Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference

Home > Financial Risk Management Checklists > Managing Your Credit Risk

Financial Risk Management Checklists

Managing Your Credit Risk


Checklist Description

This checklist explains what credit risk is and how to contain it effectively.

Back to top

Definition

Credit risk is the risk of loss caused by a debtor defaulting on a loan or other line of credit, whether the principal, the interest, or both. The sound management of credit risk involves reining in all exposure to financial risk to within acceptable limits. A company’s rate of return should always be risk-adjusted to take account of credit risk and other risks.

Good control of credit risk involves managing not only the risk associated with individual deals or transactions, but also that of an entire portfolio (i.e. ensuring that risk is both minimized and evenly spread). Banks in particular need to have a comprehensive policy in place for managing all kinds of risk—credit risk forms the most important part of any such policy. The collapse of Barings Bank in 1995 is a textbook example of what can happen when an organization lacks safeguards for managing credit risk. Loans tend to be the main source of credit risk for many banks. They are, however, exposed to other sources of credit risk, such as in the trading book, or on and off the balance sheet. For all kinds of companies credit risk also exists in other financial instruments, such as interbank or currency transactions, trade financing, equities, and derivatives.

Exposure to credit risk remains a key problem on a global basis. Companies need to learn lessons from high-profile cases such as Barings and Northern Rock. The Basel Committee drew up a set of principles to be used when evaluating a credit risk management system. Although the principles are aimed at financial institutions, they apply equally to all organizations. How a company approaches the issue will vary according to factors such as the supervisory techniques they use, whether they employ external auditors, and the size of the institution. Smaller businesses, in particular, need to ensure they have an adequate risk–return policy in place.

Firms are exposed to credit risk when, for example, they do not insist on advance payment for products or services. By billing after delivery, the company takes the risk that the customer may default on payment, leaving it out of pocket. Many companies quote payment terms of 30 days as standard, and it only takes one large defaulted payment to expose the firm to cash flow problems and possible bankruptcy.

Many firms operate a credit risk department whose role is to assess the financial health of their customers and decide whether to extend credit or not. They may use software to analyze such risks and assess how to avoid, reduce, or transfer any credit risk. Credit rating companies such as Standard & Poor’s, Moody’s, and Dun and Bradstreet also sell financial intelligence to firms needing external assistance in managing credit risk with their clients.

Companies can lessen their credit risk by, for example, cutting their payment terms to 15 days, limiting the amount of goods or services available on credit per transaction, or even insisting on payment up-front. Strategies such as these cut exposure to risk, but the downside is that they can affect the volume of sales and subsequent cash flow.

Back to top

Advantages

  • A keen awareness of credit risk that includes processes to identify, measure, monitor, and control credit risk should protect all but the smallest organizations from major problems.

Back to top

Disadvantages

  • Small firms that have only a very few customers find it difficult to manage credit risk due to their vulnerability should a customer turn out to be a late-payer or even default on payment entirely.

Back to top

Action Checklist

Specific credit risk management practices vary among organizations according to the type and complexity of their credit activities. A comprehensive policy for managing credit risk should address the following points:

  • Create an appropriate credit risk environment.

  • Implement a policy that ensures the credit-granting process is sound.

  • Assess the quality of your assets and determine that you have adequate provisions and reserves.

  • Maintain quality procedures for credit administration, measurement, and monitoring processes.

  • Ensure that you have adequate controls in place.

Back to top

Further reading

Books:

  • Bluhm, Christian, Ludger Overbeck, and Christoph Wagner. An Introduction to Credit Risk Modeling. Financial Mathematics Series. Boca Raton, FL: Chapman & Hall/CRC, 2002.
  • de Servigny, Arnaud, and Olivier Renault. The Standard & Poor’s Guide to Measuring and Managing Credit Risk. New York: McGraw-Hill, 2004.
  • Duffie, Darrell, and Kenneth J. Singleton. Credit Risk: Pricing, Measurement, and Management. Princeton Series in Finance. Princeton, NJ: Princeton University Press, 2003.

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share