Banking Back To The Future

By Ian Robinson

Probability of Default

Predictive analysis is forecast modelling based on a matrix of variables to determine future outcomes.  It is usually an amalgamation of historical data regression for market acceptability, fintech algorithms to impress Wall Street sponsors and a splash of cosmology to cover the guesswork.

The variations from actual outcomes can vary from incredulous degrees of scientific accuracy to wild card throwbacks, but they are always going to be criticised in hindsight given that outcomes are always obvious when seen in plain daylight.

For banking, determining the “probability of default” in loan assessment has been, until recently, dumbed down over the years to a sequence of filters that will throw a traffic light.  Red is an outright fail, green is approved and amber being more information is needed.

Given that banking is now going through another phase of evolution, it is surprising to see how the risk assessment model has digressed to a more archaic diluted version of statistically irrelevant analysis.  Allow me to explain.

I will ignore what the analysis was but more on what it has become.

The Royal Commission blow torched the banks on unconscionable lending.  Lending in instances where the borrower had historically demonstrated that there was no capability of repaying the loan in their current circumstances.

“Unconscionable lending?…Great Scott!”

There may have been a few isolated cases where this was evident, and the ones spotlighted in the Royal Commission were certainly qualifiable for a chapter in the sequel to The Wolf of Wall Street.

But overall, I can personally verify that commercial lending was conducted on a very professional capacity confined in a universe with finite resources.

What the banks can’t control are decisions made by borrowers that extenuated risk within their respective businesses, or macro events beyond anyone’s control.

Historically, lenders applied a qualified weighted approach to quantifying the potential (positive) cash flow generation of a business in order to demonstrate repayment capacity, benchmarked against historical performance for performance assumption credibility.  There are many more nuances to credit assessment, but it explains the trend in general terms.

Conscionable Lending

Post Royal Commission, the tendency now is to demonstrate conscionable lending to corporate watchdog APRA by drawing a linear line from historical performance to projected performance.  It is a real M J Fox “Back to the Future” analogy.

But there is one thing that all educated homo sapiens can agree on – it is the future cash flow of a business that repays a loan, not the historical cash flow.  And past financial performance can be poorly correlated to future performance.

Let’s take farming for example.  We are amid a most challenging 3-year dry spell across the large percentage of the country.  If the season breaks tomorrow farmers are going to ask their banks for two things.

First, they are going to need a substantial increase in their working capital.  This is to cover the acquisition of breeding or trading livestock, crop or pasture inputs and some much-needed capital expenditure that may be required.

Second, they are going to need it quickly as farming is all about timing.

The banks will now review their clients request through the lens of historical performance of which there is none.  If they do extend credit, then they may well be in breach of APRA’s minimum standards of lending conduct.  If they do not extend credit, then farmers will face a liquidity crisis and a self-engineered default will play itself out.

“What historical performance? Just trust me and look at Back to the Future forecasts”.

The traffic light in either case is either amber or red as the banks are caught in this credit decision paralysis paradigm.  We know this because we are seeing it already.

The canary in the cage is the lack of policy flexibility in determining origination of viability risk on a case by case basis. This is opposed to applying standardised bell curve probability analysis, on a one size fits all basis.

Top percentile farmers minimise losses in poor years and leverage good years but may fail to qualify for credit if the seasonal event endures over several years.  Our country is now leaning into 5th and 6th generational farmers who have endured and survived more challenging seasonal adversities than what is playing out today.  Yet the banks will see it differently.

This is not the banks fault, but a causality systemic from our regulatory culture to demonstrate “duty of care”.

There are three C’s in credit.  “Collateral”, “Character” and “Capacity”.  Unfortunately, “Common Sense” is not one of them.

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