How to create a basic credit risk assessment framework Featured

9:01pm EDT May 31, 2012
How to create a basic credit risk assessment framework

Understanding when, where and how much credit risk is being incurred throughout an enterprise is important knowledge to possess to not only survive, but thrive, and that applies to both businesses and financial institutions.

Smart Business spoke with Scott B. McCallum, senior manager at Cendrowski Corporate Advisors, about how to create a basic credit risk assessment framework for banks, the elements of which businesses may wish to consider adopting and adapting for their own purposes.

What is credit risk?

Credit risk is the financial exposure one party has to a counterparty’s failure to meet its financial obligation. For a typical business, the most prevalent form of credit risk is, of course, the accounts receivable owed by clients or customers. Another credit counterparty is a company’s bank, whether to access deposit balances, fund draws on a revolving credit facility or receive contractual cash flows associated with an interest rate swap or foreign currency contract. Another form is prepaid expenses, such as  insurance premiums, in which the business becomes an unsecured creditor of the provider of the service to the extent of unearned revenue.  Credit risk arises to a seller of a business to the extent that a buyer finances a portion of the purchase price with notes payable to the seller.

How does credit risk arise at banks?

The primary risk that causes a bank to fail is credit risk. Looking at credit risk on an enterprisewide basis, banks hold most of their assets in the form of loans and investment securities. The most prevalent form of credit risk is in the loan portfolio, in which the bank lends money to a variety of borrowers with the intention of getting repaid in full.

Depending on the underlying investment securities in the portfolio, there is often credit risk embedded in securities other than those backed by the full faith and credit of the U.S. government.

Was JP Morgan Chase’s recently announced $2.3 billion loss related to credit risk?

Yes, according to an editorial in the May 14, 2012, edition of The Wall Street Journal, ‘J.P. Morgan recently suffered an unexpected loss of more than $2 billion on trades related to the creditworthiness of various corporations.’ The editorial also stated, ‘The bank had tried to protect itself from the potential of deteriorating financial markets by essentially making a bet that would pay off if corporate default risks increased.’

What is a risk assessment?

A risk assessment is an analytical exercise conducted to identify the risks associated with a particular business activity. A risk inventory is developed in the context of the defined business activity or process. Once the risks are identified, they are measured and ranked in priority based on an understanding of the magnitude and frequency of occurrence. Then, key risk indicators (KRIs) are developed to facilitate ongoing measurement of actual performance versus the KRIs. Risk reporting enables management and the board to provide effective monitoring and oversight.

What does a credit risk assessment process look like at a bank?

Banks are often organized to conduct business activities in silos, which can result in some risk gaps. A credit risk assessment helps to neutralize silos. Here is a basic credit risk assessment framework.

  • Identify major subcategories of credit risk (e.g., residential mortgages and home equity lines and loans; consumer loans; commercial and industrial, and owner-occupied commercial real estate loans; agriculture and farm loans; construction and development loans; and investment securities).
  • Engage key team members involved in making/underwriting the loans to identify credit risks for each subcategory.
  • Prioritize risks based on evaluation of financial impact from the magnitude of each occurrence and frequency of occurrence.
  • Develop KRIs for each credit risk subcategory.
  • Determine credit risk tolerances, limits and controls.
  • Develop reporting for effective monitoring by management and the board.

What are credit concentrations?

Managing credit concentrations is about maintaining prudent diversification in the composition of a bank’s assets. Banks have stepped up monitoring and management of credit concentrations such as limits on dollar exposures to any single borrower, or limits on the aggregate percentage of the portfolio consisting of certain loan types. Bank regulators also have been strong advocates of managing credit concentrations, as many that failed had high concentrations of those loan types.

What can businesses learn from banks to apply in their own credit risk assessments?

Know your counterparty. For the customer base to which you extend terms, establish credit limits per account debtor, obtain credit reports, background checks or similar reports that provide timely information and monitor for deterioration. Manage concentrations of business with your top 10 accounts. Identify local market or industry-specific key risk indicators that provide early warnings of elevated risks. Look for credit risk enterprise-wide, on and off the balance sheet. Understand the financial impact of the potential loss, based on magnitude and frequency of occurrence.

Finally, don’t compound a problem. Don’t sell more to deadbeats. Stay disciplined and diligent in actively managing customer limits and monitoring account debtors for deterioration. If you are concerned, take some risk out of the sale by requiring wire transfer remittances or cash-in-advance. And know your counterparty and sleep better at night.

Scott B. McCallum is senior manager at Cendrowski Corporate Advisors. Reach him at sbm@cendsel.com.

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