In the latest quarterly FXE Lending Monitor, Funding Xchange, the leading provider of digital SME lending solutions, identifies the risk of returning to pre-crisis risk analytics that are likely to miss key challenges that businesses will face.
The Monitor shows that the extended protection of government schemes to UK businesses has largely ended: the vast amounts of cash disbursed during 2020/21 created a ‘safety net’ that meant that balances held by businesses doubled almost overnight and stopped most business failures and masked other signs of distress.
This protective cash cushion has been spent – with cash balances for smaller businesses back at pre-pandemic levels. Yet, the traditional data used to assess credit risk continues to be affected by the crisis response. Businesses that would have struggled, ended up surviving – swelling for example the ranks of businesses that are now turning three years old. These businesses did not face the typical start-up challenges as they qualified for government support but are now encountering a much harsher world. This could potentially mean that failure rates of these businesses will get closer to those expected from start-ups.
The report highlights three key areas where the crisis response will have an impact on credit assessment:
- Cash balances are returning to pre-crisis levels – removing the safety net that has protected businesses
- Businesses applying for funding through the Funding Xchange portal saw cash balances increase on average by £20,000 because of the government interventions in 2020. The average cash balance held in the latest months has fallen to the pre-pandemic level of just £5,000. The liquidity support provided by the government meant that businesses that would have struggled ended up surviving, but now face a much harsher world. In addition the debt burden that many businesses are now carrying as a result of making use of one of the government’s loan interventions has weakened their balance sheets.
CEO of Funding Xchange Katrin Herrling commented, “Given the success of the interventions, the data from the last two years is ‘sanitised’ of arrears and defaults as well as business failures that under normal circumstances would have occurred. Building risk assumptions around this data set is misleading if we accept that some of the distortions will wash out and normal patterns return as the effects of the interventions wane. Banks and lenders need to bridge this gap between observed events and actual risk as they calibrate their risk appetites. This requires an understanding of actual trading performance and available cashflow, rather than reviewing events like arrears.”
Reinforcing the impact of the intervention loan schemes, the Monitor highlights that during 2021 insolvencies reduced by 38%, whereas June 2022 outcomes show a year on year rise of 40%.
Management matters even more during challenging times
People and prudent management make a difference when navigating rapidly evolving challenges. The last two years have clearly shown that Directors with a strong financial profile have been able to steer smaller businesses through the challenges. Compiling insights from personal profiles of Directors and the trading performance of the business offers much greater correlation to credit risk for a small business than a commercial score for that business.
Where traditionally relationship managers provided perspectives on the management team, today the involvement of frontline staff in credit assessment is not the norm for small businesses. This blind spot can be addressed by considering the management of Director’s personal finances as part of credit review processes.
Identifying financial pressure pro-actively
Waiting for a rise in arrears and defaults before acting removes the opportunity to affect outcomes. Early indicators are critical to understanding the trajectory of a lender’s portfolio and creating the window to pro-actively engage with customers before arrears and defaults occur.
The Monitor notes that during the pandemic only 1% of businesses had rejected payments where bank account transactions failed due to lack of funds in the accounts. As cash balances are reducing, the share of businesses with rejected payments due to insufficient funds has tripled in the most recent months. Funding Xchange suggests that on average four months after a series of rejected payments it is significantly more likely that a business will experience default. Demonstrating how the lender is ‘avoiding harm’ is an obligation under the incoming Consumer Duty rules and also sets the tone for the FCA’s recent ‘Dear CEO’ letter on collections. It is also in the interest of lenders seeking to protect their balance sheet through proactive management of their lending portfolio.
Katrin Herrling added, “Understanding the trajectory of businesses’ performance provides the opportunity to adjust credit appetites and integrate a broader set of performance data in credit decisions to originate new credit with greater confidence. Periods of upheaval create challenges for any credit models that are trained on historic data. With arrears and defaults masked by covid interventions, data that provides confidence in current performance of businesses and business owners becomes more critical. The Portfolio Monitoring tool developed by Funding Xchange Technologies provides lenders with this critical additional insight.”
Commenting on the findings of the latest Lending Monitor, Chief Operating Officer of Simply Asset Finance, Ylva Oertengren, agreed , “SME lending isn’t easy and right now, it is probably more difficult than ever. As a lender, you need to see through the credit score and assess the business’ real potential. Lending to SMEs requires two things: an open mind and time – these are two things that are not normally abundant in credit institutions who are looking to cut costs and standardise processes.
“The good news for us is that there is plenty of data out there, new sources of indicators and information about sectors, assets, cash flow, fraud, early warning indicators. You can assess spending trends on a week-by-week basis. You can see if a customer is seeking debt or repaying it. You can estimate the true value of potential security at a low-level detail to forecast equity vs residual values at any given moment in time.
“But to digest all of this takes time. Unless you have the tech that can absorb and display the data in a way that works for you. If built correctly, it is possible to do the deeper level of review without either eroding time taken to make a decision or adding operational costs.”