Assignment 1

Credit Management

1. What are the risks associated with Lending?

Lending risk is the possibility of losing money due to the inability, unwillingness, or non-
timeliness of a counterparty to honor a financial obligation. Whenever there is a chance that a
counterparty will not pay an amount of money owed, live up to a financial commitment, or
honor a claim, there is lending risk (Bouteille & Coogan-Pushner, 2012).

The following are the primary risks associated with lending:

• Credit Risk - Credit risk is the likelihood that some or all promised cash flows on primary
securities held by Financial Institutions (FI) may not be paid in full. Virtually all types of
FIs face this risk. FIs that grant loans or buy bonds with long maturities are more
exposed than FIs that advance loans or buy bonds with short maturities. This means for
example, that commercial banks and life insurance companies are more exposed to
credit risk than are money market mutual funds and general insurance companies. If
the principal of all financial claims held by FIs was paid in full on maturity and interest
payments were paid on the promised dates, FIs would always receive back the original
principal lent plus an interest return.
• Interest Rate Risk - Interest rate risk is the probability of a decline in the value of an
asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly
associated with fixed-income assets (e.g., bonds) rather than with equity investments.
The interest rate is one of the primary drivers of a bond’s price.
• Liquidity Risk - By definition, investor liquidity risk represents any potential difficulty
that may arise when selling positions on the market. An investor who wishes to sell their
assets may indeed struggle to find a counterparty willing to purchase it at its full market
value (a difficulty which is more pronounced as a position gets bigger and trading
volumes get lower). The investor may therefore find themselves with no choice but to
accept a low price simply to be able to liquidate their position more quickly. In the
worst-case scenario, liquidity risk could even translate into a total inability to sell a
financial position due to a market that is either too narrow, or non-existent altogether.
• Transaction Risk - Credit transaction risk is the risk of financial losses and negative
social performance related to loans to clients, caused by inadequate policies regarding
loan disbursement, follow-up, and recovery.
• Compliance Risk - Compliance risk is the risk to earnings or capital arising from
violations of, or non-conformance with, laws, rules, regulations, prescribed practices, or
ethical standards. Compliance risk also arises in situations where the laws or rules
governing certain bank products or activities of the bank's clients may be ambiguous
or untested. Compliance risk is often overlooked as it blends into operational risk and
transaction processing. A portion of this risk is sometimes referred to as legal risk. This
is not limited solely to risk from failure to comply with consumer protection laws; it
 encompasses all laws as well as prudent ethical standards and contractual obligations.
It also includes the exposure to litigation from all aspects of banking, traditional and
nontraditional.
• Reputation Risk - Reputation risk is the risk to earnings or capital arising from negative
public opinion. This affects the institution's ability to establish new relationships or
services or continue servicing existing relationships. This risk can expose the institution
to litigation, financial loss, or damage to its reputation.

2. What are the advantages of good credit management?

An important aspect of credit risk is that it is controllable. Credit exposure does not
befall a company and its credit risk managers out of nowhere. If credit risk is understood in
terms of its fundamental sources and can be anticipated, it would be inexcusable to not
manage it. Credit risk is also the product of human behavior; that is, of people making
decisions. Precarious financial circumstances that obligors may find themselves in result from
the decisions that the company's managers have made. The decisions that they make are
consequences of their incentives and the incentives of the shareholders whom they represent.
Understanding what motivates the shareholders and managers is an important aspect of a
counterparty's credit risk profile.

All firms should devote significant attention and resources to credit risk management
for their own survival, profitability, and return on equity:

➢ Survival. It's a concern primarily for financial institutions for which large losses can lead
to bankruptcy, but even a nonfinancial corporation can have credit losses that can cause
bankruptcy.
➢ Profitability. It sounds trivial to state that the less money one loses, the more money
one makes, but the statement pretty much summarizes the key to profitability,
especially of low-margin businesses.
➢ Return on equity. Companies cannot run their business at a sufficient return on equity
if they hold too much equity capital. Holding large amounts of debt capital is not the
solution either, because debt does not absorb losses and can introduce more risk into
the equation. The key to long-term survival is a sufficiently high amount of equity capital
complemented by prudent risk management.

During the financial crisis, certain global players performed much better than their
peers thanks to very powerful credit risk management principles that kept them afloat. In any
economic environment and for any type of company, actively managing a credit portfolio can
help increase the company's return on equity.

3. What are the factors to consider in deciding the collection department structure?

One individual or a group of individuals can make a bad judgment about a specific
transaction. As a result, a firm can lose money, even a lot of money if the transaction is sizeable,
but it is unusual that a single transaction leads to the bankruptcy of a company. Serious
problems that lead to bankruptcy occur when portfolios of toxic transactions are built. In the
absence of fraud, what allows this to occur is a poor risk management framework and corporate
governance failure.

Risk management is the first line of defense to protect an organization's balance sheet.
Efforts to originate and structure transactions are useful but, ultimately, choosing the right
transactions is what distinguishes the good organization from the weaker ones. It is, therefore,
essential that risk managers are qualified and work in an environment that enables them to
perform their tasks efficiently.

All staff involved in risk management must have a chain of command that ultimately
reports to the Credit Manager and not a business unit head, to maintain independence and
avoid conflicts of interest.

The simple rule is that the riskier the transaction, the higher the approval level must be.
Transactions with a high exposure or a low credit quality or a long tenor necessitate senior-
management attention and must be approved by committees staffed with people with the
relevant level of knowledge, experience, and hierarchical level. On the contrary, small and
short-tenor transactions with a high-quality counterparty can be approved at a lower level.
Simple and straightforward transactions can even be approved by a single individual.

Credit positions are identified by countless different titles representing the graduations
of authority and combinations of responsibility. On the officers’ level, the credit position may
be known as Financial Vice President; in lower echelons, the position is designated as Credit
Manager, Assistant Treasurer, General Credit Manager, Branch Credit Manager, Loans
Manager, Credit Man, Credit Correspondent, and many other similar titles.

4. List down the Qualities of a credit man.

The individual who presides over this department must have certain qualities that are
essential. First, he must have due regard for system, for the information must be so arranged
as to be quickly obtainable and complete when it is wanted. He must have a broad knowledge
of business methods and practices. He must know the terms of business and the state of
business. He must know trade secrets, not to give them away, but to use. He must be somewhat
of an accountant, for unless he has the analytic mind that accountancy develops, he cannot
make proper deductions. He must know how books are kept and how to keep books. He must
be a surgeon-able to dissect, and a physician-able to prescribe.

He must have the "credit sense" which is the detective's instinct, to quickly perceive a
clue that may begin with a button and end in a conviction. He must know something of law-the
law of collections, of negotiable instruments, of bankruptcy. Like a good trial attorney, all that
he may know will come into play sometime and somewhere. His work is not like much of the
work in a bank, a daily grind; for while each day has its duties, and each day its problems, today
will not be a yesterday, nor will tomorrow be another today.

The following are the Cardinal Cs of a Credit Man:

• Competence and Capability - He must have a clear understanding of what the end
points of his efforts are and should be.
• Communication - He must have the ability to effectively convey his ideas.
• Constructiveness - He must be positive and constructive in his approach to both credit
and collection management.
• Creativity - He should constantly pursue creative answers to new questions.
• Conscientiousness - He must be a strong proponent of cooperation and coordination
in the entire organization.
• Consistency - He must not unnecessarily deviate, nor completely veer away from
policies and guidelines to accommodate friendships and other personal consideration.
• Certitude and Celerity - He must not only act with certainty and accuracy but also with
swiftness and speed.
• Contact - He must have good contact, good public relations both within and outside
the organization.
• Cost-consciousness - He knows how to minimize cost in credit evaluation, remedial
account management and others.
• Character - He must have character integrity, reliability and sometimes need to be a
“character” to cope with clients who turn out to be “characters”.
• Confidence - He must be trusted by the debtor to have reciprocity of confidence
between the credit man and the customer.
• Considerateness - It is incumbent upon the credit man to extend assistance to the
customer.
• Computer literate - He must have at least some basic knowledge of computers and
the ins and outs of information technology.
• Congeniality, charming personality, and courage - He should be cool and calm and
deliberate, but certainly firm and uncompromising when he encounters pressures.
• Common Sense - "Nothing astonishes men so much as common sense and plain
dealing." - Ralph Waldo Emerson. Much of effective risk management involves common
sense. However, just because something is common sense doesn't mean it's commonly
practiced.