What is the situation in terms of credit risk management? Does it unquestionably belong to the generally recognized treasury subject area or is it better for the responsibility to lie with operational controlling?
It is well known that treasurers like to also call themselves risk managers, especially given that a significant component of every treasury department's core business is dealing with foreign currency, interest and liquidity risk. But what is the situation in terms of credit risk management? Does it unquestionably belong to the generally recognised treasury subject area or is it better for the responsibility to lie with operational controlling?
In its position paper from June 2017, the German Association of Corporate Treasurers [Verband Deutscher Treasurer e.V.] makes its opinion on the matter clear and assigns tasks of managing financial risks to treasury. These tasks also include customer credit risks and related processes and tasks such as credit rating checks. In practice, this movement to a greater focus on credit risk issues has been in evidence for quite some time. For some companies, credit risk has already established a significance comparable with management of FX and IR risks. Reasons for this include:
- Increasing regulatory requirements
Incorrect valuation and insufficient monitoring of credit risks in the banks' trading books is seen as one of the main causes of the banking and finance crisis. The standard setters drew lessons from this, and thus from 2018 a new accounting standard for financial instruments will come into force, IFRS 9, which also brings with it significant changes in how corporates manage their credit risk positions.
- Benefits for other treasury processes, e.g. liquidity management
The quality of planning for incoming payments of outstanding receivables combined with corresponding payment behaviour of customers represents valuable information for professional liquidity planning. In this regard, precise knowledge of a customer's payment history provides valuable information to improve planning quality.
- Changes in the IT landscape and availability of new technologies
Ever more powerful systems allow credit risk management to be more professional. Integration and use of group-wide credit risk data is at the top of the task list – and treasury already has thorough experience from other processes like FX exposure or liquidity planning. Modern database and analysis technologies make it possible to gain new insights into risk factors and managing mechanisms. This improves forecasting accuracy, and system-generated proposals for action and recommended decisions pave the way for Treasury 4.0.
It is in the hands of the respective treasury department to decide how implementation of responsibility for credit risk should look. Below we illustrate two issues currently being discussed in the industry:
Due to the increasing importance of credit risks, people in the market often ask about the organisational setup of the credit risk management function. Which activities are ideally handled at subsidiary level and where should a central group function be taking the lead?
Despite the centralising trend in different functions of the financial industry, a distinct sense of personal responsibility can be observed among companies and sales units. Thus, in most areas of activity of credit risk management, you can find both central and local responsibilities. All tasks concerning strategy and governance (process-based or technical) should be covered in group treasury or in the central credit risk department. This includes aggregating risks and limit systems, deploying IT systems and developing and providing calculation models for credit decision processes – i.e. traditional areas of treasury management. Local units are leading the way in matters which see them benefiting from direct contact with the customer, for example with dunning, operational receivables management, individual impairment provisions, factoring, and holding current information on credit ratings.
Some of the most important tasks in credit risk management centre on 'scoring'. Scoring means simply awarding points, and in the context of credit risk thus means quantifying customer information to estimate credit ratings. It therefore represents a method to express diverse customer features on a numeric scale so that a 'credit rating matrix' for credit decisions relevant to performance and processes can be generated in an objective way. Whereas only a minority of companies used to implement individual scoring models (instead basing the credit decision just on external information), this approach is now changing.
The scoring process is typically divided into three stages:
i) Aggregation of risks: there are many sources of information that can be considered for the scoring process (e.g. analysis of internal historical data, external credit rating information, CDS spreads, trends specific to countries and sectors). Companies often break down their sources of information differently, as not every source offers added value for credit information for a specific company. However, it is important that the relevant sources of information actually do find their way into the risk aggregation.
ii) Risk weighting: the credit information identified must be weighted appropriately. For example, it is advisable to weight quantitative information higher than qualitative information, or to weight information resulting from the analysis of historical data degressively based on its age.
iii) Risk classification: risk weighting results in a 'credit rating score'. However, this must be correctly interpreted and classified so that it can be stored in a customer credit rating matrix and thus referred to for credit or limit decisions, and also so that it can be used to calculate loss rates.
As already touched upon, credit risk management has recently also come more into an accounting focus. IFRS 9 requires trade receivables to be measured based on credit risks. This includes a significant change in that receivables are no longer measured according to an 'incurred loss model' (based on the past) but rather an 'expected loss model' (based on future predictions). In this case, too, a comprehensive scoring process and a clean transfer of the information into a credit rating matrix are absolutely necessary.
Scoring, therefore, is certainly not a new aspect of credit risk management. However, it is subject to constant change, as the availability of information relevant to scoring and systems applicable for analysis of scoring is constantly increasing. For example, regulatory requirements placed on scoring models are increasing, as is the competitive pressure within the relevant sectors to have implemented competitive evaluation methods. This is because only a precise risk assessment allows the element of receivables defaults to be accurately factored into the price calculation – and treasury has the expertise and the related methods and tools to implement this.
Credit risk management has a double-weighted meaning for the treasury department. On the one hand, regulatory standards require credit-risk-based models to be implemented for accounting purposes. On the other, the idea of exhausting performance potential in existing credit risk areas is an extremely exciting area which holds very good prospects for success – 'cash is king' is here the watchword, whether it be boosting competitiveness through accurate scoring or implementing efficient credit risk management to reduce defaults on receivables.