The fundamental assessment of counterparty credit risk by both banks and corporates has traditionally involved very similar processes. Assessment of the counterparty is undertaken by an analyst who evaluates the usual financial/management/industry factors – as well as some consideration for the particular transaction being undertaken and how it is structured. The objective of the analysis is however, somewhat different:
- Banks and other lenders are thinking whether the counterparty will be able to pay back the principal and interest of a loan, and if not, how much could be recovered?
- The corporate credit analyst is thinking, will the counterparty be able to pay for a particular product or service within the agreed terms and conditions, and if not, will I be able to recover the value of that product or service?
While these two objectives have similarities, the subtle differences mean that the credit measurement tools and decision-making processes are focussed on different outcomes – and thus need to be implemented and calibrated with these different outcomes in mind. This could be the reason why some of the recent innovations in credit risk measurement that have been adopted in so many banks are yet to be as common in corporate credit risk departments. However, with suitable adjustment, there is no reason why corporate credit departments cannot leverage benefits from:
- Modern rating tools designed to quantify the likelihood of an event, be it probability of default (PD) or for corporate credit risk areas, probability of non-payment.
- Workflow management tools for embedding credit decisioning at point of origination and improved reporting and analysis.
Although many consumer based scorecards have been used in corporate credit departments for business to consumer (B2C) sales products, the more complex and recent innovations in rating methodologies that could be used for business to business (B2B) sales have yet to be adopted as fulsomely in the corporate world as in the banking industry. Such models typically reflect the non-linear profiles of credit risk better than traditional scorecards.
Some of the reasons that such tools have not been more widespread are:
- Overkill. Do B2B companies really need to measure credit risk as precisely as a bank?
- Resources. Building and maintaining a rating model requires specialist skills that may not be easily available.
- Data. Quantitative models typically require a level of data that many companies (nor banks) may not have ready access to.
These issues can be readily overcome by any corporate credit department, and at the very least a model that better differentiates and rank orders credit risk is a readily achievable goal. Many corporate risk departments have some significant advantages over their bank counterparts that can be leveraged for credit risk evaluation in a rating model framework. For example, a paper supplier will have great insight into the printing industry given it is a key customer base. Such knowledge on what makes a successful printer can be put to good use.
Why Do This?
Granular measures of credit risk can lead to more refined sales strategies. Having the option of developing such strategies on an informed basis is a value in its own right. Cost of credit, either explicit or implicit, can be better managed. If, for example, credit insurance is purchased by a company for some of its debtors, the expense of this insurance can be targeted and quantified to ensure greater cost effectiveness. Credit insurers certainly use these sorts of risk measurement tools, so it makes sense that the buyers of such protection have the same capabilities.For those that aren’t purchasing credit insurance, but wearing a bad debt expense when it hits, the ability to better provision and manage this risk will help reduce earnings volatility.
Many corporate risk departments, particularly for large companies, will often have much broader geographic diversity in their operations and customer base than banks typically do. While there are some good examples of global banks, the vast majority of financial institutions are typically domestically focussed. Corporates, particularly those that are sizeable and sophisticated enough to have their own credit departments, often have customers in multiple geographies.
The logic to integrate and consolidate information on the credit process is thus particularly compelling. In a competitive environment when sales can depend on fast and effective credit decisions, the ability to make informed decisions quickly is essential. By leveraging a number of new technologies to embed risk tools, policies and decision-making into an efficient workflow, corporates can ensure their time to market remains competitive.
In addition, concurrent with the improvement in decision making support for the business – consolidated information on the credit risk of the portfolio can be updated live, enabling greater insight into the risk being undertaken by the business.
Realising the Benefit
Corporates have another great advantage over banks – they are not as highly regulated and consequently are able to execute on a new credit management strategy much more rapidly and at much lower cost.
Aligning a robust credit risk model with policy and portfolio analytics can help both minimise the time spent on credit evaluation and improve the quality of decisions. Confidence in the underlying risk measurement tools is of course key. By using particular industry knowledge, especially for suppliers of critical commodities, and structuring a relative measure of credit risk based on a mix of expert and quantitative judgement, robust measurement tools are readily achievable.
This means that ‘credit’ is not an extra step but rather embedded in the day-to-day sales process. Much of the information that might be needed to make a credit decision can be gathered at the initial contact point. Where more detailed information is required in support of transactions that require further analysis – such as for larger amounts or extended terms – sourcing and including this in the risk evaluation framework should be made easy, and with some payoff for the effort such as a rapid decision, or even the promise of an immediate decision.
Consolidating that information, and making sure it is collected for future analysis, will help with portfolio management initiatives that in turn minimise the cost of credit, and are also able to support sales and marketing efforts more efficiently.
For corporates that are growing rapidly, and possibly in regions where providing credit is critical to sales due to inefficient banking systems, having such a portfolio management framework in place is essential. By ensuring the credit framework is integrated into the sales process as efficiently as possible, corporates can readily deliver value from an improved credit process.
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