Impact of Inflation on Credit Risk
The global surge in inflation, caused by an unprecedented demand for certain goods, supply-chain disruptions, fiscal policies, warring nations, and other factors, is affecting businesses and individuals worldwide — including banks and other financial institutions. High inflation rates significantly impact lending and can cause both positive and negative outcomes for customers and financial institutions. Inflation can benefit borrowers because they can pay back the money at a lower worth than the face value they originally borrowed it for.
Meanwhile, if inflation leads to higher, untenable prices, the credit demand increases, too. As a result, interest rates spike, benefiting lenders. Statista reports that the global inflation rate in 2021 was 4.35%. The most recent U.S. inflation rate was reported at 8.5% — just 12 months ago, the national inflation rate was below 3%.
Although the inflation rate is expected to lower in the coming years, it will still be higher than the historical average rate of increase. Therefore, lenders should develop a game plan for dealing with this never-seen-before credit risk management landscape attached to these eye-popping inflation rates. Here’s an overview of measuring and managing credit risk during periods of high inflation — and what your business can do to develop an effective credit risk management strategy.
How Does Inflation Potentially Help Lenders?
Inflation can be beneficial for lenders, especially in financing. When the prices of goods and services are higher, it ultimately means that more people will need credit to purchase both daily and higher price tag items. Since a rise in inflation is rarely ever met with an equivalent raise in wages, most businesses and individuals will experience a pinch in their pocketbooks.
Due to this, lenders now have new customers who need credit and are willing to take on a temporary debt to make ends meet. This puts pressure on banks and other institutions to ensure that their credit risk models can accurately predict the total risk profile of all customers.
Higher interest rates often also mean more installments, which can further increase the profit for lenders. Therefore, times like current economic environments can potentially be revenue-generating periods for credit lenders like banks. However, this is only as true as the institution’s ability to analyze financial data, credit history, market demand, and other credit risk factors.
How Does Inflation Potentially Hurt Lenders?
Inflation benefits borrowers and hurts lenders if the loan is taken before inflation spikes. Likewise, an overwhelming wage increase could benefit borrowers over banks and other lending partners compared to inflation.
Suppose wages do increase for borrowers due to high inflation. That could mean fewer installments and less interest as the borrowers might use this extra money to repay their loans sooner. Similarly, the money lenders receive during high inflation has a lower value than the money they originally lent to the borrower — before inflation struck. In this case, it is critical that lenders are careful in managing credit risk and do not overextend themselves with contractual obligations that will lead to a new borrower’s ability to pay owed principal and interest. This would further damage their overall balance sheet and potentially put the lending institution in an unnecessary bind.
Impact of Inflation on Credit Risk Management
Over the years, lending institutions have improved their forecasting abilities. However, the economy is still unpredictable, and unprecedented changes can happen anytime. In light of this, credit risk management has to be a continuous process that lenders adapt to swiftly.
Volatility is one of the biggest dangers for lenders during periods of high inflation. Volatility occurs when there’s an increase in the dispersion of outcomes for a given variable. Moreover, it’s not always possible to know the intensity of the swings, consumer behavior, and the impact of the global market on the national economy.
Due to this, lenders can face more credit risk during high-inflation periods. Even good borrower candidates can be poor customers with significant financial uncertainty since inflation may negatively impact their financial standing.
For instance, if people lose their jobs or their wages don’t increase, they might be unable to repay their loans. As a result, lenders can end up with more nonperforming loans, decreasing their profitability and fueling a potential financial crisis.
How to Improve Credit Risk Management During High-Inflation Periods
Lenders should always consider the possibility of an economic downturn when formulating their credit risk management strategy. Here are some ways to improve your credit risk management during high-inflation periods.
Practice Credit Risk Modeling
Credit risk modeling means applying risk models to assess the creditworthiness of a potential borrower. It can help lenders identify which borrowers are more likely to default and, as a result, manage their risk accordingly.
Credit risk profiles are dynamic and change with circumstances. Therefore, lenders should use credit risk modeling to determine the repayment likelihood of a loan. Modeling often includes a standardized risk assessment that looks at factors such as credit history, credit rating, current financial statements, etc. From this predictive model, an institution should have the necessary insights to determine the chance of a borrower’s failure to uphold its obligations.
Use Holistic, Deep-Think Tools
A holistic approach can help lenders identify early signs of financial difficulty for borrowers. Lenders should consider all aspects affecting borrowers’ ability to repay their loans.
Some examples include employment history and current debt obligations. A comprehensive credit risk management tool can come in handy to minimize credit risk during times of financial uncertainty.
While it’s true that high inflation can benefit lenders, that’s not a reason to overexert and take on too much risk. Lenders should always be mindful of their lending criteria and not loosen their standards because times are good.
It’s essential to strike a balance between maximizing profits and minimizing losses. Thus, lenders should consider increasing the interest rate for new loans during periods of high inflation.
Develop Time-Specific Credit Scorecards
Lenders should develop credit scorecards that are specific to high-inflation periods. This will help reduce defaults and keep harmful debt levels in check.
Monitor the Market
Some industries and sectors tend to do better during high inflation than others. Lenders should take note of how different industries are performing during such times. Monitoring the market will help you create lending criteria specifically for business loans during high-inflation periods based on the financial performance of different industries.
For instance, many businesses will be good borrowers if the manufacturing industry is doing well. Meanwhile, if a particular industry is experiencing significant losses, you might want to adjust the lending criteria for such businesses to minimize your risk.
Credit Risk Management Tools to Invest in Now
Credit risk management is vital for lenders, especially when substantial uncertainty surrounds the value of money. A robust credit risk management tool, such as GDS Link, can help you leverage artificial intelligence and data-driven insights to ensure you practice innovative lending during high-inflation periods.
Besides measuring and managing credit risk, GDS Link also helps streamline marketing, account management, and lead generation, acting as your ally during unprecedented times. Request a demo to learn how GDS Link can assist you in efficient credit risk management.
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