What is Credit Control and Why is it Important?
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January 22, 2024Understanding Credit Risk for Financial Health
Making a loan, extending payment terms to a client, or issuing a credit card opens an organisation up to risk. While revenue-generating in the short term, will accounts continue paying as expected over longer periods? Uncertainty swirls around both large corporate clients and average consumer borrowers alike.
The team of advisors here at EFF are here to answer all your queries about credit risk before you need ask, so without further a do, lets jump in!
What is Credit Risk?
This ambiguity around whether debt obligations will be satisfactorily met is defined as credit risk. Specifically, credit risk refers to the potential for losing money if a borrower defaults or fails to fulfil predetermined payment obligations tied to an outstanding loan, line of credit, or other financial agreement setting up deferred compensation.
For lenders ranging from global banks to small UK business owners, managing credit risk is crucial for enduring profitability and minimising losses from unpaid liabilities.
Efficient processes for assessing credit risk levels across customer portfolios enables confident decision making on funding offers without overexposing the business.
Ongoing monitoring and tactics to mitigate credit risk also provide checks against growing factors as markets cycle through booms, recessions, and recoveries.
This guide will explore key facets around measuring, reporting on, and responding to credit risk in order to:
- Improve judgement calls on extending credit
- Increase likelihood of debt obligations being met
- Reduce potential negative impacts from defaults
Essentially, readers will learn core techniques for balancing revenue opportunities today with sustainable performance over the long haul. Let’s jump in starting with common methods for evaluating credit risk, the building blocks for all downstream efforts.
Key Dimensions for Credit Risk Assessment
Before extending any financing offer, prudent lenders evaluate associated credit risk to set expectations and mitigate credit risk. While no model perfectly predicts all outcomes, examining various dimensions of an applicant allows estimating their ability and willingness to meet repayment obligations.
Common aspects for credit risk assessment include:
Borrower History and Characteristics
Past habits indicate future behaviour. Delving into metrics around on-time payments, prior defaults, outstanding debts, changes over time and more paints a picture of reliability. Building a profile around the potential borrower as an individual or business entity allows context.
Cash Flows and Asset Values
Understanding both liquid earnings and holdings the borrower can potentially tap provides visibility on their capacity to handle required payments. Uneven revenue, overleveraged assets, and low capital reserves increase credit risk.
Collateral Backing
Secured debt backed by property or other collateral pledged from the borrower offers recourse if default transpires. The ease and potential value of claiming these assets offsets some credit risk levels.
External Credit Ratings
For commercial and larger transactions, official credit ratings assign standardised grades measuring probability of default. These emerge from financial models and analyst judgement.
Industry Trends and Forces
Isolated financial snapshots fail to capture market realities individual entities face. Factoring in macro conditions impacting business models and profit drivers allows better projection.
Armed with scores and models calibrated using factors like these, lenders can shape decisions around credit limits, terms, and acceptable credit risk. This enables extending credit to qualified applicants likely to meet obligations at rates in line with projected defaults. Up next we’ll explore managing portfolios and credit risks over time.
Proactive Steps for Managing Credit Risk
Completing diligent credit risk assessments before originating new loans simply marks the beginning. Effective institutions also implement structured processes for monitoring borrower performance, reporting on emerging issues, containing credit risk, and taking action on troubled accounts.
Here are crucial components of comprehensive credit risk management frameworks:
Continuous Evaluation and Modelling
Historical snapshots erode in relevancy over time. Tracking financial trends, external signals, portfolio metrics, and actual repayments against obligations provides dynamic visibility. Sophisticated modelling techniques can process higher volumes of data for enhanced insights.
Diversification Across Industries and Credit Risk Profiles
Concentrating lending activity and credit risk among specific sectors or borrowed types amplifies exposure to downturns. Blending commercial, consumer, mortgage, auto loans and more smooths potential swings.
Setting Exposure Limits and Triggers
Programmatic constraints around maximum concentrations with certain counterparties prevents overextending resources even as credit risk analysts contend with biases and external pressures. Automated workflow triggers initiate reviews.
Maintaining Appropriate Loss Reserves
Financial buffering via general loan reserves, hedging instruments, and contingency credit allow absorbing some defaults without catastrophic consequences. Reserves cover stress events.
Offloading Subsets of Risk
Tools like loan guarantees, credit default swaps, and securitization through third parties transfer slices of portfolio risk off internal balance sheets while freeing up capital for further lending.
Adherence to sound credit risk management principles by both frontline lending divisions and centralised credit risk teams prevents complacency during times of easy growth while bracing for inevitable economic cycles sure to test even the strongest portfolios. Now let’s examine options once signs of borrower financial distress appear.
Mitigating Losses From Heightened Credit Risk
Despite the most prudent underwriting and monitoring systems, some borrowing accounts will inevitably veer towards distress, whether due to macroeconomic conditions or problems specific to that entity. With proper tracking, credit risk managers identify these loans showing weakness and pursue mitigating actions for containment.
Renegotiation
Proactively amending terms can provide mutual face-saving solutions, including periods of reduced payments followed by higher instalments later on, extensions on due dates without yet pursuing default, and other compromises aligning interests.
Collateral Claims
When cooperative attempts falter, lenders with collateral rights attached to loans can commence seizure following proper legal protocols. Typical collateral includes real estate, vehicles, securities, insurance payments, etc.
Debt Sales
Selling troubled loans at a discount allows credit issuers to recoup some portion immediately and remove further risk rather than awaiting uncertain outcomes. Buyers may have more flexibility around settlement approaches.
Payment Histories
Even after concluding distressed cases through collateral seizure, settlements, or sales exits, lenders track histories and outcomes to inform changes to policies, procedures, and long run credit risk strategies.
With proactive loss mitigation and ultimate acceptance that no portfolio sustains zero defaults forever, lenders navigate credit downturns and problem accounts while still responsibly supplying financing products underscoring broader economic prosperity.
Navigating The Regulatory Landscape
Given the interconnectedness of consumer and commercial lending activities to overall financial systems stability and economic health, credit risk management lives under the watchful eye of governmental supervision.
While specific regulations and expectations vary internationally, global banking systems adhere to certain common standards and guidance frameworks, either directly mandated or widely embraced as prudential best practices.
A few key inputs shaping credit risk processes include:
Basel Committee on Banking Supervision - This international body of banking authorities aims to strengthen regulation, supervisory practices, and risk management. Standards around capital reserves help buffer against credit risks.
Stress Testing Requirements - Regulators in some countries mandate large-scale stress testing showing lenders are adequately prepared for economic shock events leading to spikes in defaults.
Credit Ratings Utilisation - Official credit rating designations from sanctioned agencies often provide inputs to model calculations of capital levels required based on the risk profiles of asset classes within lending portfolios.
Adapting reporting flows, capital allocation calculations, loss forecasting, and more to align with both rigid requirements and more discretionary expectations allows financial institutions to demonstrate resilience capabilities to oversight bodies who set the stage.
To Finish…
We hope you’ve now got a solid grasp and understanding of credit risk.
Whilst specific credit risk challenges constantly evolve and elevate in complexity, adhering to these foundational practices allows financial enterprises to safely expand customer bases, enable growth among individual and commercial customers alike, and responsibly scale in asset sizes without compromising stability. In dynamic times, the basics matter most.
For lending firms and credit-extending businesses seeking operational assessments, technology implementations, or fully outsourced solutions in the credit risk domain, expert managed service providers like EFF offer an invaluable asset.
By leveraging external expertise supplemented by internal stakeholder alignments, the organisations of today and tomorrow can transform credit risk from barrier to opportunity. In dynamic times, partnerships provide edge. The fundamentals fuse with the innovative.
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Author: Klaudia Rydz, Senior VAT Compliance Specialist at EFF