Banks must act on their Early Warning Systems or risk profits downturn

With credit market conditions deteriorating and increased concerns around a potential recession, effective credit monitoring and risk management will be crucial for banks. We estimate that banks earn return of equity (ROEs) in pure corporate lending well below their cost of capital and that a recession could lead to these turning negative.

Effective early warnings systems can reduce loan losses and capital requirements materially for corporate banks. This involves expanding out the number of early warning indicators to be more forward-looking but also to adopt a systematic approach. The latter is crucial to both reducing false positives but also complying with regulatory requirements.