Credit risk

The fundamentals of credit risk management and how to mitigate credit risk

After two years of Covid-19-induced slowdown in India’s economy, there was a silver lining in the last quarter of FY2022. Rating agencies reported fewer downgrades and saw an improvement in the credit quality. Meanwhile, Russia invaded Ukraine on February 24, 2022, sending oil and commodity prices skyrocketing and again disrupting supply chains. Sanctions against Russia have shaken the international banking and financial system, disrupting cash flow. The predicted shortage of wheat and edible 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 optimism about FY23 to extreme concern over this volatility and uncertainty. In such an environment, credit risk increases significantly and it is imperative to be cautious when extending credit 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 fail to meet its contractual obligations. In commerce, credit risk refers to the likelihood that customers purchasing goods, products, or services on credit will not pay their bills. Credit risks are calculated based on a borrower’s ability to repay the amount lent to him or a buyer’s ability to pay for goods and services purchased.

What is credit risk management?

Credit risk management is the process of assessing and assessing credit risk using the 5Cs: credit history, ability to pay, principal, loan/transaction terms and collateral offered. Determining the creditworthiness of new and repeat customers helps a business extend them the appropriate amount of credit and reduces the risk of late payments or defaults.

Here are the key elements of credit risk management.

  • KYC/KYB and simplified customer onboarding process: Know Your Customer (KYC)/Know your Business (KYB) is a due diligence and risk mitigation step that identifies and verifies the legitimacy of counterparties to help build trust and prevent fraudulent misuse. identity, money laundering, tax evasion and other crimes. A good KYC/KYB is only possible if accurate and up-to-date information is collected and verified during the onboarding process. Data points may include details of business registration, tax identification, ownership structure, related parties and management. Data and documents submitted must be validated against various government databases. If a customer has a Legal Entity Identifier (LEI) code issued by the Global Legal Entity Identifier Foundation (GLEIF) and LEIL, their local operating unit in India, registration and business ownership can be validated easily. Counterparty 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 had a major influence on credit limits and customer onboarding decisions, based on their own impression of the customer. This can often result in high-risk customers benefiting from more than conservative lines of credit. In fact, a data-based assessment of customer creditworthiness should drive credit decisions. Companies must design and deploy credit risk models that predict the probability of default of their customers. These credit risk models result in risk scores for each customer based on transaction history, financial statements, legal compliance, litigation data, promoter social media profile and management, ownership model, trade 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 definition template: Companies are also deploying credit limit setting models to set credit limits in a systematic and conservative manner. These models recommend actionable credit limits for customers, distributors, and resellers by calibrating their risk scores with the companies’ credit risk appetite.
  • Credit Monitoring and Periodic Review: In today’s volatile environment, a one-time risk assessment is not adequate; Counterparty risk requires continuous monitoring, as risk profiles can change rapidly. An entity with low credit risk two years ago may have one of the highest credit risks today. A big client from a year ago could be on the verge of bankruptcy. There must be an early warning system (EWS) capable of gathering key risk indicators in near real time from various data sources, including legal compliance and financial records, news and media, to provide a dynamic view of a company’s risk. profile. A clear understanding of the industry in which the counterparty operates is also essential. In particular, potential short-term challenges should be identified, as they could impact the performance of the counterparty 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 faster processing times. However, the number of checks to be carried out on a company has only increased. Without standardized workflows, there could be miscommunication or misinterpretation of risk data, leading to flawed credit decisions. Therefore, credit risk management requires an effective technological mechanism to facilitate prompt and correct decision-making. Automation can help speed up the process and improve the accuracy of credit decisions.
  • An effective collection mechanism: It is easy to sell on credit but difficult to cash in time. Timely collection of payments from debtors is essential to ensure optimal cash flows. A robust debt collection mechanism sends a clear message to counterparties about the importance of prompt payment. It also enhances a company’s brand and reputation for prudent business conduct. Modern debt collection solutions leverage data, analytics, and technology to help predict, segment, and prioritize collections, helping to reduce the company’s overall days of sales outstanding (DSO).

Best Practices in Credit Risk Management

  • Continuous evaluation of your data sources: Make sure your model uses the best and most recent data available from the most credible sources.
  • Protect yourself against financial fraud using 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 market changes.
  • Automate the process: Automation reduces time spent on peripheral tasks and helps your credit risk team focus on the areas that matter most.

John Shedd wrote evocatively: “A ship in harbor is safe, but that is not what ships are built for. Similarly, it is impossible to grow a business without taking on credit risk, but it is important to do so with caution in today’s stormy and volatile global business environment.



The opinions expressed above are those of the author.