How To Mitigate Credit Risk?
In the Asia-Pacific region, almost 80% of companies offer credit terms to their customers. Trading on open terms is always subject to credit risk exposure. Your customers may miss the invoice payment date or even default on the payment altogether. The Coface Asia Payment Survey reported that 64% of companies experienced overdue payments. The common reasons for payment delays were customers’ financial difficulties, management problems, fraud, and commercial disputes. So, how can your business keep trading on open terms and minimise credit risk?
What Is Credit Risk?
In essence, credit is the risk of losses arising from the obligor’s failure to meet contractual obligations. For most companies, trading on open terms is the largest and most obvious source of credit risk, as the client fails to pay on time and in full. However, other sources of credit risk include loans, foreign exchange, bonds, and other financial instruments.
There are three types of credit risk:
- Credit default risk refers to the probability that a borrower will default on or fail to make full and timely repayment of debt.
- Concentration risk is the disproportionately large exposure to a single debtor or group of debtors relative to the size of the credit portfolio.
- Country risk is the risk of a sovereign state freezing foreign currency payments or defaulting on its obligations due to economic, political, or social instability.
Businesses can avoid potential credit risk losses by implementing credit risk management.
Credit Risk Management
Credit risk management implies taking steps to identify, measure, evaluate, mitigate, monitor, report, and control credit risk. Risk management begins before a customer is onboarded and continues throughout the business relationship with the customer. Here is a practical guide on how to set up the credit risk management process.
- Develop a risk management strategy that defines your credit risk tolerance levels according to the company’s business goals.
- Set up a risk management organisational structure that reflects the company’s size, the nature of its business activities, and credit risk functions. The credit risk functions should cover credit risk management, execution, oversight, and control.
- Create your company’s credit policy to document guidelines for the identification, measurement, evaluation, monitoring, reporting, control, and mitigation of credit risk. The credit policy governs an individual transaction and portfolio. The policy needs to include the credit risk acceptance criteria, terms and conditions of the credit facility, acceptable types of collateral, credit limits, and standards for credit review and monitoring.
- Document the credit criteria. The credit criteria state the characteristics of your preferred obligors and set corresponding credit terms and conditions.
- Set up credit limits for individual obligors and groups of related obligors. If needed, establish credit limits for economic sectors and geographical regions of the obligors to avoid concentration risk.
- Use a credit risk rating system, where you assign a credit risk rating to obligors to reflect the obligor’s risk profile and the likelihood of loss. The risk rating system helps you see the risk profile of the company’s portfolio.
- Create a policy and process for credit applications by related parties to avoid conflicts of interest.
- Establish the process for approving new credits and the renewal of existing credits. The process should include the credit assessment of an obligor, structuring of credit, credit approval, completion of legal documentation, and disbursement.
- Ask for collateral or guarantees to secure the debt. Employ financial instruments like trade credit insurance to mitigate risk exposure in trade transactions.
- Set up risk monitoring on the obligor’s creditworthiness, credit conditions, and intended use of credit facilities. Create a sound reporting system and get notified about risks, changes, or problem credits.
- Perform regular credit reviews to check that all granted facilities are in line with your established credit policy. Periodically review the obligor and secured assets quality.
- Implement the policies to help you grade and classify your assets, evaluate collateral, while setting up necessary provision levels.
- Establish a robust process for managing problem credits, from reporting to debt recovery.
- Review your credit administration process to ensure the completeness of documentation and the recording of transactions.
- Implement stress testing to assess the impact of credit risk on asset values, credit quality, and the overall portfolio under stress conditions.
- Have the remedial management process ready when faced with risks or problem credits so that your team knows how to act.
Good risk management practises can help your company prepare for risk uncertainty, quickly adjust to new conditions, and maintain financial growth. Ask the Coface Risk Experts about credit risk management solutions available for companies of any size.