What Lies Ahead: Credit Risk Under a Biden Administration

2020 is a year we will never forget, but will gladly put behind us. Although our short-term prospects remain uncertain given the recent acceleration of the spread of COVID-19, the announcement of effective vaccines gives us hope for the future.

As we look forward to a brighter 2021, what can we expect around credit risk modeling and management? How might the financial regulatory plans of a Biden administration affect lenders, risk managers and borrowers?

Regulation, Stress Testing and Pandemic Modeling

Given that banks have fared relatively well, financial regulation will likely be more evolutionary than revolutionary under President Biden. Stress testing and other restrictions enacted through the Dodd-Frank Act will continue to be enforced and may see some modest expansion, such as the consideration of additional stress scenarios or greater emphasis on leverage ratios. However, these are likely to be adjustments around the edges, rather than the adoption of, say, all-encompassing “Dodd-Frank Act 2.0” legislation.

Before COVID-19, the Fed faced some pressure to ease up on stress testing. It had even limited the number of banks that had to do annual versus biannual tests and reduced the number of stress test scenarios considered. But the Fed resisted calls to ease further and quickly pivoted to expanded stress testing (including the introduction of additional scenarios) during the pandemic. It's clear that these processes will be reviewed and institutionalized for future crisis management.

Regulators will also undoubtedly be looking for banks to enhance their models and processes to address future shocks. But this requirement won't be particularly oppressive, as the coronavirus proved to be a real-time operational stress test. Indeed, credit risk modeling teams are already busy re-evaluating forecasting models that failed to capture the impact of record high unemployment combined with unparalleled levels of government support to households and small businesses.

CECL: Present and Future

The need to develop flexible, adaptable forecasting processes was further underscored by the adoption of CECL - an accounting standard for expected credit losses - this year. The trial-by-fire implementation in Q1 led to a greater appreciation for running multiple economic scenarios to set loss reserves, and illuminated the need to give management the flexibility to make informed judgments when new situations demand it.

Implementing a new accounting rule was going to be a challenge under the best circumstances, let alone during a pandemic. Risk management teams rose to the occasion, with 75% of eligible banks choosing to proceed with CECL adoption, rather than taking the option to delay provided under the CARES Act.

While it is too soon to fully evaluate the effect of the CECL rule on individual institutions and the economy more broadly, the results to date have been encouraging. Loss reserves have increased in anticipation of future charge-offs, with limited effect on credit availability. Given this positive experience, widespread CECL adoption is expected to continue in 2021 without additional delays.

Fortress Capital

Despite a recession that was unprecedented in swiftness and severity, the global financial system has been surprisingly resilient. While the book is yet to be fully written on credit losses, bank balance sheets have remained remarkably strong. The sharp increase in the amount of capital held after the global financial crisis improved resiliency and reduced the number of bank failures and bailouts.

For the most part, banks have remained profitable despite setting aside billions (if not trillions) of dollars for anticipated loan losses and operating in a challenging, flat yield-curve environment. While global central banks provided relief through the rapid provision of liquidity at the start of the crisis, few institutions required the extra support.

The mere presence of funds was enough to convince investors and depositors that the financial system was secure. Although we faced many challenges in 2020, at least a bank run was not among them.

Climate Risk

One area where credit risk managers should expect more significant change under President Biden is the demand for risk assessments related to climate change. International central banks, including the Bank of England, are already incorporating climate change scenarios into their annual stress testing exercises - and the Federal Reserve has indicated it will follow suit.

We can expect a Biden administration to direct agencies, such as the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, to consider climate in their regular bank reviews and risk assessments.

While this would be a significant departure from the Trump administration's approach, a regulatory focus on climate risk complements existing market forces. Institutional and individual investors are increasingly requiring businesses to not only report the environmental and social impact of their activities but also incorporate climate change risk into their share-price evaluations.

Credit risk analysis has already been moving in this direction, independent of regulatory requirements. Regulatory focus from the Biden administration may accelerate this trend and help bring some order to the marketplace.

Although consensus has now formed around the need to consider climate change in credit risk assessments, the best approaches and methods continue to evolve. Credit risk modelers should expect more discussion and debate in 2021, along with the creation of new datasets, scenarios and tools. Given the complexity and interdependence of climate and the economy, machine learning and AI techniques are likely to figure prominently.

Early Days

Of course, it is still too early to assess the Biden administration's financial regulatory plans. Much will depend on who the incoming president appoints to key financial regulatory positions, along with the composition of the Senate.

But new leadership may not have as much impact as market forces. The coronavirus underscored the value and necessity of risk management that is both effective and agile. Shareholders and bank managers are already challenging their risk management teams to enhance their risk identification, scenario development and loss modeling processes - independent of new regulatory requirements.

This is not to say that a new regulatory regime is irrelevant. On the contrary, regulators could interpret the COVID-19 crisis as a justification to bulk up capital further. Navigating this crisis required trillions of dollars of support from the Federal Reserve and the federal government, and there is no guarantee that we would have the necessary resources or political will in the future to implement similar measures.

To address this, a new regime might demand lower leverage ratios or restrict higher-risk activities such as leveraged lending. Fintechs may also be subjected to greater scrutiny, given their expanded market share in areas such as personal loans and mortgage lending. While many fintech business models have proven resilient, others have failed. The Consumer Financial Protection Bureau and other regulators will certainly be taking a closer look.

Overall, the Biden administration is likely to view the financial services industry much like it views public health and the economy more broadly: we are all in this together. Excessive risk taking and bad behavior by a few actors puts everyone else at risk. Risk managers can expect the new administration to be tough but fair, with a centrist position that recognizes the vital role private lenders play in providing credit to households and businesses.

Cristian deRitis is the Deputy Chief Economist at Moody's Analytics. As the head of model research and development, he specializes in the analysis of current and future economic conditions, consumer credit markets and housing. Before joining Moody's Analytics, he worked for Fannie Mae. In addition to his published research, Cristian is named on two U.S. patents for credit modeling techniques. He can be reached at cristian.deritis@moodys.com.