Adapting lending practices during a recession

Opinions are mixed on whether a recession might be on the horizon for 2023. In any case, it remains to be seen if federal policy can deliver a soft landing for the economy as it works to ease inflation. Estimates are further clouded by the fact that recent economic downturn caused by the pandemic was a unique situation.

In addition, the last true cyclical recession occurred in 2008 and 2009, meaning that lenders who have entered banking in the last decade have never navigated a recession.

We spoke with three seasoned community bankers to gain insights into how lenders can prepare for a potential recession from a risk management perspective.

Every recession is different, but generally speaking, how does lending during a recession differ from lending in non-recessionary times?

Mark Duffy: During a recession, the bank looks at the industries that will be most affected, and we adjust and tighten our underwriting standards. I know larger banks during recessions will shut off lending to those industries, but we do not do that, knowing we need to be there for our customers. We will just be more cautious.

Justin Proctor

Justin R. Proctor: Typically, you’ll see a tightening in underwriting standards and fewer exceptions to loan policy. A majority of banks will not take unnecessary risk when originating loans during a recession compared with non-recessionary times.

Nicole Austin: During the years of low rates and great growth, the loan deals were walking in the door. We didn’t have to go out and call on customers or prospect for loans; they came to us. Businesses were growing and expanding. Cash levels were strong. Even those businesses that struggled during COVID were bouncing back. With the new reality of rates going up and the economy slowing, lenders will have the opportunity to solidify relationships with existing borrowers and prospect for new ones. This may not necessarily mean new lending but, instead, selling the value of the community bank across all products and all areas of the bank’s services. Proactively reaching out to customers to see how they are weathering the new realities of this economy will be very important. Being a partner and not just a lender will be the focus.

Beyond credit risk best practices, is there more bankers can do to mitigate risk?

Proctor: Absolutely. Having conversations often with customers who are more susceptible to stressed cash flows and credit quality issues during a recession is highly recommended. Early communication can help prevent credit issues from escalating too quickly.

Austin: Yes, communication is key. Our credit analysis processes, if they are strong, shouldn’t need to change. If our collateral evaluation is strong, then that shouldn’t need to change. Truly taking the time to know what is going on with our customers personally and in their businesses will be vitally important. Making sure we evaluate all financial information is always important no matter what the economic situation, but there is more than just looking at the numbers. We need to have “boots on the ground” at the actual business locations of our customers. We need to see with our own eyes what they are trying to accomplish. Asking good questions and really listening and determining the needs of our customers is extremely important.

Duffy: I think the best thing bankers can do to mitigate risk is to reach out to their customers and find out how the recession is affecting them. The sooner a banker understands what effect the recession has had on their customer, the easier it is to help them. Too many times, a customer will have issues but does not communicate early enough to their bank, and the issues get bigger and sometimes harder to solve.

Nicole Austin

What lessons learned from the last recession, or past recessions, would you share with lenders who have not weathered a recession before?

Austin: If the customer in front of them has weathered a past recession and/or made it through the pandemic smarter and stronger, then they are probably a good candidate for lending opportunities. Are there cash reserves to weather any downturns or unforeseen events? Is the collateral value going to hold up in a downturn? What it is valued at today is probably decreasing. How does that affect the security position of the loan? Are there financials of good quality that the bank can rely on? Touch base with existing customers. Go visit them. Talk to them. Ask lots of questions. Ask what the customer needs to continue to succeed.

Duffy: When a customer is struggling, bankers need to work with them to come up with a mutually beneficial solution. In the last recession, we found that when we worked out solutions with our customers, we did not incur losses or we reduced our losses in comparison with when the situation was adversarial. We also found that the sooner we tackled a problem, the outcomes worked out better for the bank and the customer.

Proctor: Communication is vital during a recession with customers who are struggling with revenue and cash flow issues. Being able to have conversations early not only helps credit issues from escalating but also provides reassurance that the bank will be with their business every step of the way. A recession is an opportunity to gain customers for life by helping them through an economic hardship and avoiding foreclosure.

Has your bank made any specific changes regarding lending, credit analysis or underwriting in anticipation of a more challenging economic climate in 2023?

Duffy: We are stricter on our coverage ratio policy on commercial real estate loans due to the increasing rate environment, which in turn will ensure that borrowers can weather higher monthly payments. We have also increased our stress-testing scenarios to a higher level to understand what could happen in a worsening economy.

Proctor: We’re ensuring that our lending staff understands the lending environment we are entering into and avoiding any unnecessary credit risk. We’re also emphasizing that exceptions to loan policy should be limited and not sacrifice loan quality for loan growth.

Austin: We feel very good about our analysis and underwriting processes. They have to be as strong during the high times to sustain us through the low times. Changes we would make in a downturn would be more related to industries that may be harder hit and not adding more exposure in those areas.

Community banks work hard to build strong relationships with their customers. What conversations should lenders be having with customers who may be struggling?

Proctor: Conversations with struggling customers should emphasize that we, the lender, are here to help as much as we possibly can during the lean economic times. Compassion for the customer’s situation is a positive. However, it is also important to emphasize the expectations of quality communication between both parties.

Austin: The key is the conversation. Be proactive in reaching out to existing customers, especially those who may have struggled in the past. We can’t wait for our customers to come to us with a problem. By then, it is probably too late. Does the customer have any cash reserves? How can they conserve cash? Where can they save money? How can they become more efficient? Do they have good financials or financial advisors and CPAs who can help guide them?

Duffy: Lenders should sit down with their borrowers and find out what issues are keeping them up at night and also understand how their company is being affected by the economy. They also need to ask their borrowers what the bank can do to help and remind them that the bank is there to help and to communicate any issues early.