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COMMERCIAL CREDIT

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ince the credit crisis started in 2007, lenders have become more risk averse, which has resulted in more strict regulations and credit policies for granting credit or commercial loans to businesses. In this article we will discuss how technology can help businesses to deal with this situation; in a world where credit is tight and, more than ever, businesses have to focus on their customer’s ability (and willingness) to pay. It seems that the world of credit, and especially credit risk, has fundamentally changed. If you search on Google with the words ‘banks tighten credit’ you will get the results shown in Table 1. Though credit standards of banks may not seem to get significantly tighter than they are right now, the results of this non-scientific Google search indicates that credit will be tight for the near, and probably also for the not-so-near, future. This situation obviously has significant impact on the way B2B companies have to do business, as companies – in general – can rely less on their banks for their cash and other financing needs. In other words, companies have to focus more on the creditworthiness and Table 1. Google search string ‘banks’+‘tighten’+‘credit’ +‘2006’ +‘2007’ +‘2008’ +‘2009’ +‘2010’ Number of hits 9,190,000 12,300,000 17,500,000 19,200,000 23,300,000

payment behaviour of their customers and suppliers to ensure a reliable cashflow and efficient use of working capital. To put it differently, credit management, and especially credit risk management, will become much more important for (B2B) companies. Nowadays, many companies have to deal with budget constraints due to decreased sales and lower profit margins. These budget constraints simply come down to doing the same, but more often than not more, work with less people in the same, or sometimes even less, amount of time. Obviously this puts a lot of pressure on credit risk management departments. To enable companies to deal with this situation, predictive analytics technology can be a great help. Predictive analytics Credit risk management and predictive analytics are typically associated with the advanced banks, where complex models and calculations such as probability of default (PD), exposure at default (EAD) and loss given default (LGD) are common practice. So far, in B2B corporate environments, this is far less the case. According to Aldo Taranto, founder and CEO of Credience, this is gradually about to change. “For the last decade, the advanced banks have enjoyed saving millions of euros from applying advanced predictive analytics,” he said. “This kind of high-end technology is becoming more and more available for other business sectors as well.

“Basically, in any business, getting, keeping and growing profitable customer relations is essential, but that only makes sense if you know that your customers are financially sound. With predictive analytics you can actually cover both sides of the return on investment equation, by identifying and analysing both risk and opportunities. “As such, predictive analytics can help make better and faster decisions, which basically have a positive impact on your bottom line results.” During my meeting with Mr Taranto I asked him some more detailed questions about the role of technology and credit risk management for B2B corporations. Q: What is the difference between scorecard and business-rules-based methods and predictive analytics? A: Many providers claim to do predictive analytics but only offer scorecard/rules-based decisioning. These are just simple ‘if...then...else’ rules created by experts (hence expert systems) and are backward looking rather than forward or predictive looking. They do not, for example, look at transactional and behavioural patterns in data, which means they are too simplistic for today’s complex financial patterns. Q: How can predictive analytics help B2B companies to improve the performance of their credit risk management? Can you give me some practical examples? A: Probability to default models – B2B companies, rather than using generic

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September 2010

COMMERCIAL CREDIT CCR world PREDICTIVE ANALYTICS AND CREDIT RISK MANAGEMENT As lenders have become more risk averse in the current economic climate. By doing so. can have a custombuilt model for their B2B companies and data. so creditors need to implement systems to ensure better credit decision making By Marcel Wiedenbrugge ‘industry ratings’. Figure 1. This involves passing their company’s balance sheet and profit and loss data through systems that produce predictive models.wiedenbrugge@wcmconsult. Other approaches include various stratified sampling techniques. they can make fewer adverse credit decisions. How can predictive analytics make corporations less dependent on bank credit? A: By corporations running their own data through predictive analytics software. how to better price it when purchasing it. Q: About those default models – how does a predictive analytics solution deal with a situation. and balance sheet spreading models to cater for these statistical discrepancies. then the better the overall model. so that you do not need expensive analysts and expensive vendors. for example. Knowing who is most likely to default is invaluable for risk-based pricing. CCRW Marcel Wiedenbrugge is the principal of WCMConsult marcel.com September 2010 www. Do you share that opinion? A: Not at all. technology will become more important for B2B companies to better manage risk and opportunities. My company. determining whether to lend or not. The more records one has. when there are not sufficient balance sheet and profit and loss data available? A: Most solutions apply a number of approaches to the data to remedy these data issues. for example. This in turn places less pressure on the corporation to ask the banks for bridging finance to ease cashflow and liquidity issues. such as low default portfolios (LDP) – where. Bayesian inference. due to more strict banking regulations and tighter credit policies by banks themselves. and how to collect on it when purchased. rather than it being exported into a proprietary environment. Q: Predictive analytics has a reputation of being expensive. We have overcome some limitations by allowing the data to be processed within its original environment. access to credit and commercial loans has become more restrictive. This saves time and money and the product guarantees each model built is a very good model. Another example of the limitations we have overcome is taking a holistic view of features and benefits – most vendors only look at predictive analytics from their specialty.net 25 .CCRWorld. companies will become less dependent on the credit facilities their banks offer them. Risk-based pricing can cover the corporation from losses by charging the more riskier accounts a higher price. banks in the Middle East do not have as many default data as many Western banks. Probability to pay models – whether you are a debt purchasing company or a debt collections company. or whether to do business with that company or not (see Figure 1). Due to the changing role of the banks towards credit. knowing which accounts are likely to cure and which are not is vital in knowing which debt to purchase. This will ultimately be beneficial for all parties: the customers. and the better the quality. Q: What are the limitations of predictive analytics technology? A: Number and quality of records in one’s database. at the 30% level is ≈ five times more accurate than scorecard/ rules-based decision % defaulters contacted Q: As we know. has automated the building of predictive analytics models into an extensive system. suppliers and the banks themselves. Power curves measure model performance 100 90 80 % defaulters detected 70 60 50 40 30 20 10 10 20 30 40 Random decision Scorecard/rules-based decision Predictive model 50 60 70 80 90 100 Uplift due to predictive model.