Small businesses entering recession in weak position – lenders can’t ignore preparing for deterioration in portfolio performance even as traditional risk signals remain muted.
The most recent FXE Lending Monitor, published by FXE Technologies, the technology arm of Funding Xchange, highlights that more than two years after the government provided unprecedented support to businesses at the start of the covid crisis, the protective effect of the Treasury’s cash cushion has worn off.
Tracking businesses that are using FXE’s marketplace shows that cash levels held by businesses returned in Q3 to pre-crisis levels.
The reduced bank balances directly translate into rapidly rising indicators of financial distress like rejected payments where businesses do not hold enough cash to successfully make payments from their accounts. While only 1% of businesses had at least three payments rejected during the height of lock-downs, around 5% of businesses are now affected.
The signs of increasing financial stress is crystalising as the UK economy is entering what is expected to be a long and deep recession. Challenges in creating positive cashflow is coupled with weak balance sheets burdened by debt taken on during the covid crisis.
The patterns of where FXE is seeing distress is not following normal patterns of industry-led downturns. The Lending Monitor shows that individual businesses in sectors have widely different trajectories – suggesting that factors like the quality of management team matters more than exposure to a specific sector. The influence of management was first identified by FXE during the covid crisis as businesses led by directors with strong personal credit records fared significantly better.
The cash cushion has successfully protected lenders from arrears – the effect can still be seen as arrears and defaults remain at historically low levels. Yet, with cash balances down to pre-crisis levels, rejected payments from businesses’ bank accounts are ticking up rapidly. These very early warning signs are bound to translate into arrears and defaults as a chain of risk events is being set off.
Incoming regulation for the FCA requires lenders to demonstrate that they are pro-actively engaging businesses to ‘avoid harm’. Lenders need to rethink their engagement strategies with businesses not just to comply with the regulation but also to protect their own portfolio.
How lenders are impacted depends on the robustness of their portfolio and their ability to mitigate defaults by engaging with businesses early. However, ‘traditional’ risk indicators are not providing a read on the future exposure as the cash cushion muted normal risk indicators.
FXE advises lenders to understand the trajectory of businesses’ performances to seize the opportunity to pro-active engage with businesses and adjust credit appetite and integrate a broader set of performance data in credit decisions to originate new credit with greater confidence.
CEO of Funding Xchange, Katrin Herrling explained, “The FXE’s Lending Monitor uses macro-data from FXE’s marketplace to understand how risk trends are playing out. The vast amounts of cash disbursed during the pandemic created a safety net with balances almost doubling overnight – masking temporarily other signs of distress. Cash levels are now back at the pre-crisis levels at a time when the economy is under stain from increasing interest rates, record energy prices and a looming recession.
Lenders cannot be compliance while arrears remain surprisingly low but have understand how their exposure is evolving by dynamically monitoring their portfolio and tracking trading performance of businesses. This is the provides the basis for proactively engaging with customers and demonstrating how funders are avoiding harm.”