Dear banks, are you in control of your lending?

At a time when macroeconomic indicators point to a more robust economy than feared, and banks’ expected loan losses are continuously being reduced, it might seem that everything is rosy in the banking sector. But do bank directors really have a firm grasp on their lending?

The anticipated crisis thankfully hasn’t materialised despite the sharp increase in inflation and interest rates. However, there are still several uncertainties ahead, such as structural economic shifts: the green transition, climate risk, technological development, and a new geopolitical world order.

If banks' credit risk management is not up to scratch, they can end up with too many bad loans on their books, leading to losses. Bank executives' paramount task is now to ensure that everything is in order within their organisation.

Here are the key questions banks should ask themselves:

• Are we at the forefront of credit processes? Are they satisfactory for customers? Have we got high quality loans?
• Are we adept enough at identifying signs of vulnerability in our credit portfolio?
• Do we have the right operational capacity to handle an increase in the number of financially weak customers?

Our experience shows that Danish and Nordic banks generally have reasonable credit standards and that their credit policies are well-balanced in dealing with risks and growth ambitions. Detailed regulations such as growth guidance and creditworthiness assessments have also contributed to this.

The problem for many banks lies in adhering to reasonable credit standards, i.e., doing what they have agreed to in their credit policy.

There is, colloquially speaking, some slackness in the system.

We often see that the quality of credit applications in the banking sector varies excessively. This results in many loans being granted to customers who are essentially outside the bank’s risk appetite. Some issues are caught by internal control processes, while others are never detected.

In both cases, it might be too late. The credit has been granted, and the bank risks losing on the loan – and a customer may possibly have put themselves in an unsustainable financial situation. A primary cause of errors is typically a high degree of manual processes in granting loans, where the advisor may not correctly calculate disposable income or other key metrics – and the complexity of case handling has increased significantly over the past 10-15 years.

Better system support for these key elements will ensure consistency in handling cases, and the advisor will be able to focus on good customer experience and on ensuring sound reasoning in assessing cases. In other words, good system support is a prerequisite for complying with the bank’s policies.

Another major challenge is identifying economically or socially vulnerable customers in time. It is important to handle these customers quickly so that problems do not become large and unmanageable. This is not only about minimising the banks’ risk of loss but also about ensuring that vulnerable customers are dealt with appropriately.

Banks often have large amounts of data, but they do not utilise it sufficiently to identify customers with potential weakness in their application. Additionally, advisors often focus on sales and may deprioritise work with customers with weak cases.

Finally, there is the operational capacity of banks to handle an increase in the number of customers who would be vulnerable if there is an economic downturn. Banks last experienced a significant increase in vulnerable customers almost 15 years ago in the aftermath of the financial crisis. Back then, as now, it involved manually intensive processes.

The employees who handled the cases back then may no longer be with the bank, and the experience from the financial crisis was that the staff handling financially weak customers and debt collection cases needed to be quickly doubled, tripled, or even, in some places, sextupled.

In the short term, banks need to have robust plans for upskilling employees and allocating resources quickly if there is a sudden surge in demand. Following this, banks should revisit their processes for dealing with weak customer processes to ensure they are up-to-date and system-supported.

So, dear banks, use your time now to ensure that you are in control and ready for whatever type of landing may lie ahead.

Read the article in Danish Finans.