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Director, Market Strategy – F2000
eCredit.com, Dedham, Massachusetts, USA.



Credit is 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.

Increasingly 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.

Of course, 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 management processes.

Information Architecture for Credit Risk Management

The management of credit risk has three major dimensions - the transaction-level credit decision, the management of the credit risk portfolio, and value-added services.

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.

This 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.

Once 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. 

In 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.

In 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. 

A 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 way around.

Historically, 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.

The 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.

The 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 individual firm.

In 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 portfolio.

Monitoring 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.

A 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

Limits can be replaced by the current exposure to provide a current versus probable assessment of portfolio risk. 

Consistently 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.

Keep 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:

Flexible definition of a portfolio.

Flexibility in specifying risk measurements.

Representation of portfolio thresholds.

Triggering of ‘red flags’ for credit managers, on an execution basis.

Using different scorecards for different types of customers/requests.

As organizations look to implement portfolio based credit management solutions, they need to carefully measure their alternative approaches against these criteria.

There 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.

As 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.

Portfolio 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.

Kelly Cundiff is the Director of Market Strategy (Fortune 2000 Corporations) for eCredit.com Inc. 
Email: kcundiff@ecredit.com or visit: www.ecredit.com.

Published with permission.

© Copyright 2001  K Cundiff – All Rights Reserved.


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Last Updated:  February 03, 2020 15:56 -0000