Making decisions is a significant part of managing an SME. Customer payment is one decision-making scenario that frequently results in problems. When it comes to consumer payment, you must always choose carefully because it can make or break your firm.
In addition to being necessary for business, giving credit to customers is also ethical. However, this is vulnerable to credit risk, along with other things. A late-paying customer can cause turmoil for SMEs with little outside support. Maintaining a robust credit system is key to handling strict credit management and customer relationships. It also makes it possible for you to keep your market share.
What is Credit Risk?
When a bank extends credit to a borrower, there is a chance that the loan may not be repaid. Based on the borrower’s or the business’s capacity to meet future obligations, loans may be granted (of principal and interest).
Lenders go to great pains to comprehend a borrower’s financial situation and determine the likelihood that the borrower would eventually cause a default.
Responsibility for credit risk
Although credit risk management involves several steps, it can be roughly divided into two groups. As follows:
- Measurement
- Mitigation
Evaluation of Credit Risk
Lenders evaluate credit risk using their unique risk evaluation systems, which vary depending on the company or region and are based on whether the debtor is a consumer or a commercial borrower.
To make a personal loan, creditors must know the borrower’s financial condition, including their income (about all of their responsibilities), other assets, and liabilities. They will also want to know how their credit history looks. Personal guarantees and collateral are frequently used in personal financing.
Contrarily, commercial lending is considerably more complicated, and many company clients borrow more significant sums of money than private customers. Several qualitative and quantitative methodologies are needed to rate the risk of a commercial borrower. These are some categories of qualitative risk assessment:
- Knowing what’s happening in the corporate world and the larger economy
- Examining the borrower’s industry of operation
- assessing the company’s strengths and weaknesses in the market as well as its growth plans
- Examining and comprehending the ownership and management (if the business is privately owned). The examination will consider management’s reputation and the owner’s credit scores.
- The financial analysis makes up the quantitative portion of the credit risk assessment. Lenders consider several performance and financial ratios to determine the borrower’s overall financial health.
- A borrower’s credit assessment will result in a score based on the lender’s analysis methods, models, and underwriting criteria.
Numerous names can be given to the score. For instance, credit ratings or debt ratings are used to describe scores for public debt instruments (such as AAA, BB+, etc.); risk ratings may be used to describe scores for individual debtors (or something similar).
The score indicates the probability that the borrower will cause a default event. The likelihood of a borrower defaulting decreases with credit score and rating; it increases with lower scores and ratings.
Credit Risk Reduction
If credit risk is not managed correctly, lenders may experience loan losses, which hurt the financial services industry’s profitability. Among the techniques, lenders employ to reduce credit risk (and loan loss) are, but are not limited to:
Credit deal
Credit structuring approaches enable some reduction of credit risk.
The amortization duration, the utilization of (and the caliber of) collateral security, LTVs (loan-to-value), and loan covenants are a few examples of credit structure components.
For instance, a riskier borrower might have to agree to a shorter amortization time than usual. It’s possible that a borrower will need to submit more frequent (or thorough) financial reporting. It is crucial to comprehend any attainable collateral security and structure credit appropriately.
Sensitivity testing
Sensitivity analysis is the process by which a lender modifies a few elements of the proposed credit structure to determine how the borrower’s credit risks would vary if the speculative circumstances materialized. Examples comprise:
A lender would want to check the borrower’s credit metrics at a 7 percent or 8 percent interest rate if they plan to give credit to them at a 5 percent interest rate (in the event that rates ever increase materially). It is referred to as a “qualifying rate” at times.
A lender might be considering providing a borrower with a 10-year term loan. Still, they might first want to evaluate how the credit metrics would alter if the loan had a 6- or 7-year amortisation (if conditions changed and the lender wanted to accelerate the repayment of the loan).
Controlling the portfolio
Financial institutions and non-bank lenders may use portfolio-level controls to reduce credit risk.
Monitoring and comprehending the percentage of each type of loan in the total loan book are two strategies.
The Five C’s of Credit
The 5 Cs of Credit are a paradigm that is frequently used to help understand, measure, and mitigate credit risk. There are 5 Cs:
Character it’s a personal loan, who is the borrower and do they have a good credit history?
Character refers to the reputation and dependability of a firm’s management about commercial creditors; if a company is a private corporation, the character also includes ownership.
- Capacity
Capacity refers to a borrower’s capacity to acquire and repay debt. Different debt service and coverage ratios are used to assess a borrower’s capacity for retail and commercial borrowers.
Understanding the borrower’s competitive edge is essential for commercial lenders since it will affect the borrower’s ability to produce cash flow in the future if it can keep or increase this advantage.
- Capital
A borrower’s “wealth” or overall financial health is frequently described as their capital. Lenders will determine how much debt and equity sustains the borrower’s asset base.
Knowing whether a borrower can obtain alternative funding from other sources is crucial. Exists a linked business with available funds (for a business borrower)? Can a parent or relative guarantee a personal loan for a borrower who may not have a stellar credit history?
- Collateral
Collateral security is crucial in how loans are set up to reduce credit risk.
Understanding the value of the assets, their location, the ease of transferring the title, and the right LTVs are crucial (among other things).
- Conditions
Conditions include the goal of the credit, extrinsic events, and other elements of the outside world that could present hazards or possibilities for a borrower.
They can be political, macroeconomic, or related to the current phase of the economic cycle. Industry-specific difficulties and societal or technological advancements that could affect competitive advantage are examples of circumstances for company loans.
Conclusions
Assessing the borrower’s profile is the first step in effective credit risk management, which continues through recovery and beyond. Banks must develop flexible lending processes equipped with pertinent rating systems to determine creditworthiness and set reasonable interest rates. They can hide any future loan defaults in the future with this. Additionally, banks must set aside enough capital to offset significant loan losses and stay afloat. These procedures are required to lower greater default probabilities and enhance the condition of loan books.