Both banks and businesses incur credit risk, but for very different reasons. For banks, credit risk is one of the principal reasons why and how they make money. The financial structure of a bank is designed to support the acquisition and management of reasonable levels of credit risk, with the emphasis being on reasonable. For a business, credit risk is a consequence of their normal business activity, whether it is manufacturing or the provision of service.
The focus of this article, however, is about what businesses can learn from banks in their counterparty credit considerations. Given recent history, some may rightly say not much – particularly as banks seek to reassert controls on their own credit risk management.
However, accepting that the recent track record of banks is dire in this regard, the real learning points are more likely found closer to the origins of the banking industry rather than in the past decade. In fact, it may be instructive to go as far back as the Victorian age.
Defining Credit Risk
But, first of all, it is useful to start from a quick definition. Credit risk is the risk of not getting paid monies due for goods or services supplied or the risk of not obtaining repayment of funds held by another party on your behalf.
If we deconstruct the topic we can identify three different facets:
- Understanding your credit risk position.
- Mitigating your credit risk position.
- Managing the impact of a default.
All three facets are common to both the bank and the business. However, it is likely that the bank’s approach will be more developed than that of the business.
Understanding your credit risk position starts with defining your financial supply chain and identifying what links in the chain are exposed to credit risk. In the bank that will principally be the bank’s borrowing clients and their guarantors. The exposure can either be straight cash or a contingent liability as a result of a guarantee or pledge given.
For a business it will be customers who receive goods or services before partial or full payment or trading partners who demand payment in advance for goods or services.
Thinking through, measuring and mapping out the composition and sequence of these financial supply chains is a challenging but critical first step to managing credit risk.
Once the chain has been defined and the exposure points identified, technology can step in with mechanisms to calculate and measure financial exposure and duration for each customer or trading partner. Limits can be set and monitored, providing management with a tool to measure and therefore start to manage credit risk.
Banks can take a proactive approach at this point and offer assistance and value. Providing corporates with real-time reporting on their financial supply chains via new generations of corporate banking portals can be of invaluable assistance in helping a business manage its credit risks more effectively.
However, technology can only do the measuring and execute predefined actions if triggers are fired. The real tolerance and management of the risk rests with people and in relationships with business, as in banking.
This is a fundamental principle of good banking. Indeed, Lloyds Bank’s ‘Rules for Branch Managers’ handbook says: “Managers should be in frequent communication with the head office and with each other concerning the character of customers, changes in partnerships, bill transactions and other banking interests. No new current accounts should be opened without knowledge of, or full enquiry into, the circumstances and character of customers.” And those principles should apply to both banks and businesses.
What is striking is that those rules were written in 1874. They highlight how and when we consider credit risk management. The part of the phrase that stands out for me as pivotal is the word ‘management’ in practice not theory. As the handbook says, this cannot be done lightly, demands real effort but is not particularly difficult to understand or apply when described in such simple terms. In fact, it is good business common sense.
Back to Basics
Indeed, this return to basics is reflected in how banks are addressing credit risk management internally. The Ernst & Young 2010 report into risk management strategies of the banks revealed a root and branch review of risk identification procedures and policies. It is not mentioned in there but the inference is that banks needed to re-assert older principles and approaches like those found within the Lloyds Bank handbook.
Knowing, understanding and appreciating actively who you are doing business with is as important now as it ever was, whether you are a bank or a business. Being the last to know that a certain party is having financial problems probably means that you will be the last to do business with them. Being the first to know gives you all the options. And it is the best mitigation of credit risk possible. The motto is ‘stay informed at first hand’.
Technology has a key supporting role, if it can spot telltale signs of problems in their earliest stages. But, acting on these still requires banks and businesses to up their skills in credit risk management as an everyday discipline of running their businesses.
Another field of mitigation that should be exerted is the principle of avoiding concentration. To return to my Victorian principles, don’t keep all your eggs in one basket.
Being aware of the risks within over-concentration is complicated by how businesses and their financial supply chains function within an increasingly globalised economy. This means looking for correlations across borders and also looking for diversification across borders. Economies on different sides of the world may well move in different cycles and certainly at different speeds. And this brings with it risks that buffet and put the financial supply chain under strain.
There are many nuances to be addressed and analysed here. Surely price is important, either paid or received, when choosing partners and dealing with clients but it takes many years of trading at a fractional uplift in margin to replace the capital lost by a significant default. There is usually a reason why trade is conducted at off-market prices and margins, and it is rarely a sign of rude health. Technology can help in these areas by providing exposure reports by geography and industry and analytics of price against the market.
This area of credit risk is becoming especially interesting or – depending on your attitude – worrying. With so much of the world’s trade and supply chains intertwined with China and its booming economy, we are presented with a classic example of concentration on a grand scale. Could advising business customers on better diversification of their customer bases and supply chain sourcing become a new line of banking consultancy? Maybe.
Impact of Default
The third facet of credit risk consideration is to understand what the impact will be of a default and how to recover from it. Technology can model the impact of a default and identify the component of the supply chain that has failed. Thorough profiling and modelling technology can then identify other partners or customers who show the same characteristics, so that terms or trade can be modified or withdrawn. But the final decisions and actions have to come from management and active participation in the industry ecosystem and network. This will provide market intelligence of great value – perhaps here we could see a real use for social networking among peers who share experiences and information in more transparent ways.
Currently, banks are in no position to preach to corporates about credit risk management but their recent experiences and historic founding principles offer some worthwhile lessons. Banks also are seriously addressing the areas for improvement within their own businesses with credit risk management a higher priority and area of investment – another finding of last year’s study by Ernst & Young.
Banks and corporates should be close partners, and we can see that both banks and businesses incur and have to manage credit risk but for very different reasons. Similar techniques can be used to measure, mitigate and manage credit risk but to different degrees. Technology can be a great facilitator alongside people who are encouraged and trained to spot signs of risk. However, excellence of both management and technology is required and neither replaces the other. And finally, nothing replaces know your customer (KYC) and know your business, and how you understand and nurture your relationships along those financial supply chains.
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