Date : 12.02.15
Topic : Credit Risk
Management for Corporates – Part 1/5
Forewords
I am a customer service
professional who had worked for a Fortune 500 company for almost a decade. I
live and work in Thailand and occasionally travel abroad to gain both personal
and professional experience. I started my blog because I believe in the power
of learning and sharing knowledge and experience and have some spare time to
share with dear readers how to integrate all theories, processes, and
techniques relevant to customer service operations.
I try to keep my content
simple and straightforward to show the practical approaches to customer service
operations with reference to textbooks on the subject. If any of you have any
questions or would like to share with me your thoughts and insights, please
feel free to drop me an email at p.manajitt@gmail.com.
I am happy to listen to comments and respond to questions at my best. Also,
please feel free to let me know any of my language errors for English is not my
native tongue.
Today is about credit
risk management and my reference textbook is The Handbook of Credit Risk
Management: Originating, Assessing, and Managing Credit Exposures by Sylvain
Bouteille and Diane Coogan-Pushner.
Credit Risk Definition
Credit risk
is the risk of default caused by changes in credit quality of the
counterparts.
Types of Transactions
The types of transactions I will be concentrating on
is receivables.
Credit Type
|
Losses Result From
|
Loss Type
|
Receivables
|
Non-payment of goods delivered or service
performed
|
Face amount
|
Credit
Assessment Procedures
1.
Evaluating exposure
The first
step after we receive information about potential customers is to evaluate the
risk to trade with them through qualitative and quantitative credit assessment.
- Qualitative credit assessment involves
documenting and giving assessment results to customers based on customers’ data
such as type of business, number of years in current business, size of
enterprise, industry, and customer competitive position.
- Quantitative credit assessment involves
obtaining customers’ financial information and providing credit assessment
results based on the selected financial ratios such as profitability,
liquidity, and leverage ratios.
2. Deriving
default probability
Next, internal
credit rating is conducted on the potential customers by assigning risk category
to them accordingly. Below is the example of risk category, probability of
default, descriptions and common types of organization in each category.
Risk Category
|
Probability of Default (Pd)
|
Descriptions
|
Common types of organization
|
Very Low
|
0.05%
|
Strong to exceptionally strong capacity to meet all payment and
financial commitments. Highly unlikely to adversely affected by foreseeable
events.
|
Government organizations
|
Low
|
0.30%
|
Capacity
to meet payment and financial obligations is considered strong but may be vulnerable
to adverse business or economic conditions.
|
Large
multinational corporations
|
Medium
|
1.00%
|
Adequate capability to meet payment and financial commitments but
adverse business or economic conditions may lead to impaired capacity.
|
Established public or private companies
|
High
|
5.00%
|
Able to
meet current payment and financial obligations but susceptible to business
and economic conditions that affect willingness to meet trade payment
obligations
|
Small and
Medium-sized enterprises (SMEs)
|
Very High
|
25.00%
|
Dependent on favourable conditions to maintain operations. Limited
margin of safety and may not currently meeting all trade obligations.
Continued payment is dependent upon favourable business and economic conditions.
|
Public or private companies and SMEs
|
Limited Assessment
|
1.00%
|
Low
exposure levels under threshold requiring abbreviated screenings
|
SMEs
|
3. Calculating
risk tolerance guidance
Margin Risk
Index (MRI) is used to determine whether or not we would like to trade with any
potential customers. The idea is to weigh if the reward to trade (margin) is
greater than the risk or not. If MRI is greater than the threshold established,
then sales or responsible function has to revisit and make adjustments to Trade
Credit Limit (TCL), payment terms or security if they wish to trade with such
potential customers.
MRI Formula
= Pd
x Loss Given Default = 25%
Maximum (for example)
Anticipated
Annual Contribution
Probability
of Default (Pd)
|
Loss Given
Default (LGD)
|
Anticipated
Annual Contribution
|
Very Low
|
0.05%
|
Trade Credit Limit
|
Sales margin
|
Low
|
0.30%
|
+ Payment
Reversal Risk
|
+ Other
margins
|
Medium
|
1.00%
|
- Liquid Security
|
- Costs
|
High
|
5.00%
|
-
Recoverable Value of less liquid security
|
|
Very High
|
25.00%
|
- Recoverable Taxes
|
As MRI of
the potential customers were calculated, the results will help credit analyst
and business line if the company should trade with such potential customers,
and if they need to lower LGD in case of the MRIs exceed threshold and they
wish to trade with the customers.
Please see
below table for example on how to improve MRI.
MRI
components (USD)
|
Fail MRI
of Maximum 25%
|
Reduced
Terms
|
Acquire
additional security
|
Improve
Contribution/Margin
|
Pd (Medium Risk)
|
1%
|
1%
|
1%
|
1%
|
Loss Given Default
|
1,000K
|
900K
|
700K
|
700K
|
Annual Contribution
|
20K
|
20K
|
20K
|
30K
|
MRI
|
50%
|
45%
|
35%
|
23.33%
|
Date : 15.02.15
Topic : Credit Risk Management for Corporates – Part 2/5
4. Defining
exposure
This is the calculation
of the approximated maximum amount of money that the company can lose from
trading with their potential customers. The calculation differs from company to
company depending on the nature of business. Here is how to calculate exposure
from selling products to the customers.
In this
case, trade exposure is calculated by adding trade credit limit, and payment
reversal risk, and deducting liquid security.
Trade Credit Limit Calculation
First, the maximum
trading amount in trading currency is calculated. In this case, the potential
customer is going to buy two products. The maximum trading amount can be
calculated by deriving the maximum monthly sales per day and multiplying them
by the number of payment terms and billing period in days.
Products
|
Max monthly Volume
|
Price/unit (USD)
|
Max monthly sales (USD)
|
Payment Terms (days after delivery)
|
Billing Period (days)
|
Order Frequency
|
Max Trading Amount (USD)
|
Product 1
|
500,000
|
1.5
|
750,000
|
5
|
4
|
Every week
|
225,000
|
Product 2
|
100,000
|
2.5
|
250,000
|
5
|
4
|
2-3 times
per week
|
75,000
|
|
|
|
|
|
|
Total
|
300,000
|
Then, the buffers
and adjustments deemed necessary are added to the maximum trading amount to
obtain the trade credit limit. The amount of buffer is determined according to
the risk category of the particular customer.
In USD
Max Trading Amount
|
300,000
|
Buffer for growth, disputes, temporary price hike and etc.
|
90,000
|
Adjustments
|
10,000
|
Trade Credit Limit
|
400,000
|
Adjustment remarks:
rounding
Trade Exposure Limit
Following
the evaluation of trade credit limit, the trade exposure limit is calculated by
taking into account payment reversal risk in case the customer pay by cheques,
bank transfer or credit cards, and liquid security received from the customers.
Please see an example below.
In USD
Trade Credit Limit
|
400,000
|
Payment Reversal Risk (2 days)
|
600,000
|
Security (according to risk category)
|
200,000
|
Trade Exposure Limit
|
800,000
|
The approval
request to trade with the potential customer is then sent to the designated credit
analyst, supervisor, or manager with the authority assigned by the company to
approve based on trade exposure limit.
6. Obtaining
Security
The most desirable
security to secure trade payment commitments is the liquid security. It can be cash
deposit, a bank guarantee or a letter of credit from creditable banks. Sales
representative can request a certain amount and type of liquid security from a
potential customer in the process of opening a trading account following advice
from the credit function.
However, if
the liquid security cannot be obtained, the company may accept less liquid
security such as letter of credit issued by financial institutes other than
banks and collaterals, for instance. In any case, the less liquid securities
are not preferable and it is probable that not all of their face value can be cashed
in case of defaults.
The amount
of security to be obtained from the customers is determined according to the
risk category and/or trade exposure limit the customer received. For example, if
the customer received Very High and High risk category, the company may request
100 percent security of the trade credit limit.
Below is an
example of security request guideline.
Liquid security Request
|
Risk Category
|
100% liquid security of TCL
|
Very High and High
|
50% liquid security of TCL
|
Medium,
Low and Very Low
|
100% liquid security of TEL < threshold e.g. 30K USD
|
Limited Assessment
|
Date : 03.03.15
Topic : Credit Risk Management for Corporates – Part 3/5
Credit Risk Assessment
Process Flow Chart
