One Man's Journey through Credit Risk and Trade Finance Management
After writing an article on Dynamic Hedging for Tomato many years ago and enjoying the positive feedback over the years it was on the Tomato website, Martin Schneider has asked me to write another article.
Martin and I decided that it should not be an academic or technical article, but simply an article on my experiences as a credit risk and trade finance manager. It is sort of like an op-ed piece one might find in a newspaper or magazine, whereby I will try to impart upon the reader key learnings from my own experiences.
Caveat 1: Let me be fully open and transparent by saying that I will not give away all of my secrets and insights here, because there is not enough space in this article and because I still want to get hired for future credit risk and trade finance projects!
Caveat 2: Like Martin Schneider, I am a big believer in efficiency, optimization of flows and intellectual honesty; therefore I am telling it like I see it without regard for political considerations. I know I will be stepping on some toes, but the aim is that Tomato customers and supporters can profit as much as possible from this article. So, my sincere apologies to some of the toes out there!
Understand Your Company’s Strategy and Risk Appetite
As a credit risk manager deciding whether to grant a counterparty credit or not and how much credit and under what terms and conditions, you must have a crystal clear understanding of your business line’s strategy and risk appetite. In most cases, this will be in alignment with the overall company’s strategy and risk appetite. If they are different, why are they different?
In simplistic terms, if your company wants to grow fast, gain a lot of market share and is willing to take some risks to make that happen, then you will probably want to be more flexible in granting credit. And vice versa!
To find out, you must have clear and direct discussions with the business managers and with your finance line managers. Sounds simple enough, right? Well, in reality you may receive conflicting messages from business manager to business manager, from finance manager to finance manager and of course, the eternal and classic different viewpoints between finance and the business.
I experienced many conflicting messages in two large international companies that I worked for. One solution that I found was to read everything coming from the CEO and CFO on strategy, direction of the financial results, market conditions, etc. This gives you a top-down starting point in discussions with managers as you go down the hierarchy. After all, if the CEO or CFO said something and it is part of the public record, then it is difficult to argue with.
I did this and I even went one step further. I had the chance to ask the CFO of a very successful and large multinational company directly how he expected the finance department to behave after the financial crisis in 2008-2009 and it was very clear that he wanted to protect and preserve the company’s financial assets. He wanted to see an increase in security on the accounts receivables, especially in the emerging market countries and for us to be vigilant and rigorous in our credit risk work. This is what I wanted to hear and what I agreed with at that time.
On a different occasion just a few weeks later, guess what the number one business manager who reports to the CEO said? Ha! Just the opposite of what the CFO said. This was exciting for me to discover that our celebrated leaders were not in alignment on this subject. It did not seem that anyone really realized this at the time. However, I am sure that if you put them in the same room and ask them, their message would be much more reconciled and congruent.
So, this top business manager basically said (I am putting this in my own words now) that we have to weather the storm, keep doing business, trust our customers, don’t abandon the customers just because of an economic downturn, think long-term, maintain market share, don’t let the competition steal business because we are too strict, but be sensible.
Now, when I went a level lower, the discussion and viewpoints were basically the same. Finance wanted caution and business wanted to keep doing as much business as possible. However, the business managers were a little more on the side of caution, because we were influencing them with facts and figures on a daily basis.
The conclusion was that we only accept pre-payments or bank guarantees from our D-rated customers that we try to get as much security as we could with other customers, but without damaging the relationships and sales and that we stay on top of local market conditions. So, it was essentially a compromise between business and finance and I have to say it worked out quite well. One might think, why doesn’t someone just issue a clear policy rule from on high to make it clear to everyone, but then you wouldn’t have the iterative and powerful effect of discussions and influencing at all levels of the organization. The end result was a mixture of ideas and approaches which is much more effective than one top-down decree.
Another solution is when you are in a large meeting with many senior business and finance managers, ask the question! Very simple and effective! What is our risk appetite with credit looking forward short-term, medium term and longer term (12-18 months out)? You will trigger a very interesting and very important discussion as there will be different perspectives. Try to lead and manage that discussion so that you create a consensus on how you should be managing the credit. Try to get it in writing whether in the minutes from the meeting or by confirming via email.
Communication and Ways of Working
If you are an introvert, if you are too shy, if you do not like talking to people, etc., you might have a hard time as a credit manager. As the above section on understanding risk appetite illustrates, communication is essential to an effective credit risk management.
I personally love meeting all kinds of different people, talking with them, learning from them, perhaps helping them learn and finding ways of working together to create win-win situations or even better win-win-win situations. This has served me well in my various credit risk roles, although at different times I got bogged down in process improvement, outsourcing issues, audit and administration, cleaning up old cases, etc.
If I could turn back the clock, I would have spent even more time communicating with business managers, customers, credit risk colleagues, other finance colleagues, customer service people, banks, credit insurers and credit managers outside of our company and less time on trying to perfectly clean up the mess, as important as that is. Set priorities where your impact for the company is maximized.
However, I believe we did save the company a lot in audit costs and management time, because the external auditors massively reduced the resources applied to our area once it became very clear it was very tightly controlled and managed. The only open question is, could we have improved sales and customer relationships had we not spent so much time on controls, inherited old accounts and audit issues? One has to get the balance right with priorities - which is a trial and error process - but be aware of this process.
In summary, talk to as many people as possible, especially the customers and the business managers, and as frequently as possible! Build strong personal and professional relationships which will help you discover those win-win-win situations. Find out how they tick, what motivates them, what they worry about and what they think the solution is. Together you will find the creative solution which is often not in the black and the white, but in the various hues of grey. Sorry to use such an old cliché!
In international environments with all the different languages and cultures in play, make sure the communication is clear and simple to avoid misunderstandings. Check people’s understanding of your message several times, before you assume they truly did understand. Repetition, simplicity, clarity and confirmation of understanding are the key.
It goes without saying that regular, face to face meetings with key stakeholders and minutes taken and distributed are very helpful. Finally, establish clear ways of working!
There is a great book which has helped me with communication, relationships and ways of working . It is called “The Four Agreements” by Don Miguel Ruiz. Here is a summary:
- Be impeccable with your word
- Doon't make assumptions
- Don't take it personally
- Always do your best
Financial Analysis for Credit Risk Decisions
"In God we trust, all others bring data."
- W. Edwards Deming
This is one of the most interesting aspects of credit risk management, because the numbers do not lie. You have a clear picture of a counterparty’s financial performance via the income statement, of their solvency and overall situation via the balance sheet and how they are managing cash via the cash flow statement. And, of course, you see the trends in these various financial statements by comparing them to previous years.
Furthermore, you know how timely a customer is paying you through the payment history records, you know the sales statistics the customer has with your company and you know the sales phasing throughout the year.
All of this and the macroeconomic data will help you calculate credit limits, set a risk rating and decide upon payment terms.
There have been books written on financial analysis for credit decisions and many articles, therefore I will refer you to those for all the details and various approaches. There are also many courses and certifications on credit risk management, for example from FCIB and ICTF to name just a few. The internet is, of course, a well-spring of useful information. And referring back to the previous section on communication, talking to people about how they do their analysis is always interesting and educational.
Depending on what kind of counterparty I am analyzing and which industry I find myself in, I want to understand their top-line sales trend over 5 years and their future forecast, their cost structure trends separated by fixed and variable costs and their net income trends. I also want to understand their working capital costs and trends, their inventory turnover trend, their accounts receivables turnover trend and their debt and equity ratios and trends. Market share growth vis a vis competitors is also very helpful information.
Now, all of the above is assuming audited financial statements are readily available and/or there are reliable, current credit reports available. In many of the emerging market countries, audited statements and reliable, up-to-date credit reports can be very difficult to come by. We had this challenge with many of our Central and Eastern European, Middle Eastern and African customers. What is the solution? The old axioms about “Trust is good, control is better” or what Ronald Reagan mentioned during the Cold War, “Trust, but verify”, which is an old Russian saying, come into play.
For the larger or riskier counterparties, one must insist upon audited financial statements from an accredited, reputable auditor. You could help pay the costs of the audit if the customer does not want to take on all of the costs. You might have to show up at his office and do the audit yourself, of course with their full agreement. A translator is often highly recommended. The times that I travelled with a business manager and a translator for Russian were the most effective meetings.
In some cases, you will just have to trust, but if you see the sales growth, the low inventory year after year and a good payment history going back many years, then your trust is probably well placed.
Again, going back to the communication section: If you have excellent, open and trustworthy relations with the customer and/or after visiting him you see that his business is doing well and that they keep professional records, you may not have to insist on audited financial statements.
Obviously, one also has to look at the country and regional macroeconomic situation as well as the individual company. What are the Foreign Direct Investment (FDI) trends, the local currency fluctuations against the major currencies, the unemployment situation, GDP growth trends, local bankruptcy trends and credit spreads seen in the bond markets?
Finally, everything mentioned in this section, should be captured in a customer profile document which standardizes the way you evaluate the counterparty’s financial situation, the way you calculate the credit limit, the way you risk rate the counterparty and the way you grant payment terms.
This customer profile document should be approved by the finance line management and the business managers, so everyone agrees to the standardized process of evaluating and deciding. This document should also be signed off by the credit risk manager and the responsible business manager. When a certain threshold of credit limit is exceeded, the customer profile document should be signed off by the finance line manager and eventually others according to the delegation of authority system in your company.
Financial Analysis for Credit Risk Management Performance
"Measurement is the first step that leads to control and eventually to improvement. If you can't measure something, you can't understand it. If you can't understand it, you can't control it. If you can't control it, you can't improve it." - H. James Harrington
How effective is your company at credit risk management? This is very important as the quote above illustrates.
There are 5 key measures of effective credit management according to a very useful article:
- Days Sales Outstanding – DSO
- Collections Effectiveness Index – CEI
- Best Possible Days Sales Outstanding
- Average Days Delinquent – ADD
- Average Days to Pay
Here is the summary from the FB Debt article:
„Having KPI’s that measure your credit management’s effectiveness and efficiency are crucial to improving your cash flow.
DSO alone will not accurately measure your performance so you should also measure your Collection Effectiveness Index.
In situations where your CEI and DSO track the same way due to revenue fluctuations for example, your Average Days Delinquent score can be relied on as it takes both of these measures into account.“
Additonally, the changes in bad debt provisions and write-off’s over time can give you very compact and demonstrative measurement of performance.
Credit Management Policy and Procedures
Once you have all the previous sections in place, it is time to write a policy which is more of a general, overview document setting up the playing field and the rules. The procedures are more step by step processes for each task.
The policy and the procedures should be socialized and iterated upon until all key stakeholders agree and sign off on it. The final documents should be distributed as appropriate.
These are very important documents as you will be evaluated based on these, internally and by the external auditors.
One would think that a policy and procedures document as laid out above is obvious, but you would be surprised at how many companies do not have a final, working, approved policy and procedures document.
Outsourcing Credit Risk Management
My own view and experience is that the most effective and efficient credit risk management is in-house and not outsourced to a third party. An actual employee of your company is aligned with the vision and strategy of your company, works closely with business managers and other stakeholders within the company, is responsible for preserving and protecting the assets of the company and has delicate customer information and sensitive customer relations. Therefore, it is virtually impossible to replicate this in a 3rd party outsourced center.
However, the accounts receivables accounting can be outsourced to a third party service provider given the right conditions. Collections can be outsourced if the decision has been taken to sever ties with that customer.
I have worked with a company with in-house accounting and a company with outsourced accounting and my own personal experience is that in-house accounting is far superior. It is more efficient for a credit manager and a business manager to have the accountant in-house for all the obvious reasons: Physical proximity, understanding of the business, understanding of the company history, knowledge of the right people, longstanding relations with customers and banks, knowledge of legal and compliance issues and so on. There is simply far less management time invested with in-house people as opposed to 3rd party outsourced resource.
Now, from a broader, helicopter view, outsourcing can save costs if done properly. I have helped implement a new target operating model in various countries using a shared service center for new, global and standardized finance processes and I know where it works and where it does not work. This subject is, however, too big to include in this article.
I hope that this article was helpful in some way for you. There is a lot more to tell you as seen in the list of possible future subjects below, but that will have to wait for another time.
- Reporting, Data Quality, Single Point of Truth
- Barter
- Internal Controls, Compliance
- Credit Insurance
- Training Business Managers
Please feel free to send me any feedback you might have to allen@intergga.ch.
Allen Holland is an experienced Credit Risk and Trade Finance Manager with many years of emerging market experience. He worked with us at Tomato in 2004 as a consultant and business developer. Since the 1990s, he worked at a major Swiss bank and two large multinational companies in such positions as Risk Management Advisor and FX Option Specialist, Credit Risk and Trade Finance Manager, and Regional Finance Transition Manager. In his most recent position, he was involved in the implementation of a new Target Operating Model including new global finance processes, a shared service center and outsourcing to India. He is currently working as a free-lancing consultant.