A Practical Approach to Credit Risk Management

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