. The many jobs that were lost during 2020 will take time to replace.

The ECB recently unveiled plans to purchase an additional €500bn of bonds, extending its Pandemic Emergency Purchase Program (PEPP) to March 2022, and continuing to support banks to keep credit flowing, in a bid to support the Eurozone economy through the anticipated end of the COVID-19 pandemic. The package appears aimed at keeping borrowing costs low for governments, households and firms, and takes the ECB closer to outright targeting of specific levels in bond yields and spreads. Monetary hawks and doves are engaged in a conversation about how much future support there may be across the ECB, i.e. whether the €500bn is within a range or may now be the ceiling.

The pandemic may leave some long-term scars. Economies across many countries may have declined by 5-10% in 2020, with only a modest recovery anticipated in 2021. Reduced capital investment means that capital stock may be smaller for longer and productivity gains may be constrained with workers shut out of offices and factories or laid off.

In addition to the immediate COVID-19 crisis, Europe also faces several longstanding issues. Productivity – the main sustainable source of rising living standards – has long been diverging across euro-area economies. The rapid move to digitization and e-commerce is increasing pressures on businesses to economize further, which may not accommodate full job recovery. Then, at the same time, demographic pressures, such as aging populations, continue to intensify.

Regulators have taken note of these challenges. The ECB’s recent “Dear CEO” letter requires 113 Significant Institutions (i.e. large banks) to respond by the end of January 2021 with their plans to address rapidly evolving credit risks, as the ECB expressed concerns that bank losses could possibly exceed losses experienced during the Global Financial Crisis. The ECB emphasized that banks should enhance processes and controls, ensure that data is current, and increase use of forward-looking credit measures (e.g. point-in-time probability of default as opposed to the through-the-cycle ratings agency approach that has not dynamically captured the increase or variability in credit risk). The ECB expects banks to actively assess financials and quantitative calculations of Probability of Default, Exposure at Default and Loss Given Default, as related to capital use and to assess impairment under IFRS 9.

An evolving credit risk management landscape

A time of unknowns and challenges is also an invitation to reassess and upgrade risk management infrastructure. In recent years, banks, asset managers and corporations have taken a broad range of approaches to credit risk management, with the various focal points depending on the individual firm’s priorities, which creates discrepancies in the ways risk profiles are determined, terms or credit exposure given or taken, and credit risks quantified and managed.

Lessons learnt from the Global Financial Crisis (GFC) have come in the form of more detailed regulatory guidance and the ever-increasing need for rigorous analytics and data, all of which aim to provide more stable safeguards as well as help firms negotiate the significant post-financial-crisis market changes, such as higher volatility, less predictable economic cycles, and political and trade frictions. Banks have also benefitted from additional capital buffers, increased methodology and data consistency across business units, and the strengthening of risk management infrastructure and governance. Although markets are much better equipped to deal with unknowns in 2021 than in 2008, such measures may not be sufficient.

Upgrading risk management systems should improve available analytics and may even reduce costs. For this reason, a number of asset managers, seeking to protect 2020’s hard-earned alpha, and answerable to increasingly engaged investors, are actively acquiring and implementing analytics and data sets that enable them to explain risk-adjusted performance, understand risk scenarios and prepare for them. Corporations, though relatively recent entrants to the credit risk conversation, are also seeking to identify, assess, monitor and control their business credit risks. Concerns among corporates include supply chain risk and business risk, knowing which customers may become delinquent and which banks to choose as trading and hedging partners.

How we can help

Bloomberg’s Multi-Asset Risk System (MARS) for credit risk leverages Bloomberg’s extensive risk analytics and rich data sets to enable obligor and obligation-level credit analytics across a portfolio, providing early warning signals about an obligor’s credit quality, as well as a wide range of credit analytics and scenario analyses for a universe of companies (globally, several hundred thousand firms, daily).

Advantages include:

• Full-term structure of default probabilities and model-implied credit default swap spreads.
• Evaluations of the potential Loss Given Default and Recovery for all covered obligations.

The need for a common risk platform with a consistent and extensive set of analytics and data is central to a firm’s needs. As an uncertain future highlights the need to see around corners, Bloomberg’s solutions provide the means to identify, assess and monitor valuation, market, credit and margining/collateral risks.