The basics of credit risk management and how to mitigate credit risk – Times of India | Region & Cash

After two years of a Covid-19-induced slowdown in India’s economy, there was a glimmer of hope in the final quarter of fiscal 2022. Rating agencies reported fewer downgrades and observed improved credit quality. Meanwhile, Russia invaded Ukraine on February 24, 2022, sending oil and commodity prices skyrocketing and disrupting supply chains again. Sanctions against Russia have disrupted the international banking and financial system and disrupted the flow of money. The projected shortages of wheat and cooking oils and the potential reduction in the flow of crude oil and gas from Russia have impacted the global economy. In India, the wholesale price index (WPI) rose to 14.6% in March 2022.

The mood of the Indian economy has shifted from FY23 optimism to extreme concern amid this volatility and uncertainty. In such an environment, credit risk increases significantly and it is imperative to be cautious when lending to counterparties.

What is credit risk?

Credit risk is the possibility that a lender will lose money if a borrower fails to repay a loan or meet contractual obligations. In commerce, credit risk refers to the likelihood that customers who purchase goods, products, or services on credit may not pay their bills. Credit risk is calculated based on a borrower’s ability to repay the amount loaned to them or a buyer’s ability to pay for the goods and services purchased.

What is credit risk management?

Credit risk management is the process of assessing and evaluating credit risk against the 5 Cs – credit history, solvency, principal, terms of the loan/transaction and collateral offered. Determining the creditworthiness of new and returning customers helps a business provide them with the appropriate amount of credit and reduces the risk of late or non-payment.

The main components of credit risk management are listed below.

  • KYC/KYB and streamlined customer onboarding process: Know Your Customer (KYC)/Know your Business (KYB) is a due diligence and risk reduction step that helps identify and verify the legitimacy of counterparties to build trust and prevent identity fraud, money laundering, tax fraud and other financial crimes . Proper KYC/KYB is only possible when accurate and up-to-date information is collected and verified during the onboarding process. The data points can include details of business registration, tax number, ownership structure, related parties and administration. The submitted data and documents must be validated by various state databases. If a client has a Legal Entity Identifier (LEI) code issued by the Global Legal Entity Identifier Foundation (GLEIF) and LEIL, its local operating entity in India, the company’s registration and ownership can be easily validated. A counterparty’s identity risk can be mitigated by insisting that they obtain an LEI before a transaction can take place.
  • Design and deploy a robust credit scoring model: Traditionally, sales managers have exercised great influence over credit limits and customer onboarding decisions based on their own impression of the customer. This can often result in you having high-risk customers who have more careless lines of credit. Rather, a data-based assessment of the creditworthiness of customers should be the basis for credit decisions. Businesses need to design and deploy credit risk models that predict the likelihood of their customers defaulting. These credit risk models determine risk scores for each customer based on transaction history, financial statements, regulatory compliance, litigation data, social media profiles of promoters and management, ownership patterns, commercial references, related parties, and customer and employee feedback. Automated risk management and monitoring platforms offered by specialized companies can be used for this purpose.
  • Credit limit setting model: Businesses also employ credit limit models to set credit limits in a systematic and prudent manner. These models recommend actionable credit limits for customers, distributors, and dealers by calibrating their risk ratings with companies’ credit risk appetite.
  • Credit monitoring and regular review: In the current volatile environment, a one-off risk assessment is not appropriate; Counterparty risk requires ongoing monitoring as risk profiles can change rapidly. A company with low credit risk that had low credit risk two years ago can now have one of the highest credit risks. A major customer from a year ago could be on the verge of bankruptcy. There needs to be an early warning system (EWS) that can aggregate key risk indicators in near real-time from diverse data sources, including regulatory and financial records, news and media, to provide a dynamic view of a company’s risk profile. A clear understanding of the sector in which the counterparty operates is also essential. In particular, the potential short-term challenges need to be identified as these could affect the counterparty’s performance and its ability to meet its financial obligations.
  • Proper credit workflow and credit limit approval protocol:Now more than ever, credit decisions need to be made faster as customers demand shorter processing times. However, the number of required controls in a company has only increased. In the absence of standardized workflows, risk data could be misunderstood or misinterpreted, which could lead to erroneous credit decisions. Therefore, credit risk management requires an effective technology-enabled mechanism to enable fast and correct decision-making. Automation can help speed up the process and improve the accuracy of the credit decision.
  • An effective collection mechanism: It’s easy to sell on credit, but difficult to collect on time. Collecting payments from debtors in a timely manner is crucial to ensure optimal cash flows. A robust collections mechanism sends a clear message to counterparties about the importance of prompt payment. It also reinforces a company’s brand and reputation for doing business prudently. Modern collections solutions use data, analytics and technology to predict, segment and prioritize collections, helping to reduce overall business days sales outstanding (DSO).

Best practices in credit risk management

  • Continuously evaluate your data sources: Make sure your model uses the best available and most recent data from the most credible sources.
  • Protect yourself from financial fraud with the latest risk management platforms.
  • Maintain a proactive risk monitoring program
  • Make sure your credit risk scoring model is up to date to keep up with changes in the market.
  • Automate the process: Automation reduces time spent on non-core tasks and helps your credit risk team focus on the areas that matter most.

John Shedd eloquently wrote, “A ship in port is safe, but that’s not what ships are built for.” Likewise, it’s impossible to build a business without taking credit risk, but it’s important to do so prudently in today’s tumultuous and volatile global business environment .



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Disclaimer

The views expressed above are the author’s own.



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