of European leasing, we discover the real impact the credit crunch
is having on the asset finance industry and how it is faring in the
age of bad debt and Basel II
With finance companies facing the consequences of the so-called
‘credit crisis’, caused by sub-prime mortgages in the USA, the fact
that implementation of Basel II is gathering pace, and a forecast
softening of growth across a number of European markets, it is
clear effective credit, arrears and portfolio management will be a
critical factor in maintaining strong profit levels.
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This survey by Leasing Life, carried out in conjunction with
consulting group Invigors LLP, reveals the true scale of changes
facing finance companies across Europe, with over 50 per cent
indicating that the credit crisis has already impacted their cost
of funds.
With 59 responses across Spain, Germany, the Netherlands,
Belgium, Romania and the UK, the survey delivers an up-to-date
perspective on how finance companies across Europe are responding
to these challenges.
Impact of crunch hits home
More than half of respondents indicated that the credit crisis
has already affected the cost of funds of their businesses.
Slightly more than one-third have already changed their
underwriting criteria, while around one-fifth have changed the type
of funding used for their businesses. Equally, one-fifth have
changed their approach to managing arrears.
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By GlobalDataInterestingly, those affected were both bank and independent
leasing companies, roughly in equal measure, highlighting the
extent of the contagion.
New opportunity?
But the news for finance providers is not all bad, with a
feeling among some respondents that a new competitive environment
would bring opportunity. Among those was Barry Nicholson, a vendor
finance consultant, who stated: “It can actually provide a
competitive advantage for small, niche operators.”
Looking forward to the coming year, 80 per cent of respondents
believe the credit crisis will have a moderate or strong impact on
their cost of funds. Contrary to expectations, there was no clear
correlation between the means of funding and the impact of the
credit crisis, but cost of funds and a drive among lessors to
generate increased gains to offset expected credit losses. Those
organisations able to hold their current pricing, even in the short
term, may be able to generate a competitive advantage leading to
an increase in funding volume and market
share.
New income types
A related impact that was highlighted is a drive towards other
incomes, with some funders seeking to generate more non-interest
incomes, such as fee income. Three quarters of respondents
believed there will be a moderate or strong impact on their
underwriting criteria, while half expected changes to how they will
manage their arrears. In the words of one funder: “We are watching
the position in terms of arrears very carefully, given that
statistics suggest we may be entering a significant
downturn in the economy.” Lucian Vinatoriu, regional manager of
Raiffeisen Leasing, highlighted the dilemma facing decision-makers
with the comment that there is “sort of a psychological impact
translated into a state of continuous alert among the financial
companies: is there a tsunami at the horizon, or just a small
wave we can easily avoid?”
Tighter underwriting
Where viable, it appears underwriting standards will tighten.
Also, a larger upfront deposit appears more likely to be required
for marginal credits, underwriting flexibility will be reduced and
customers are likely to find credit lines more restricted or with
more onerous terms
Surprisingly, as many as half of respondents anticipate an
impact in terms of the type of funding used to fund their business,
not just the cost of funds. However, there were no indications as
to what revised funding structures may be.
Overall, nearly 50 per cent of respondents feel the credit
crisis would have a serious or very serious impact on their
business (see Chart One).Those saying the impact was “very serious”
ranged from bank-owned to independent and captive finance
businesses, suggesting the impacts may be felt severely across a
broad spectrum of leasing organisations.
Portfolio selling likely to rise
Ninety per cent of respondents believe that, as a result of the
credit crisis, over the next 12 months there would be material
changes in the competitiveness of some finance companies in their
target markets (see Chart Two). More than 80 per cent believe there
would be sales of distressed portfolios or leasing companies. At
the same time, more than 80 per cent believe there would be an
increase in bad debts in their markets.
While many finance companies will be preserving liquidity, and
are likely to be taking a conservative approach to riding out the
storm, it does appear there are substantial M&A opportunities
for companies seeking growth by acquisition. Companies with
weakened cost of funds may be unable to generate adequate
shareholder returns, leading to divestment activity.
In next year’s marketplace, underlying income streams may be
less expensive than in recent times, with material shifts in market
positioning achievable for those firms with deep enough pockets and
with enough bravery to build through acquisition. After all, banks
adopting Advanced IRB will still consider leasing a superior
lending form to standard bank loans.
Basel II strengthens lessors
Credit crunch aside for a moment, we now consider the impact
Basel II is having. Sixty per cent of respondents suggest their
business is implementing Basel II, likely to be bank-owned lessors,
and 15 per cent suggest their capital requirements would be reduced
as a result. These companies were primarily, but not completely,
organisations implementing Advanced IRB (AIRB).
Around half indicated that Basel II has led to changes in
underwriting criteria, credit management processes and pricing
policy within their business. These changes include risk-based
pricing with new criteria, risk grading and risk-based pricing on
all proposals, and greater attention to equipment information.
Of those leasing companies implementing Basel II, 56 per cent
believe their business would be in a stronger position as a result
of Basel II. Of these, more than half were implementing Advanced
IRB.
No respondent thought their business would be in a weaker
position as a result of Basel II. All those believing their
position would be unchanged were implementing standardised versions
of Basel II or were not implementing Basel II. Based on the
assumption by some of an improved situation (mainly reported by
those implementing AIRB), lessors implementing the standardised
approach may in fact find themselves disadvantaged compared to some
of their competitor set and need to think carefully about how they
can respond to the new market dynamics.
Greater use of risk-based pricing
Increased use of risk-based pricing appears to be driven by
Basel II-related developments, combined with the threat of weaker
macro-economic conditions.
The vast majority of lessors (more than 90 per cent) applied
some form of risk-based pricing, with 58 per cent applying risk
based pricing at an individual transaction level. Around one-third
report that risk-related pricing is applied to some transactions
rather than on a systematic basis. One lessor highlighted the
impact of transaction size, with risk-sensitive pricing generally
receiving more focus on larger transactions of more than €1m in
value. Another reality check came from a funder operating in the
commercial vehicle sector, citing the relevance of aggressive
competitor action in setting low market rates, rather than any true
risk analysis.
Eighty-six per cent of respondents believe their business is
effective, or very effective, at matching risk with reward at a
transactional level. While that appears an impressive statistic, it
suggests around one in every seven lessors is ineffective, or very
ineffective, in this discipline.
It also appears risk-related pricing will become more prevalent,
both on a deal-by-deal and portfolio level. However, a concern was
expressed by respondents that “unless it can be automated, it will
add additional cost to the business, which in turn may have to be
passed on to the customer as reflected in the pricing”.
Fewer than 10 per cent of respondents applied no form of
risk-based pricing. Not surprisingly, the general view of this
group was that matching of risk and reward was “very ineffective”
in their businesses.
Increase in overdue accounts
Lessors appear to be suffering from a worsening trend in terms
of overdue accounts. Twenty-eight per cent of respondents indicate
that, over the past six months, the number of overdue accounts had
increased, while only 7 per cent stated they had decreased.
SMEs, new starts, partnerships and sole traders were all
highlighted as areas showing increased default behaviour. If, as
anticipated, market pricing increases, these groups are likely to
be increasingly vulnerable.
Respondents indicated that a number of actions are being taken
to manage this worsening situation, both in terms of initial credit
approval and collection activities.
Debt management actions include increased resourcing, improved
monitoring of overdues and faster action, lower tolerance of
requests for changed payment terms, tighter adherence to formal
escalation processes and earlier transfer to lawyers.
Definitions of arrears vary by funder. Approximately one-third
indicate that an account was in arrears as soon as a payment date
was missed, while around 20 per cent operate on a 30-days-late
principle. The remainder have a range of thresholds up to 90 days.
The definition of ‘bad debt’ was equally variable.
However, despite the worsening arrears situation, bad debt
losses remain largely controlled, with 56 per cent of respondents
indicating losses below 0.5 per cent of assets and 81 per cent
operating below 1 per cent.
Captive finance companies
Notably, the worst performer in terms of bad debts was a
manufacturer captive, which did not have strong risk appraisal or
related pricing strategies and had automatic underwriting approval
for a large percentage of proposals. This was no doubt driven by
the parent company to provide a financing solution to as many of
its potential customers as possible.
On a stand-alone basis, the finance operation may be in a
loss-making position and require a detailed review of the overall
profitability of its transactions (from both funder and equipment
provider perspective), with a change in policy and operating
processes where necessary.
Those with bad debt levels above 1 per cent all highlighted a
range of factors that may have helped their credit performance,
including training, improvements to operating processes and
increased organisational focus on credit issues.
Non-interest incomes
Against a backdrop of weakening credits, as well as higher
margins to reflect customer risk, respondents highlight a number of
non-interest incomes that increased their transaction
profitability. Most commonly applied were administration fees at
the start of the contract and a range of insurances.
Half of respondents applied documentation fees during the life
of the contract, while fewer than half charged interim rentals.
These appear to be areas in which transactional profitability can
be enhanced materially and relatively easily, both in a vendor and
direct finance arena.
In terms of other risk mitigants, a significant proposition of
finance providers operating in asset categories with strong
residual values sought buyback arrangements to manage risks. This
applied to firms operating in both direct and vendor finance. Not
surprisingly, loss pools were only used by a small number of
lessors, focused on large vendor finance programmes.
Residual values
Respondents had split opinions on the trend in residual values.
This is presumably the result of conflicting forces of softening
economic conditions and manufacturing under-capacity in a number of
industrial sectors, as new equipment and resources are aimed at
higher margin, developing markets.
Around half of those expecting RVs to reduce expected to take
RV-related losses in 2008. All those expecting RVs to reduce would
respond by lowering RV levels on any new business that was written.
While this reduces risk, it also increases rental amounts for
customers and reduces interest income – clearly a balancing act is
necessary. Other planned responses include investigation into new
disposal routes and the use or design of ‘refresh’ products to lock
customers into new deals to offset projected losses. Almost half
believed some form of provisioning would be necessary, while none
expected to use planned early terminations to spread the return of
assets over a longer period.
Credit and debt management
More than 83 per cent of respondents believe that competitive
advantage could be created through credit management and 66 per
cent through debt management, yet knowledge of competitor activity
was considerably below these levels.
Lessors without the requisite level of competitor knowledge must
decide on the importance of competitive advantage that can be
created and – as necessary – establish the appropriate competitor
intelligence processes.
Lack of credit training
The main developments in terms of risk assessment processes over
the coming year appear to relate to Basel II implementation of
financial analysis, customer risk grading and reporting.
While much focus has been placed by organisations on credit
analysis models, when asked how to improve credit management in
their business, more than half of respondents consider credit
training to be “very important” (see Chart Three), while 97 per
cent of respondents identified sales and deal information as
“important” or “very important”. The fact a high proportion of
respondents highlight such a core operational flow as an area for
improvement suggests hidden inefficiencies within the operational
model of many leasing businesses, potentially requiring a
combination of training, process re-engineering and staff
realignment. To support this view, both internal management focus
and sales training were also highlighted as “important” or “very
important” by more than 80 per cent of respondents.
The author is a partner in the consulting and services firm
Invigors LLP peter.hunt@invigors.com
