One quiet 33question: Will payment actually come? – for each loan, invoice or trade agreement. The question is at the core of credit risk management. It influences the terms banks offer loans, suppliers offer terms, and investors offer bond prices. Make the wrong call, and the losses will slowly add up until they can no longer be ignored. If it’s done correctly, then an organization can expand with confidence, knowing that its exposure is measured and controlled.
This article explains what credit risk management is, why it’s more important than ever and how businesses of all sizes can create a process that helps to manage and control credit risk without limiting growth. Learn about credit risk assessment, practical tools for credit risk mitigation, regulatory considerations, and subtle pitfalls that take your profitability down with them.
What is Credit Risk Management?
The credit risk management process refers to the process of identifying, measuring and controlling the risk of a borrower or counterparty becoming credit worthy and not satisfying the financial obligations. From banks that are issuing mortgages to suppliers that are providing trade credit, and even landlords screening tenants, it has been applied. It’s the same concept in any location: someone owes money and there is a possibility it will be paid late or not at all.
Credit risk is a relational risk unlike operational risk which is concerned with failure in internal processes. It relies on the financial condition, wishes and outside conditions of another party. This renders the control more difficult, which is why structured credit risk assessment is so important.
Why Credit Risk Cannot Be Ignored
Uncontrolled credit exposure has led to bank failures, bankrupt suppliers and financial crises. The 2008 financial crisis is the best example of the consequences of failing to enforce credit standards. Lenders gave loans to people who weren’t able to pay them back. As defaults cascaded, the impact was felt around the world.
This is the similar problem which is smaller businesses experience on a daily basis. One big customer who doesn’t pay the bill can cause significant cash flow difficulties. That’s why even non-banking entities are now concerns with credit risk as a key component of enterprise risk management.
The Core Types of Credit Risk
The first step in understanding credit risk is to identify the various types of credit risk. There are a few different tools and monitoring strategies required for each type.
Default Risk
The credit risk most directly related to default risk is the credit risk of a loan. It is a measure of the likelihood that the borrower will make no payments whatsoever. Banks use these historical information, credit scores and behavioral patterns to model it. When default rates are trending up for a loan book, it usually means more serious economic problems.
Concentration Risk
Concentration risk occurs when a significant portion of exposure is concentrated with a single borrower, sector, or geographic area. A bank with a major focus on commercial real estate is more likely to experience increased losses when the commercial real estate market declines. This is minimized by industry and geography diversification of portfolio credit risk.
Counterparty Risk
The main area where counterparty risk is relevant is in trading and derivative transactions. It represents the risk of the other party in a financial transaction defaulting on its obligations. This risk gained momentum after a number of large financial institutions failed during previous financial crises.
Country Risk
Country risk occurs when borrowers are solvent, but the political climate, currency limitations, or economic factors make repayment impossible. This must be taken into account by international lenders and exporters, along with the quality of individual borrowers.
Building a Credit Risk Management Framework
A robust credit risk framework is not a given. It takes conscious planning, clear accountability and a sustained effort from everyone in the organization.
Step 1: Establish Clear Credit Policies
All credit granting institutions should have written policies outlining acceptable risk. This includes minimum credit score thresholds, maximum exposure limits and even approval hierarchies. Policies need to be clear enough to be used to make decisions on, but have enough flexibility to fit into different situations.
Step 2: Conduct Thorough Credit Assessment
A quantitative and qualitative approach should be used to assess creditworthiness. Quantitative factors are things like income, debt ratios, and payment history. Qualitative factors are the conditions of industry, quality of management, and stability of the business. These combine to provide a greater risk picture than numbers do on their own.
Step 3: Apply Risk-Based Pricing
Risk based pricing is for people with higher risks to pay higher rates or fees. This will cover the added exposure for lenders and maintain the availability of credit to the higher risk borrower. Without this practice, safer borrowers will be paying to cover the costs of riskier borrowers.
Step 4: Monitor Continuously
Credit risk will not remain constant once approved. Continuous monitoring identifies early warning indicators, such as late payments, a drop in revenue or a crisis in the industry. The majority of the lenders today are leveraging automated notifications connected with real-time financial information feeds.
Step 5: Set Exposure Limits
Limits impose a restriction on excessive concentration on any one borrower, sector or geography. These caps should be reviewed on a regular basis, as market conditions change. The limits which seemed fair two years ago may be too low or too high today.
Credit Risk Assessment Tools & Techniques
The Credit risk assessment is a mix of traditional assessment and new technology-based assessments.
Credit Scoring Models
A credit scoring model is a mathematical formula that converts financial information into a single number that is comparable. FICO scores are still popular in consumer lending and commercial lenders often create their own scorecards. There is a wide range of these models which accelerate decision-making and mitigate subjectivity, but they should not be viewed as a substitute for human judgment.
Financial Statement Analysis
Business borrowers can assess the ability to repay by examining the balance sheets, income statements and cash flow statements. Some important ratios are the debt to equity ratio, current ratio, and interest coverage ratio. Even if a borrower has a solid income, but a poor cash flow, they can still have trouble repaying their loan on time.
Credit Rating Agencies
Larger borrowers like corporations or sovereigns have external ratings from agencies such as Moody’s or Standard & Poor’s. These ratings provide a helpful guideline but must be used in conjunction with other factors—not a stand-alone decision.
Predictive Analytics and Machine Learning
The newer models employ machine learning to recognize subtle default patterns that humans may not. They work on thousands of variables at a time and as they continue to analyze data, the better their predictions get. But they need careful management to ensure that they don’t further perpetrate an unintended form of bias in who gets loans and who doesn’t.
Practical Strategies to Mitigate Credit Risk
Assessment is about identifying risk, whereas mitigation is about actually reducing risk. The following risk mitigation strategies are applicable to all industries.
1. Diversify the Credit Portfolio
A diversified exposure by industry, geography and borrower type helps mitigate the negative effects of a default. If a lender has a narrow focus, he/she will experience increased losses in a particular market during a downturn in that market.
2. Require Collateral or Guarantees
Collateral provides a fallback recovery option for lenders in case of borrower default. Business owners may be held liable through a personal guarantee as well. They both don’t do away with risk, but both make a significant difference in recovery.
3. Use Credit Insurance
Trade credit insurance is a form of insurance which guards the supplier against failure of the buyer to pay. It is particularly useful for companies issuing big bills to a few significant clients.
4. Set Clear Payment Terms
Uncertainty in the payment terms leads to disputes and delays. Confusion is prevented and a timely payment is facilitated by clear terms of payment, well-defined due dates and documented penalties for late payments.
5. Conduct Regular Portfolio Reviews
Periodic reviews allow for identification of declining credit quality before it becomes a default. There are many organizations that review the higher-risk accounts quarterly, and the stable ones annually.
6. Implement Early Warning Systems
Teams can intervene early thanks to automated triggers, like missed payments or falling credit scores. In many cases, a manageable problem can be avoided if acted upon early enough to prevent it from becoming an irretrievable loss.
7. Strengthen Internal Controls
When credit approval, monitoring and collection responsibilities are separated, there is less likelihood of internal errors or conflicts of interest. A robust internal control system also contributes to meeting regulatory expectations.
Real-World Example: How a Mid-Sized Lender Reduced Defaults
Let’s look at a scenario where a regional bank saw an increase in default rates for its small business loan book. The team did not simply go from here and there tightening approvals, but rather looked at the data first. They found that most of the defaults were concentrated in a particular industry segment in a phase of decline.
The lender did not eliminate the line of lending altogether, but rather changed the manner in which they charged for the risk of that loan and made the requirements for collateral more stringent. It also enacted quarterly reviews on accounts pertaining to that industry only. The share of loans defaulted in that segment fell by almost one-third over the course of a year and a half, and the volume of lending remained unchanged.
This is an example of why sweeping changes in policy may be misspent. Changes to the portfolio are focused and based on data, providing protection without unnecessarily limiting healthy borrowers.
Credit Risk Management in Banking
Credit risk presents a special challenge for banks, given that lending is an integral part of their business model. Banks are mandated by the regulatory system, such as Basel III, to maintain capital reserves that are commensurate with their credit exposure. This way, banks may be able to weather the storm during economic downturns without going under.
Another common use of stress testing is to help banks see how their loan portfolios would behave in the event of a very severe economic climate. These simulations assist institutions in building capital buffers before stress strikes, but not after they have experienced losses. These practices are closely monitored by the Federal Reserve and the Bank for International Settlements and are also subject to regulation by other regulators in major institutions.
Credit Risk Management Metrics Worth Tracking
Effective credit risk measurement is more than periodic “spot checks,” it is consistent measurements. Organizations can get a preview of the health of their portfolios with a few key indicators.
Non-performing loan ratio is based on the percentage of loans in which borrowers have ceased to make payments. A deteriorating ratio may be the first sign of the degradation of credit before its individual defaults are fully apparent.
Days sales outstanding is the average time that it takes customers to pay an invoice. When the trend is a lengthening one, it is a sign of declining liquidity of the customers or a loose collection discipline.
Loss given default is an estimate of the lender’s actual losses in case of default, on top of the recovery from the borrower’s collateral. This number is used to determine the proper loan loss reserves.
Probability of default is an estimate of the probability that a borrower will fail to make payments on the loan over a specific period. Together with exposure size this determines the expected loss calculations for the portfolio.
Keeping these metrics at hand instead of reviewing them just at audits enables risk teams to spot issues before they grow too large to handle.
Credit Risk Management for Small Businesses
Most small businesses do not have a risk department, but they do have credit exposure – with customers and vendors. There are simple practices which make all the difference here.
Performing the simple credit check before giving a customer large payment terms allows high-risk customers to be filtered out early. If orders are large, part payment allows for lower risk on individual orders. Promptly follow up on overdue invoices – do not let them „age”, to significantly increase recovery.
Another option that many small businesses avail is factoring, in which the business sells the bills to a third party at a discount for prompt cash. This takes the collection risk away and enhances liquidity in the short term.
Credit Risk Management Across Different Industries
Although the most often discussed is banking, credit risk extends to most industries that provide payment terms and/or financing.
Retail and wholesale suppliers credit their business customers, so they may be directly exposed to the risk of non-payment by customers. Many suppliers have adopted the common practice of carrying out simple credit checks prior to granting net-30 or net-60 terms.
Insurance companies are exposed to credit risk in the form of reinsurance contracts and bond investments. A weak reinsurer can leave a strong primary insurer vulnerable in the event of big claim incidents.
The telecommunications and utility companies deal with credit risk through the use of deposits, credit checks, and policies on account suspensions for late payments. These industries typically process large numbers of small transactions, where automation is crucial in scoring these transactions.
As health insurance plans increasingly make patients responsible for a larger portion of the cost of many elective surgeries, healthcare providers are increasingly considering a patient’s payment risk before allowing them to book their next surgery.
While the definitions of the fundamental elements of credit risk remain the same across different industries, their implementations are unique to the specific customer population and transaction types and models in each industry, and the common ground is the same: safeguard revenue through an understanding of who is likely to pay and who is not.
Common Mistakes in Credit Risk Management
What experienced organizations inevitably encounter are traps that they don’t know and which simply creep up on them over time.
Using only credit scores fails to incorporate other qualitative attributes such as management or industry outlook. Numbers don’t tell the full story.
When policies are not applied uniformly across departments or branches, they result in uneven risk exposures. Once exceptions become a regular occurrence, policies lose their effectiveness as a control.
When warning signs occur too late, they can be turned into unrecoverable losses. It’s not a good idea to delay any action on a down trending account for long.
Not taking into account macroeconomic trends makes portfolios vulnerable to broader market-wide events that are not covered by the analysis of the individual borrower. Whole portfolio interest rates are impacted by interest rate changes and industry cycles.
For models that aren’t updated regularly, this can result in less accurate predictive tools as economic conditions change. A model that works well in a stable economy can badly underestimate the risk in an economic downturn.
The Human Side of Credit Decisions
While models and scorecards dominate most of the credit decisions made today, expert credit analysts still provide valuable “human” input beyond the figures. A customer whose score has dropped temporarily because of a one-time medical bill could still be a good “long-term” customer.
Expert analysts learn to interpret circles of information, beyond the numbers. They ask further questions, look at supporting information, and reflect on other factors that models may not capture. This human filter helps to avoid the unnecessary screening of good borrowers and it helps to weed out bad borrowers.
Using models with fresh analysts takes time to get used to, but is always a benefit to long-term portfolio quality. Too many organizations are relying on credit scoring as an end goal rather than a beginning point, and they end up missing opportunities and misunderstanding edge cases.
Credit Risk vs Other Types of Financial Risk
Though the credit risk and other financial risks are considered together, they each have different characteristics and management strategies.
This comparison provides the basis why credit risk management needs to have its very own tools instead of taking them from market/liquidity risk management practices.
The Role of Technology in Modern Credit Risk Management
The way organizations make credit decisions has been revolutionized by technology. The automated underwriting systems can now process applications in mere minutes, not days. Real time data feeds enable real time monitoring rather than periodic manual monitoring.
AI models can detect subtle trends in payment patterns which could indicate increasing risk of default. But human intervention is still required. While automated systems can be great at catching financial patterns that are unusual but legitimate, they cannot make final calls on financial patterns that are on the edge of being legitimate and not.Experienced analysts have to call the shots on patterns that are borderline legitimate and not legitimate, and automated systems can be excellent at recognizing unusual but legitimate patterns.
Cloud-based credit risk platforms also enable smaller entities to have access to tools that were previously only available for large banks. This has brought enterprise level risk management much closer to the small business practice of risk management.
Regulatory Standards Supporting Credit Risk Management
There are a number of well-known structures that provide guidance to organizations on how to structure their practices around credit risk. The ISO 31000 standard gives general principles of risk management that can be used in all industries, including credit risk. Basel III contains a series of banking capital and liquidity standards for banks worldwide.
In the U.S., the Office of the Comptroller of the Currency offers guidance to credit risk practices for national banks. The frameworks are not designed to prevent any losses, but they provide a minimum level of security for a safe approach to risk management for all industry sectors.
Credit Risk Management During Economic Downturns
In times of economic trouble, even the best credit risk systems are put to the test. As unemployment rises, revenues decline and household budgets are shrinking, the likelihood of default rises for most categories of borrowers at once.
In such times, firms have to adjust risk models based on more solid economic indicators. A model developed over years of consistent growth may underestimate risk if there is a sudden change in conditions. It is no longer an option to review and modify these models.
Communication is also key in times of downturn. Early intervention with borrowers through indicators of stress, rather than total default, can result in feasible repayment options. This is often a more profitable route to recover than to wait for the formal default and then to pursue collections.
Organizations can build up capital reserves during periods of stronger business activity to offset losses in other periods. It is not enough to wait until the downturn starts to put money aside to cover it; the reserves should be established in advance of the downturn.
How to Build a Credit Risk Culture
Good credit risk management is not all about policies or models. It calls for a culture that embraces the concept of boundaries of risk at all levels of the business.
Training should enable staff to identify signs of impending disaster in a timely manner, not just relying on automated alerts. Having escalation pathways clear will help to get concerning accounts to decision-makers quickly. Leaders should ensure that they remind everyone that achieving their sales objectives is never an excuse to compromise on credit.
In organizations where credit discipline is a joint responsibility of the organization, rather than a compliance function, it is more likely to make it through economic downturns than organizations that don’t.
Conclusion
A properly managed credit risk helps in safeguarding organizations from the sneaky harm caused by unpaid liabilities. With a comprehensive credit risk evaluation, strict monitoring and proven mitigation strategies, businesses and lenders can offer credit, instead of withholding it. There is no risk-free system in place, but a structured approach can always lower losses and build financial resilience. First, examine existing credit policies and observe any deficiencies in the monitoring process, and establish habits of monitoring exposure so that it remains manageable well in advance of any issues.
Frequently Asked Questions
1. What is the main goal of credit risk management?
The primary aim is to prevent the loss of an organization due to the borrowers or the customers defaulting on payments. It is a balancing act between granting credit to grow and controlling potential losses in a responsible manner.
2. How do banks measure credit risk?
Stress testing, financial statement analysis and credit scoring models are all used by banks. They also keep an eye on things outside of the house that may impact the repayment ability of a borrower, such as industry news and economic conditions.
3. What is the difference between credit risk and default risk?
Credit risk is one of the types of default risk. Within this category of credit risk is the concentration risk, counterparty risk and country risk as well as non-payment risk.
4. Can small businesses really manage credit risk without special software?
Yes. Routine measures such as credit checks, clear payment terms, and follow-up of invoices can substantially minimise exposure. Discipline is more important than software in smaller operations, and software are important at scale.
5. What is risk-based pricing in credit management?
Risk based pricing is a pricing model that costs more interest or fees for riskier borrowers. This helps to offset lenders’ extra risk exposure and gives the more risky applicants access to credit.
6. When should credit risk policies be reviewed?
Policies are generally reviewed once a year, but in some cases, high-risk accounts require quarterly reviews. A major policy review does need to be conducted immediately with a significant economic change or portfolio change.
7. Does diversification really reduce credit risk?
Yes, diversification is a means of distributing risks among borrowers, industries and regions. This helps to make sure that if one default or one sector has a downturn; it won’t affect the whole portfolio.