Credit Markets Broaden View of Risk and Portfolio Diversification

October 31, 2022

As global monetary policy tightens, corporate treasury teams should be re-evaluating their risk management profile to reduce their exposure to risky customer accounts.

Ranjini Pillay
Senior Vice President, Credit Division, Crum & Forster

Andrew Shapiro
Chief Executive Officer & Chief Underwriting Officer, Applied Risk Credit

Geopolitical and economic turmoil fueling global credit market disruptions is triggering a broadening view of portfolio risk exposure. Confluence of complex financial marketplace dynamics has accelerated tightening of the credit markets amidst looming recessionary concerns on the horizon.

Inflationary pressures on macro issues are emerging in countries worldwide contributing to financial management cautionary outlook. Today, inflation is tracking at the fastest pace in more than two decades. Revenue influences, based on the cyclical nature of the credit markets heightening sensitivity to unpredictable economic conditions, are driving portfolio business models in search of lower volatility investments. Rising interest rates in mature economies, marking a drastic departure from a low interest rate environment in recent years, underscore the significance of broader loan portfolio diversification. The risk profile of bank and corporate asset portfolios has never been more important within a world steeped against the backdrop of simultaneous recessionary and inflationary fears.

Despite challenging headwinds, there is ample demand in the marketplace for the extension of credit. Volume is driven by sector. The global energy markets are under scrutiny in the wake of disproportionate levels of demand and available sources of supply within the respective countries, thereby inflicting volatility. Yet, the energy sector is sparking renewed volume levels in search of access to favorable credit and new deal opportunities. International banks have deep capacity to align that demand for clients equipped to satisfy payment of higher interest loans. Greater attention is focusing on those investments within low cyclical sectors such as healthcare, or organizations with the ability to pass through cost increases such as business services. Of note, favorable demographics and non-cyclical end-market demand make some healthcare sectors particularly interesting.

Rising interest rates in countries worldwide is in direct response to inflationary stress to preserve market integrity and support recovery stability in a post-pandemic environment. Central banks are raising rates aggressively in 2022 leading to more expensive credit. According to The New York Times in a business article that appeared on July 18, 2022, “at least 75 central banks lifted interest rates this year.” Rising interest rates will have the greatest impact on default risk, which is a global phenomenon.

Global Monetary Policy Tightening

As global monetary policy tightens, credit markets are leaning toward reduced demand for riskier assets and the liquidity in high-risk bonds or longer-term assets is diminishing. The monetary climate poses the threat of default for those companies that are highly leveraged and subject to near-term refinancing requirements. Rates hikes causing a reversal in the flow of funds enjoyed in previous years are creating an adverse chain reaction drying up liquidity in international finance markets. Vulnerable countries are facing currency devaluation, thereby worsening domestic demand and leading to negative credit growth. Banks that depend heavily on foreign funding are suffering from balance sheet disparity linked to the strong dollar and, in some countries, resulting in at-par market currency rates.

Emerging markets are being confronted with a wall of issues; not the least of which is the continued strength of the U.S. dollar. The value of the U.S. dollar has been driven by inflationary pressures and rate hikes in markets worldwide. The U.S. dollar is at a 20-year high, upon gaining more than 10% this year. Credit market consequences in the aftermath of the global pandemic has had the most severe effect on emerging markets, including stagnating the supply of essential goods and causing a lingering inability to manufacture consumer goods for export.

Alternative Business Approaches for Default Risk

Banks and corporates face the necessity to address risk management profile issues to effectively capture credit market finance opportunities, while reducing overall exposure to risky assets. Demand for non-payment insurance is on the rise due to three underlying trends: transactions coming to market as corporate entities and banks seeking portfolio diversification, the need for bank capital relief to best optimize balance sheets, and desire of banks to capture more revenue from clients while capping credit risk. Debt market disruption is a global occurrence as capital markets worldwide are increasingly intertwined and interdependent.

Outstanding debt obligations may require refinancing but could spark a wave of default outcomes within a rising rate economy. Insurance coverages potentially offer an approach that would allow for the extension of credit commitments, hedging against the risk of payment default. Programs are underwritten to manage portfolio assets by sharing a percentage of the default risk exposure with the insurer to achieve capital efficiencies and balance sheet protection.

Credit insurance carriers should be the silent partner assuming a significant portion of the risk, particularly for banks looking to build a robust book of business in a controlled manner.

Often referred to as “accounts receivables” or “failure to pay” insurance, programs can be structured to protect valid and enforceable debt obligations against the risk of non-payment. Coverage options can apply to a single debtor owing monies to the institution, or as a more encompassing portfolio approach for one business or financial institution with multiple commercial account debtors. Historically, credit insurance markets have been dominated by European and Japanese banks but in today’s economic climate, more involvement is emanating from U.S. banks, which are focusing on use of non-payment insurance to make larger client commitments to capture more revenue without additional credit risk. Credit insurance offers an alternative balance sheet financing strategy for banks, multilateral financial institutions, global commodity firms and exporters, and multinational corporates.

Emergency of Strategic Risk Transfer Strategies

Credit markets are striving to navigate capital requirements within regulatory parameters faced with economic challenges. Corporates and banks are looking to bring to market a wide distribution of risk within a diversified portfolio of loans. A broadening view of risk has evolved into a fresh look at what entities can deploy in terms of capital allocation strategies.

European banks have turned to alternative markets to optimize their balance sheet within the context of jurisdictional regulatory regimes. The emergence of Strategic Risk Transfer (SRT) strategies has become an acceptable, while still evolving business model. SRT transactions are designed to ease the bank’s overall non-payment exposure on a range of assets and lessen capital allocation prerequisites for more efficient, profitable portfolio risk management.

SRT is, in essence, a transactional structure that de-risks loan portfolio exposure by transferring the risk of aggregate borrower non-payment to a third party. SRT deals can involve corporate loan assets such as trade finance loans, loans to SME’s, infrastructure and project finance loans, or mortgage loans, among other classes. SRT strategies can be executed on a funded basis via note purchase by specialist credit firms dedicated to the SRT arena and/or on an unfunded basis via non-payment insurance coverage offered by various credit insurance market carriers. The level of protection required for the bank is determined by the respective regulatory body and must be so approved by such to achieve SRT designation. SRT transactions can offer banks a competitive advantage to manage various risk asset classes to grow their business and reduce capital allocation requirements.

As global credit monetary policy tightens, credit markets are leaning toward reduced demand for riskier assets and liquidity in high-risk bonds or longer-term assets is diminishing.
Myriad economic and geopolitical variables driving volatility across all industry sectors now require business model investment strategies that embrace today’s irreversible shifts in the near future for sustainable risk management soundness.