David Croen, Head of Risk Products at Bloomberg L.P., was interviewed by Alison Fletcher, a Corporate Treasury Specialist at Bloomberg, on what customers have faced when evaluating credit rate risk and what measures they can take to address it. Croen also discusses the innovations he anticipates in the space, as well as regulations to watch out for. (Edited for flow.)
Q: Why are corporations and asset managers asking about credit risk?
There have been over 300 major business bankruptcies in the US year to date (and nearly 16,000 total). And we’re seeing this not only in the US, but in Europe where there has been the highest level of business bankruptcies since 2015. And it’s not limited only to corporate bankruptcies. We also saw Birmingham – the second largest city in England – note that it would not be able to meet its obligations and so will be restructuring. This is an issue that’s likely to continue for some time.
Corporations are paying much higher interest rates now than a year ago and credit is harder to come by. Many firms, particularly those with large capital needs, borrowed heavily during the years of near-zero rates, and these firms are now approaching a maturity wall; that is, firms are starting to have to repay and refinance their debt. And when they do that, the question is, will they be able to time the market, or will they be able to get new financing if rates go down? Some firms are biting the bullet while others are waiting in the hopes that rates go lower.
Q: Why are there more credit rate uncertainties currently?
A lot has changed during the past 20 years or so. Interest rates have been on the way down due to slower economic growth and demographic factors. Populations are getting older, and their borrowing patterns are changing. Some are not necessarily spending as much while some other groups are spending a lot more, particularly on credit cards.
Central banks have pushed rates higher in an effort to combat inflation, and have raised Fed Funds rates aggressively, resulting in rates from 3.5 to 5.5 percentage points higher over the past two years. Many say the rates are now the most important financial measure in the global economy.
Treasury rates recently touched 5% and this is the highest for 10-year Treasury since June 2007, just before the global financial crisis (GFC) began. This means that, although central banks provided a great deal of support during the GFC and during the global pandemic, it also found that combining the low policy rates and stock of asset purchases led to significantly higher inflation. And now that central banks across the globe are withdrawing their support, it has become more challenging for firms to obtain financing.
Even as these downward pressures on rates are fading, GDP growth likely hasn’t bottomed out. As populations are aging, Chinese demand for risk free assets has fallen, and government debt is rising globally (and there is not enough demand to meet the supply). With rising political and military risk, climate change, fiscal risks, and rapid technological progress – all of this has posed an upside to risks, meaning that rates might stay higher for longer.
Q: What are the best practices for risk management, considering those uncertainties?
Credit risk management refers to the process of assessing the creditworthiness of counterparties (e.g. Identifying, assessing, monitoring and managing credit risks), which includes customers, suppliers, trading and banking entities. It includes procedures and analytics for active monitoring of existing credit exposures and portfolios, evaluating scenarios, and implementing risk mitigation strategies.
The ultimate goal of credit risk management is to minimize the impact of credit risk on an organization’s financial stability, while also allowing it to grow and prosper through the extension of credit. For example, business credit (sometimes called trade credit) is important to manage, as counterparties can use credit as a form of financing, for example, when dealing with large purchases or sales.
How do you identify, assess, monitor, and manage the risk of counterparties that includes your customers, suppliers, and your banking partners? It’s no longer acceptable to just use ratings. In fact, most regulators have moved away from ratings to quantitative credit risk measures mitigation techniques. So, how do you reduce risk?
Some other steps companies can follow include obtaining business credit information. Who is your counterparty and what are their financials? Are the financials publicly available? If they’re not, are their other alternatives? Understand the company and its structure, its financial statements, and its performance metrics. The metrics you choose, as well as comparative industry benchmarks, will help evaluate credit risk. For example, what happens if that counterparty defaults? How bad could the loss be? And what are the various scenarios that you might apply if the economy shrinks over the next couple of years? What if rates continue to move up, how could that affect your business? Understanding the impact using the tools that are out there can help.
You also need to assess industry risk, not just the company but the industry in which they operate. For example, in the oil industry, oil prices are in the mid $80s. Now, will they go into the $100s or will they go back into the $60s? Understand the market sentiment. Understand the geopolitical risks. Understand the supply chain. The need for monitoring is not once a year, or once every six months, but it’s ongoing, and some regulators now say it’s continuous.
Bloomberg models can help assess this. There are models to provide early warnings, as well as information about a company’s credit, both in the present and up to the next 20 years. The models also provide scenarios that will help assess the what ifs that you don’t know and for which you don’t have a crystal ball.
Q: Can you talk about new regulations and how this is impacting credit risk analysis?
For a long time, banks and corporates used ratings to monitor the credit quality of counterparties, customers, suppliers, banks, and investment entities. What was found during the Global Financial Crisis was that ratings sometimes didn’t keep pace and didn’t provide an early warning of potential credit deterioration. In 2010, Congress passed the Dodd-Frank Act, which among other things, required regulators to move away from ratings to other measures of credit risk.
The SEC, in 2022, decided to take a more quantitative approach to credit risk. They approached us about our default risk models, which are now referenced in Regulation M, which governs the underwriting for US dollar-denominated bonds. Underwriters need to evaluate the risk and provide investors with what that risk is, five business days before issuance. This analytic is a quantitative point-in-time credit risk measure, as opposed to ratings, which are a through-the-cycle measure of the likelihood of survival over some indeterminate longer period of time.
Q: It certainly sounds like the market has moved away from ratings to evaluate credit. Can you explain some of the new terms we’re hearing and why they are important?
Market participants have increasingly sought to quantify these exposures – the risks, the measures, the valuations. 15 or 20 years ago, we started talking about hedge effectiveness, which was referred to in FASB 133 and other accounting guidance. The interesting thing about this guidance is that you were supposed to determine at the time who was the owner of the risk. Who had the residual risk, residual gains, residual losses and ultimately who should claim the asset on their balance sheet. Some firms balked at that because they had to do real analytical work. Some of the government sponsored enterprises actually had to consolidate a great deal of assets that were not on their balance sheet, onto the balance sheet. And so that was the first of many of these quantitative requirements. Regulators started to pick up on them as well.
In 2008, we had the financial crisis and by 2009, the International Swap Dealers Association realized that they needed to have a standardized way of representing credit default swaps. ISDA required that credit default swaps (CDS) would have a certain structure with a certain assumed recovery, and a certain way of those prices being quoted. That opened up trading in CDS. It wasn’t enough because CDS only reflected what market participants saw, not necessarily what the risk was.
That led to extensive use of probability of default metrics, which is the likelihood of a default within a certain period of time. We’ve developed a measure which has an over-92% accuracy ratio, helping us to see ahead of time the likelihood of deterioration or amelioration. Each of these measures are part of a move towards standardizing and quantifying the level of risk faced. In applying Current Expected Credit Losses (CECL), another recent accounting guidance, it is focused on understanding the value of an instrument and the potential impairment to the instrument.
Q: Which innovations can we expect to see in the credit risk space moving forward?
A lot of the innovations in the credit risk world will continue to be around data, but increasingly moving to intelligent analytics and machine learning. For example, when seeing one news story, or 100 news stories, does it tell something about the credit risk of the company? How can this be compared that to what has already happened in the market? It seems that while we still see lots of differences in the global markets for credit risk and what is defined as default, there will be increased transparency and increased use of machine learning and artificial intelligence models. There also will be increased uses of not only financial information but also non-financial information.
I think we’re going to continue to see development in relational credit risk models that help to understand the risk of a company to the rest of its industry as financial transparency continues to expand globally, allowing for better comparability. We might also see movement in terms of indices. If you can’t value an asset, could you value an index? Could you apply that valuation to that asset?
Other methods will increasingly become more electronic, and I think technologies, like blockchain, will continue to progress so that you can more readily validate trades. It’s an exciting time ahead, indeed.