Things are changing quickly. According to the Fed Small Business Credit Survey released in March 2024, more than nine out of ten companies experienced a financial or operational change over the past year. Financial health for the majority of businesses still falls short of pre-pandemic levels and, as the Fed puts it, “continue to face operational and financial headwinds.”
Businesses need to improve their credit risk management process and credit risk management solutions to protect themselves from increased exposure. Credit risks are rising. Yet, many businesses continue to evaluate customer credit in the same way. Modern credit risk management software and improved data sources, however, can help lower your risk.
We will explain the main causes of credit risk, how credit models and credit risk management solutions work, and the importance of a structured credit management program.
What Are the Main Credit Risks?
When you extend credit to a customer or client or lend money, you are taking a risk. While it is impossible to eliminate all risks, you can limit your exposure by deploying credit risk management solutions and being proactive.
We will explain the credit risk management process in-depth, but first, you need to understand the most common causes of credit risk.
Customer Default
When customers, clients, or borrowers fail to pay what they owe you, it puts you at risk.
Personal bankruptcies are up 16% so far in 2024 and business bankruptcy filings have increased a staggering 40.4% from a year ago according to the United States Courts. S&P Global reports that rising default rates are occurring in 2024 and stressing private credit markets.
Economic Conditions
Industry downturns, changing consumer behavior, recession and inflation, and market volatility increase credit risk. When things are unstable, it can place a bigger financial burden on businesses, making it harder for them to pay their bills. Higher wages and labor shortages only add to the challenge.
Newsweek reports that 43% of small business owners were unable to pay their rent on time and in full in April 2024. The delinquency rate has now reached its highest point since the height of the pandemic.
Concentration Risk
When businesses rely too heavily on a few large customers or a specific industry, it increases the concentration risk. Even if individual customers are evaluated for creditworthiness, the loss of any one of the customers can put your cash flow in jeopardy. If there is a market downturn or a customer faces financial difficulties, it can put a significant crimp in your working capital.
Poor Credit Assessments
Many businesses still rely on manual methods or self-reporting by customers to evaluate credit. It is easy to miss the warning signs that underly financial problems without a comprehensive picture.
Credit risk management software can help pull together various information sources to objectively evaluate credit risk in a more accurate and complete way.
Ineffective Credit Risk Management Solutions
Poor credit management practices can also increase risk, such as:
- Not paying close attention to overdue accounts
- Lack of clear credit policies
- Inefficient collection efforts
- Not monitoring ongoing customers’ financial health
What Are the 5 Pillars of Credit Risk?
In banking circles, lenders use the five pillars — also known as the five Cs of credit — to evaluate creditworthiness and risk when working with borrowers. The five Cs of credit include:
- Character
- Capacity
- Capital
- Collateral
- Conditions
Let’s take a closer look at each of these.
1. Character
This includes a review of the credit history to examine the borrower’s track record for repaying their debts. Usually, this information comes from a personal credit report or a business credit report to assess credit utilization and payment history. Lenders use credit scores to make loan decisions and also to set rates and terms. Those with better credit ratings get more attractive offers. Those with poor credit may get denied or have higher rates and more restrictive terms to offset the increased risk.
Most lenders have minimum credit score requirements, although these may vary over time depending on the book of business and changing risk tolerances.
2. Capacity
Capacity refers to a borrower's income and overall financial situation. It measures someone’s ability to repay loans by comparing recurring debts and the debt-to-income ratio (DTI). A low DTI ratio shows that the person or business has enough income to service the debt and make timely payments.
3. Capital
Banks will also want to look at the amount of money a borrower can put toward a potential investment. For example, requiring a downpayment for an auto loan or mortgage. Larger contributions decrease the chance of default and impact rates and terms.
Likewise, businesses extending credit can ask for deposits upfront for orders as part of their credit analysis process to lower risk.
4. Collateral
Collateral is an asset that is pledged as security in case of a default. These secured loans also decrease the risk for lenders because the assets can be recovered when someone can’t pay what they owe. Lenders may place liens against certain assets to protect that right.
5. Conditions
The next step in the credit risk management process is assessing a borrower’s condition relating to the loan. For example, banks may take into account the length of time someone has held a job or owned a business, general industry trends, and economic stability.
This may also include examining how the loan will be used. For businesses that are reinvesting for future growth, this may be viewed more favorably than someone who is paying down debt.
What Is a Credit Risk Rating Model?
A credit risk rating model is a way lenders determine the level of credit risk associated with extending credit.
If you are a business extending credit to another business, for example, you will want to forecast your credit risk in three ways:
Probability of Default
First, you want to look at the business and determine the risk and the probability of default (POD).
Loss Given Default
You will also want to look at the impact such a default would have on your business, known as the loss given default (LGD). In other words, how much do you stand to lose if someone can’t pay their loan? Keep in mind that the loss may go beyond just what you are owed; you likely have costs involved in the materials, goods, or services you provide that are always lost.
Exposure at Default
This typically looks at your overall credit portfolio to evaluate the exposure at default (EAD) to make sure your exposure stays within your preferred tolerance range.
Importance of Credit Risk Management Solutions
Effective credit risk management solutions are going to be more important than ever over the next few years. The Global Association of Risk Professionals (GARP) points out that a large number of bank loans are coming due between now and 2026. Refinancing these loans will be at dramatically higher interest rates than in the past, putting an additional strain on businesses. This will also tighten liquidity in the corporate credit market, making it more difficult to get financing.
This means that even long-term customers with a stellar credit history may be facing new challenges that impact their ability to pay. Credit risk management software and credit risk management solutions will be crucial to navigate uncertainty and protect your financial interests.
The key benefits of credit risk management solutions include:
- Improved credit decisions: By leveraging advanced analytics, credit scoring models, and data-driven insights, businesses can use better information to make decisions about extending credit, setting credit limits, and managing credit exposures.
- Proactive risk mitigation: Regular monitoring and review of creditworthiness, coupled with early warning systems, enable businesses to proactively identify and address potential credit risks before they escalate into significant losses.
- Efficient portfolio management: Comprehensive credit risk management solutions allow businesses to effectively manage their overall credit portfolio, analyze concentrations of risk, and implement appropriate diversification strategies.
- Compliance and risk governance: Robust credit risk management solutions ensure compliance with relevant regulations and industry best practices, fostering a culture of risk awareness and governance within the organization.
- Increased profitability: By minimizing credit losses and optimizing credit exposures, businesses can enhance their profitability and maintain a healthier financial position.
Ensuring you have access to business credit reports, credit scoring, and other financial data is essential. Deploying effective credit risk management solutions is a strategic move to protect your business.
8 Steps of Credit Risk Management
What is the method to control credit risk? Effective credit risk management solutions will follow best practices in the credit analysis process and monitoring. The eight steps of credit risk management include:
- Credit policies and procedures: Develop clear and comprehensive credit policies that outline the criteria for granting credit, credit limits, payment terms, and collection procedures. These policies should be regularly reviewed and updated.
- Credit analysis and evaluation: Conduct thorough credit analysis and evaluation of potential customers or clients. This may involve reviewing their financial statements, credit history, payment patterns, industry trends, and other relevant factors to assess their creditworthiness and ability to repay debts.
- Credit approval and limits: Based on the credit analysis, determine whether to approve or deny credit for a customer or client and set appropriate credit limits. This step should involve a well-defined approval process and clear guidelines for credit limit determination.
- Credit monitoring and review: Regularly monitor and review the creditworthiness of existing customers or clients. This includes tracking payment patterns, changes in financial conditions, and any other factors that may impact their ability to repay outstanding debts.
- Credit risk rating and scoring: Assign credit risk ratings or scores to customers or clients based on their creditworthiness. This helps categorize customers based on their level of risk and can guide decisions regarding credit limits, pricing, and monitoring efforts.
- Credit risk mitigation: Implement strategies to mitigate credit risk, such as requiring collateral or down payments, obtaining credit insurance, diversifying the customer base, or using factoring or invoice financing services. These measures can help protect the business from potential losses due to customer defaults.
- Credit portfolio management: Manage the overall credit portfolio by analyzing the concentration of credit risk across different customer segments, industries, or geographic regions. This helps identify potential areas of concern and allows for appropriate risk mitigation strategies.
- Reporting and monitoring: Establish a system for regular reporting and monitoring of credit risk exposure, delinquency rates, write-offs, and other key performance indicators. This information should be reviewed by management and used to make informed decisions about credit risk management strategies.
Frequently Asked Questions — FAQs
What are credit risk principles?
The credit risk principles are a set of guidelines and best practices that lenders and businesses use to evaluate and manage credit risk effectively. These principles often include factors such as creditworthiness assessment, risk appetite, credit policies, ongoing monitoring, and risk mitigation strategies.
How do banks determine credit risk?
Banks typically determine credit risk by conducting comprehensive credit analysis and evaluation, which includes reviewing financial statements, credit history, payment patterns, industry trends, and other relevant factors. They may also use credit risk rating models, credit scoring systems, and stress testing to assess the probability of default and potential losses.
How can businesses leverage technology in credit risk management?
Specialized credit risk management software solutions and cloud services can automate and streamline much of your credit evaluations. These solutions may include access to business credit reports, credit scoring models, data analytics tools, credit monitoring dashboards, and integrated platforms that facilitate credit analysis, portfolio management, and reporting.
Can you explain credit risk management in simple terms?
The easiest way to think about credit risk management is to boil it down to three steps:
- Identify the potential credit risk
- Analyze the credit risk
- Monitor the credit risk
If you are vigilant in doing these three steps consistently and integrating the right data and credit risk management software, you can limit your exposure.
Looking to improve your credit risk management and lower your exposure? Talk to the credit risk management experts at Command Credit today.