AN EVOLVING APPROACH
Market Strategy – F2000
Dedham, Massachusetts, USA.
an integral part of commerce and the management of credit risk has evolved from
individuals interpreting broad corporate policy, to sophisticated methodologies
that enforce consistent analysis and decisions. It is interesting to note the
rather striking difference in the sophistication of credit risk management
techniques in different types of corporations - manufacturing, retail, leasing,
insurance and banking. For example, the mission critical nature of credit in the
financial services sector has given rise to substantial information technology
infrastructure investments surrounding the credit granting process. Whereas, to
date, in the manufacturing trade credit arena, many organizations lag behind in
their IT infrastructures that support automated credit processing.
across all industries management sees rapid advances in technology and the
increasing sophistication of software applications as an opportunity for
improving the management of credit risk. The collective promise of these
developments is substantial. However,
to fully realize their potential, it will be necessary to look at broad
approaches that integrate software and hardware technologies. With the vast
capabilities of today’s technology, credit decision processes are likely to
change more rapidly in the future.
technology in and of itself, is only the means to the end. With all of the
exciting possibilities that are offered by technology, it is important that the
credit department of the future adopt a long-term-building-block perspective, if
technology is to be used effectively. Emphasis must be placed on the engineering
of credit risk processes using technology as a tool. To be truly effective the
technology framework must be capable of supporting rapid changes in credit risk
Architecture for Credit Risk Management
management of credit risk has three major dimensions - the transaction-level
credit decision, the management of the credit risk portfolio, and value-added
The transaction-level credit decision represents the
traditional view of credit. The acceptance of a customer order and subsequent
granting of credit, initiates the acceptance of risk by the organization. The
objective in managing individual credit transactions is largely to determine the
risk-return tradeoff in granting credit to each customer. The risk tolerance or
preferences of the organization are driven by a number of factors. Typically
this includes the competitiveness of its markets, its cost of capital and the
profitability of its products and services. As organizations look more closely
at ways to compete effectively in the midst of increasing global competitive
pressures, credit will receive more scrutiny as an area that can contribute to
market share growth.
changing environment necessitates management look at a broader view of risk
preference. In response to the portfolio view of risk management, credit is
taking on increasing importance in today’s market. At any given point in time,
the credit manager is really managing a portfolio of credit risk. The portfolio
perspective is quite different from that of the individual credit transaction.
It allows credit to be viewed from the standpoint of pooled risk. The
opportunity to take on a slightly greater risk in an individual transaction
becomes acceptable provided the overall risk pool stays within an acceptable
tolerance level. As the need to grow markets in the face of increasing
competition continues the portfolio perspective is likely to grow significantly
in importance in the future. Thinking of credit risk management as a portfolio
issue will represent a major shift for many in the traditional manufacturing
trade credit world.
again, new advancements in technology can be deployed to aid organizations in
the aggregation of similar customer groups, and the benchmarking of those
customer groups’ performance against one another.
In addition, organizations can establish automated warning flags that
provide notification when the credit risk associated with a given portfolio has
reached the threshold of acceptability.
some corporations, credit has the opportunity to provide value-added services to
customers and internal groups such as sales and marketing. For
example, frequently the corporation has an intermediate distribution channel
where the nature of the business relationship between the distribution channel
and the corporation is usually quite strong. In these circumstances, there is a
strong flow of information from the channel partners to the supplier’s credit
organization. For the credit organization there is the opportunity to provide
value-added services. These services may take the form of on-site credit
reviews, which provide insights in areas within the distributor’s customer
base that offer growth opportunity, or which offer help with identification of
customers that may be facing delinquencies.
another example, the organization may wish to provide each customer with an
automatically generated benchmarking report which compares their financial
history and current business performance to comparable peers.
These peers may be reported as anonymous data points to protect
competitive advantages, but at the same time to stimulate proactive improvements
within each customer’s business practices.
common aspect of each of these three dimensions is all of them consist of many
processes and sub-processes. An important new perspective and goal of the credit
department may be to design and implement an optimal set of processes for its
business and environment. To be highly effective any process design must also be
extremely flexible. To create such an environment necessitates close integration
of process and technology. Unfortunately, it has not been uncommon for many
corporations to become captive to a set of technologies and to be forced to
configure their businesses to fit available technology, rather than the other
credit decision processes have been implemented either manually or with the
limited application of interactive decision support tools. While many credit
managers, have had the vision of a process-oriented organization of their
responsibilities, limitations of technology and information availability have
hampered the realization of this vision. The alignment of newer, integrated
decision support technology infrastructures - along with the recognized
opportunity to benefit from a portfolio view of credit risks - represents an
exciting opportunity for credit organizations to realign their operations with a
fully integrated process approach that is empowered by technology.
Promise of Portfolio Credit Risk Management
As noted previously, a
portfolio of credit customers represents a bundle of individual credit risks.
Credit decisions at the customer/transaction level constantly affect this bundle
of risk. As the management of
credit risk has matured with the increased adoption of consistent scoring
methodologies, portfolio risk management has become more feasible and relevant.
concept of portfolio risk management may encompass the tracking and analysis of
a number of different risk dimensions. Regardless of the sophistication of the
portfolio analysis techniques, the common approach is to stop looking at
individual customers one at a time and instead segment them by some logical
grouping that incorporates common behaviors and risk factors. Within a given
portfolio each customer represents a different level of risk and opportunity.
These differences may be based on the risk of non-payment, slow payments or the
possibility of bad debts and the costs associated in the recovery of such bad
debt. However, because these customers have similar risk characteristics the
overall group performance becomes more important than the risk attributes of an
the past, primary concern for the corporate credit managers has been limiting
risk and setting adequate reserves. By setting up a customized credit policy for
each portfolio, specific credit policies can be established that allow an
organization to maximize return relative to the risk profile of the overall
of the portfolio risk can lead to proactive actions to influence the composition
of the portfolio, the tightening of credit standards and the allocation of
appropriate reserves. Through portfolio analysis the credit department can also
help Sales and Marketing understand where the best opportunities may exist to
grow the business. Often Treasury will be positively impacted because the
portfolio approach allows lower loss reserves than were previously necessary
when all credit analysis was transaction based. The essence of portfolio
analysis is the ability to view credit as a risk/reward scenario rather
than just as risk avoidance.
simple measure of portfolio risk can be defined as follows:
Portfolio Risk = sum of [credit limit x risk score] over
all customers in the portfolio
can be replaced by the current exposure to provide a current versus probable
assessment of portfolio risk.
measuring portfolio risk over time will allow the credit manager to manage
aggregate risk within an acceptable range. Credit managers can determine the
level of risk that the organization is willing to accept and set credit policy
accordingly. By constantly monitoring aggregate risk, credit managers can ensure
that the reserve levels are adequate and also influence portfolio
composition/business development decisions. For example, if the Sales group
targets a 20% growth in a segment of the current customer base, the credit
manager can provide valuable information on how the resulting credit exposure
can be achieved with minimal increase in portfolio risk.
in mind when developing an automated approach to the management of portfolio
risk, the information architecture for portfolio risk management needs to
support the following processes:
organizations look to implement portfolio based credit management solutions,
they need to carefully measure their alternative approaches against these
is no doubt the competitive climate in which we operate today will continue to
intensify. Factors, such as deregulation, further globalization of markets
through e-commerce and reduced trade barriers, will make it increasingly
challenging to expand markets and maintain desired levels of profitability.
we have discussed, forward-thinking organizations are starting to tackle the
challenges with portfolio management techniques, as well as sophisticated
analysis and process automation tools. They will undoubtedly continue to look at
ways to segment their customer base and devise pricing, product and distribution
strategies that leverage the knowledge that portfolio analysis provides.
based risk management techniques will offer the opportunity to expand market
share within acceptable risk tolerance levels. Investment in sophisticated, but
flexible and easy to deploy IT infrastructure will allow organizations to evolve
beyond the realm of traditional credit policy and create significant
“value-added” customer relationship management services.
is the Director of Market Strategy (Fortune 2000 Corporations) for eCredit.com
Email: firstname.lastname@example.org or visit: www.ecredit.com.
Copyright 2001 K Cundiff – All Rights Reserved.