How to Analyze Credit Risk and Effective Credit Risk Management?
Credit Risk Management: Ways to Mitigate Credit Risk
The coronavirus pandemic had an unprecedented impact on the global economy in 2020. Thanks to the exceptional measures and the most robust capital and liquidity positions built up. Since that financial crisis, the banking sector nevertheless played an essential role in the global response to the crisis. It supported the real economy by continuing to provide credit and meeting the liquidity needs of households and non-financial corporations.
Overall, the risk environment has changed significantly and quickly in recent months, and short- to medium-term uncertainty levels are still high despite the possibility of a company to foresee all the risks inherent in its project. The management of the risks requires the implementation of a strategic study.
What is Credit Risk Management?
Credit risk refers to the possibility of loss due to a borrower’s inability to repay any debt. Credit risk management limits losses by checking whether a bank’s capital is in line with its provisions for expected credit losses at a given time, a process that has long given financial institutions a hard time.
Obstacles to Effective Credit Risk Management
- Lack of group-wide risk modeling framework: Without this framework, banks cannot establish complex and relevant credit risk measures nor have a global view of risk at the group level.
- Inefficient data management: The inability to access payload data when needed leads to problematic delays.
- Constant changes: Analysts find it difficult to change model parameters, which force them to work harder and affects the institution’s rate of return.
- Cumbersome reporting process: Manual reporting processes in the form of spreadsheets tie up analysts and IT teams.
- Insufficient risk management tools: Banks are unable to recognize portfolio concentrations or categorize portfolios consistently enough to manage risk without an efficient risk management solution.
Who are the actors involved in customer risk management?
Customer credit risk management is increasingly becoming a priority. Many players in the company, like sales staff, collection manager, credit manager, accounts receivable manager, etc., are concerned and can have a positive or negative impact on cash flow. This is why it is important to establish a cash culture, raise awareness and involve all employees. Everyone should have a role to play in securing turnover and sustaining their business.
Six Elements of Successful Credit Risk Management
Know your customer
To avoid credit risks and late payments, you need to know your customer. Make sure to check the identity, profile, and financial situation of your business relationship before working with them. And not just for prospects but also for existing customers. This is logical because if the solvency of your customers takes a negative turn, they will not inform you.
It’s up to you to do the research and make sure your business stays protected. You can search online and even ask other contractors about their experiences with this client. But you obviously have to know these fellow suppliers. You can also call on an agency specializing in business information for a detailed and objective view.
Get to Know the Sector
In addition to your client, you must also know the sectors in which you are active. In particular, you should know the following:
Who are the market leaders?
What are the growth prospects for the sector?
What are the challenges facing the sector?
Positive or negative changes in the sector will undoubtedly also influence business and, in particular, the loans you grant. Your customer’s problems can become your problems. Because if they don’t pay, you will be in trouble.
If you know the sectors well, you can take into account the payment terms that apply there. If you work in less stable sectors, you can reduce your credit risk by applying shorter payment terms or by closely monitoring outstanding invoices.
Robust Credit Scoring
Credit scoring is a very effective way; giving you a better view of your customer portfolio and helping you improve your profitability while reducing credit risk. Several credit assessment tools are available to determine if the requested limit is acceptable. You can rate companies based on payment history, revenue, growth potential, and strategic importance to your business, and more to implement credit scoring.
Assign a weight to each factor to get a total score. Next, divide your customers and prospects into different categories. In this way, you will be able to immediately separate the stable companies that pay well from those that do not respect payment deadlines. Finally, define a distinct approach for each segment. Consider the granting of credit, and payment terms, but also a sales approach.
Set Realistic Credit Limits and Terms
Choose payment terms that are suitable for your customer and that are standard in your industry. If you don’t have a good understanding of the customer’s creditworthiness, you can reduce the risks by having them prepay you, using letters of credit, shortening the payment term, or giving them a discount if they pay early.
Check the Annual Accounts
Many entrepreneurs still use annual accounts to assess the solvency of their customers and prospects. Annual reports are intended to provide financial information, and in this sense, it is worth consulting them. If you read the annual accounts for the last 3 to 5 years, you can check whether sales are increasing or decreasing, how profit or equity are developing, etc., hoping to find a positive evolution.
But there is a downside. The annual accounts, by definition, provide old information. They are also often manipulated to give a good image to the outside world or to pay a minimum of taxes. It also takes a lot of time to analyze and compare the annual accounts of several years.
The right credit approval process and credit limit protocol
Credit decisions must be made more quickly than ever since clients want quicker turnaround times. The quantity of checks that must be performed on a business, however, has only increased. Without standardized workflows, there may be misunderstandings or misinterpretations of risk information, which could lead to poor credit judgments.
As a result, credit risk management needs a robust technology-enabled system to enable quick and accurate decision-making. Automation can accelerate the procedure and increase credit decision accuracy.
Conclusion
The technologies of yesterday are no longer suitable for managing the credit industry of today and tomorrow. Customers seek quicker decisions and reasonable risk premiums while also demanding more customized loans. Banks are already under intense competition for prices and the maximum amount of allowable risk. Numerous opportunities exist in credit risk management to digitize manual procedures and fully or partially automate them.
