Evaluating risk in times of uncertainty

Since the COVID-19 pandemic, the world has battled volatility and unpredictability in adjusting to unprecedented events. Businesses across the globe continue to endure those repercussions.

Over 800,000 US businesses closed last year — 200,000 more than the average number of closures in recent years. The pandemic and other events such as the Russia-Ukraine, weather and supply chain challenges, rising inflation, and rising interest rates, will impact the businesses in banks’ lending portfolios.

According to the National Centers for Environmental Information, in 2021, the U.S. experienced 20 extreme weather events causing $1 billion or more in damage. This is in addition to the dozens of events that caused up to hundreds of millions of dollars in damage. Wildfires, tornadoes and hurricanes are increasingly common occurrences. These natural disasters often deal with direct damage-causing businesses to close.

Other risk factors, such as supply chain issues, have a ripple effect on consumers and businesses around the world. For example, last holiday season, consumers felt the squeeze of supply chain issues, as businesses struggled to manage delays in delivering key ingredients, parts and products.

Lenders need to be aware of how these different scenarios will impact their commercial borrowers when evaluating risk. By taking a granular, forward-looking approach to risk, they can significantly improve credit outcomes while also pursuing growth.

Risk assessment must go beyond history

Banks typically consider historical data and business impact as the most prevalent predictors of risk. Pandemics, trade wars, economic cycles, supply chain challenges, and natural disasters for example, all hold essential data. Decision-makers need to supplement this data with forecasting data such as: revenue projections, industry benchmarks, macroeconomic drivers, and scenario and sentiment analysis.

Historical data is helpful as it’s based on collected data of events, but information such as revenue projections can bolster this data by analyzing possible outcomes based on certain scenarios. By adopting this forward-looking approach, banks and borrowers can make more informed decisions based on foresight as well as insight.

Banks should consistently run and re-run scenarios using real-time data as it becomes available. Before 2020, banks looked at historical data such as supply chain shortages or food recalls in the restaurant industry to predict how businesses could adapt and succeed. The pandemic changed that approach and has highlighted the need for more granularity. Fine-dining restaurants for example, temporarily closed for in-person customers following the initial lockdown in 2020. While some switched to pick-up services, revenues clearly didn’t match pre-pandemic levels. Meanwhile, many pizza delivery businesses, which fall within the same sector as fine-dining, saw an increase in demand because their model was well-suited for lockdown life. Once countries reopened from lockdown, fine-dining experienced a resurgence in popularity but clearly the experiences of the two businesses during the pandemic period were very different. That is why a sub-sector, granular approach is so important.

Whether it’s global health crises, economic instability or political unrest, banks need to build a deeper understanding of a business’ ability to pivot and adapt before providing a loan. Forward-looking analytics based on a range of scenarios using granular data is the only way to truly grasp that adaptability.

Industry analysis requires granularity

Industry benchmarks play a crucial role in understanding risk, so drilling down to the granular level should be a priority.

Last October’s gas shortage for example, forced a spike in consumer prices that continued driving interest in fuel-efficient vehicles. Traditional gas-powered automobiles lack the efficiency of hybrids, and electric vehicle owners don’t need to worry about increased gas prices. These scenarios make car manufacturers with a growing electronic fleet — or companies whose vehicle fleet is electric — significantly more appealing to lenders in the long term.

When conducting scenario analysis, banks must consider the impact of changes to a business' industry and specific sub-sector. We’re living in an ever-changing world with new challenges and expectations. Banks and businesses must evolve to meet modern demands, and that evolution starts with updating and adjusting their approaches to risk assessment and industry analysis.

Based in San Francisco, Peter Grant is OakNorth’s President and COO leading its revenue and growth, working directly with OakNorth’s co-founder, Rishi Khosla.

This article is the first in a three-part series on how finance-function professionals can effectively assess a pandemic, climate change or supply chain shortages with scenario analysis. Part two focuses on how different scenarios such as climate change present risk and opportunity for businesses.