Could a recession be creeping up on us? What are the indicators and what can alternative finance providers do to prepare for the inevitable?
It’s said that the credit cycle leads the economic one by about 18 months. That means that it turns down – or up – a year or more before the economy does. So which are the most prevalent credit indicators that we are on the cusp of an economic downturn?
First of all, rising inflationary pressure. While the UK’s inflation rate fell more than expected during September, the fact that the Bank of England has raised interest rates twice leaves officials anticipating that a tight labour market could soon lead to high wages being passed on to consumers through inflation. The unwanted consequences of the uncertainty around Brexit could also weaken the pound as imports will become more expensive with company also being more cautious in making investment.
Secondly, in October this year, the Bank of England’s financial policy committee issued a stark warning over the rapid growth in lending to indebted companies, noting that lending standards were falling and that it would more closely monitor the risks to the UK.
Alternative finance providers are dependent on credit from investors or individuals and therefore could be hit hard as a result as raising capital could be more challenging. There are also concerns over how loan books might withstand the stress of borrowing companies not being able to repay their loans. Industry default rates are currently suggested to be around one to three per cent. These could increase during a recession, testing the credit and risk assessment models built by the different platforms, and potentially resulting in financial losses for the lender.
How can alternative finance providers prepare?
Having an adequate risk management in place is vital. This includes a clearly defined risk management strategy and a comprehensive risk management framework, which should be in line with banking regulations. The alternative finance industry has not yet been through a full credit cycles. Therefore, we can’t be sure how the different providers will hold up when exposed to changes in credit conditions and systematic risks. But those with a robust risk governance framework have a higher chance to come out of a downturn unscathed.
In addition, alternative finance providers with teams that have been through credit cycles and that are aware of systematic risks are more likely to have built businesses that are better able to withstand an economic downturn. Experience matters. They are also better in upholding the highest regulatory and reporting standards.
Alternative finance providers should also remember two guiding principles: When the economy is doing well, there is more room for inefficiencies. And once investments and spending slows down, the shake-out will be inevitable and the most efficient providers with the best product will come out on top. Secondly, greed isn’t good.
An economic downturn will inevitably bring challenges for alternative finance providers, but ultimately help the alternative lending industry evolve. The good news is that the alternative finance providers that don’t get weeded out or snapped up will emerge stronger. An exciting prospect for investors, businesses and alternative finance providers alike.
This article has been originally published on TRF News, a leading provider of news, market intelligence & events for the receivables finance industry.
Originally published November 15 2018 , updated February 24 2020