Business Credit Risk Management - What It Is And Why It Matters
In simple words, Credit Risk is a defaulter's risk that arises if the borrower is unable to pay back the debt.
Moreover, credit risk involves other aspects that are crucial to avert business closure. The financial market, especially the banks, have witnessed laxity in the credit standards. This is because of a lack of portfolio management from institutions and does not pay attention to the economic changes.
The loss due to this risk may be temporary or permanent. It solely depends upon the inclusion of the Principal and the interest rate by the lender so that cash flow is not disrupted. Moreover, "higher borrowing costs" is equal to the "higher credit risk level."
Many economies face critical conditions if the borrowers are unable to repay the loan due to unavoidable circumstances or higher credit risk. Like, if we talk about the Asian market, especially Malaysia, where the banks are facing underlying risks. Here, the household and corporate indebtedness are on the increase due to the failure of payment of loans. It made the country's financial institutions faced higher credit risk. Even this has put Malaysia's GDP growth rate below the ASEAN countries near about 4.2%.
Experts say even the failure of Credit Risk Management is one of the critical issues for the financial institutions and the banks. It can lead to significant risk in the economy as a whole. In Malaysia, if the banking sector is facing credit risk, then it can collapse the whole financial system of the country.
To avoid credit risk, the lender can carry out a credit check for the borrowers. Lenders can let the borrower take security over assets or mortgage insurance, which can be used for paying credit. Moreover, the credit risk depends upon the interest rate because if higher the credit risk, then the interest rate will be higher too.
For making things more comfortable, it is essential if the lender carries out a full credit risk assessment by hiring reputed finance analyst Malaysia as "Credit Scan Malaysia." Their innovative thinking and intelligent risk management solutions will help you to assess credit risk for a particular borrower. ASSESSMENT: WHY IT IS SIGNIFICANT
A lender (bank, financial institutions, lending agencies, etc.) will not like to take risks on the money he has lent to the borrower, which can be an organization or an individual. Credit risk assessment is a procedure through which the lender acknowledges borrowers' potential credit risk.
Here, the risk is calculated on the borrower's capability to repay the loan. A lender checks out the five essential C's related to the borrower at the time of taking a loan. It includes:
- Credit history and credit score
- Capacity to repay the lender's loan
- Capital of the borrower
- Condition for taking a loan
- A Collateral asset on which the borrower will be taking the loan to secure it
A few lenders or financial institutions take care of these 5 C's before lending the loan. But, calculating the credit score and checking the credit history is quite essential for risk assessment.
Like, if you are a Malaysian citizen, then there is a "national credit rating system" used by the lenders to assess the capability of the borrower. Credit Score actually is a three-digit number that is used to evaluate a person's credit health. The Credit Debt Malaysia agencies check out the credit score to approve the loan application.
A good credit score can lead to getting more products on credit like a car, home, and any type of personal loan. Let us now see which factors contribute towards credit score calculation:
- Payment history contributes 40%. It checks whether you have missed any payment to the lender or financial institution in the last 12 months.
- 30% depends upon the loan amounts owed and credit mix by the borrower. Here, the lender sees what type of credit cards you owe, secured credit like a car or home loans, and the unsecured credit like the personal loans or the credit cards. Even the amount owed to the banking institutions is also checked.
- The length of your credit history also matters. It includes how many times you had a loan or how long you had a credit card. It contributes 10% while checking a credit score.
- If you have applied for any new credits, then 10% of it's also seen while calculating the credit score. The lender will check the record of credit facilities approved past 12 months.
- 10% contributes to credit score from your legal track records. It checks whether any legal action taken against you or any claims are pending.
The borrowers can even check their credit report in Malaysia with the three well-known Credit Reporting Agencies or CRAs. The Credit Reporting Agencies Act 2010 governs these CRAs. Credit Bureau by Bank Negara Malaysia provides a report on CCRIS (Central Credit Reference Information System), RAM Credit Information that renders RAMCI Personal Credit Report, and CTOS Data System, which provides MyCTOS Score Report.
Types of Credit Risks
It's good to carry out credit risk analysis, but one must be aware of the potent credit risks that exist in the market set up. Below are types of risks that one must know about:
- Credit Default Risk
This type of risk arises when the debtor is unable to pay the full loan amount to the lender. If the debtor has crossed 90 days and still the payment is pending, then default risk arises. The Credit Default Risk is known to affect all the sensitive market transactions. The transactions related to the credit include derivatives, loans, and securities. The financial institutes also check this risk type before approving the personal loan or providing credit cards.
- Country Risk
This risk arises when the sovereign state freezes foreign currency payments overnight. This default becomes the Country Risk, and it is termed as the Sovereign Risk too. Moreover, Country Risk is also associated with the macroeconomics performance of a particular country and is related to its political stability too. The higher Country Risk occurs when the instability occurs during the election times.
- Concentration Risk
Concentration or industry risk occurs when the risk arises from any one of the sectors or industries. This relates to producing lager losses that can also threaten the operations of the banks. It may appear as the sole concentration risk too. For example, if the investor/lender has provided loans to one type of group related to the automobile industry like battery manufacturers, oil companies, and tire manufacturers, then any shock to this particular industry may lead to higher credit risk.
- Institutional Risk
Institutional risk is associated with the entity that supervises the deal between creditor and debtor and deals with the breakdown of the legal structure. Let's understand this with an example. An institutional risk arises if the lender lends money to a property developer in a politically unstable country, then a slight change in the political condition can increase the loss rate or probability of credit default.
- Other Credit Risk Types
There are few other credit risk types like Credit Spread Risk that occurs because of volatility in the difference between risk-free return rate and investment interest rates. The other type is the Downgrade Risk that happens because of downgrades in the risk rating of the lender.
So, lenders and borrowers who are not aware of these risk types can take advice from experienced financial risk management Malaysia providers. You can get advice from Credit Scan Malaysia, where they can help you manage potential credit risks.
Mitigation of Risks
While giving credit, sometimes, the lenders can run into risky situations. The credit risk management becomes of paramount importance so that there is no monetary risk caused to lenders. So, the big question lies ahead on how to mitigate credit risk?
The financial institutions, banks, and lenders can adjust the cost of credit, carry out risk-based pricing, reduce credit amount to the high-risk buyers, tight the credit provision, purchase the credit insurance or derivatives, and much more to curb the menace.
Like, as an example of mitigating credit risks, the Malaysian banks are using loss-absorbing buffers that will recover any type of economic loss. Moody's Investor Service reported that the Malaysian banks could survive the credit risk as they have maintained enough liquidity and funding.
Apart from this, there are significant ways to mitigate the credit risk that will save lenders from credit losses.
- Checking Borrower's Credit Record: The lenders must check the credit score and credit history of the borrower by checking with the Credit Rating Agencies in Malaysia. This will give a fair idea of the risk involved with specific borrowers.
- Risk-Based Pricing Method: In the credit risk-based pricing method, the lenders charge a higher rate of interest from the borrowers who are defaulters. This is known as credit risk-based pricing. Here, the factors taken into consideration to mitigate the risk are loan to value ratio and on-purpose credit rating.
- Setting Credit Limits: The lenders can set the credit limit for the borrowers by using the credit agency reports that provide a complete history of the borrower. If the debtor is working somewhere, then the employment report can also prove significant. In case the borrower is an organization, then getting their bank reports and audited financial statements can also provide a complete view to the lenders.
- Purchasing Credit Insurance and Derivatives: The bondholders curb credit risk by purchasing credit insurance and credit derivatives. So, if the borrower is unable to pay the loan amount, then the lender can present the credit insurance or derivative and gets reimbursed for the required amount. Here, borrowers can take the "Credit default swap," which is the most common form of derivative used in the financial market.
- Diversification Method: To reduce the credit risk further, the lenders diversify their borrower's pool. It means the lender, like banks, financial institutions, or credit lending agencies do not provide debts to one industry group but to diversified ones. If there is any instability caused to, say the automotive industry, then lenders can derive their loans from other sectors like clothing, food, and beverages, hospitality, etc.
- Provide "Covenants": Covenants are the "stipulations" written by the lenders to the borrowers. It includes providing periodic reports about borrower's financial condition to refrain from further borrowing of funds and not to pay dividends as mentioned in the loan agreement, or to carry out any specific action that may affect the debtor's financial position negatively. Moreover, the covenant also states that the debtor needs to pay the full amount of loan to the lender if there is any change in debt-to-equity ratio, in case borrower changes or interest coverage ratio changes.
Lenders must mitigate the credit risk and keep a check on the late debtors' accounts. This way, they can get their loan amount back without any hassle. Even lenders can hire reputed and experienced debt collection agency Malaysia like Credit Scan Malaysia for complete advice and support.
CREDIT RISK ANALYSIS: WHO REQUIRES IT?
Credit risk analysis or financial analysis is essential for lenders who provide loans to borrowers. The reason being, it states about the high-risk defaulters. Sometimes, the lenders may not be able to track or seek who will default on the money borrowed, so credit risk analysis is the intelligent tool to mitigate any losses.
Even lenders can take assistance from the professional financial analyst to get support for credit risk analysis. So, if you are wondering who all can make the Credit Risk Analysis, then banks, non-banking financial providers who offer mortgage loans, financial institutions, and credit card providers are at absolute risk. They require wholesome credit risk analysis to save themselves or their business from recurring monetary losses.
Even the companies/lenders who issue a bond, credit, financial investors, and insurance companies must also get the risk analysis or assessment done. The creditors or agencies can get the credit score tested through the Malaysian Credit Rating Agencies or hire finance analyst Malaysia who will make their job easier.
Credit Risk Analysis or Credit Risk Management is crucial as it helps the lenders to acknowledge any unforeseen risk that may occur on behalf of the debtor. It is even necessary for curbing the market risk and recover the obligation or the loan paid to the borrower.
On the other hand, the debtors must check their credit score or analyze their credit history before availing the loan. It will help them get a low rate of interest and make them eligible to get different types of loan that is secured and unsecured. Even the credit risk analysis done on the part of the debtor will help them get the collateral-free loans too.
Another effect of credit risk analysis falls on the interest rates too. Like, if the lenders witness higher credit risk, then they will charge a higher interest rate as well. But, if the debtor's history states default over the loans, then the banks/credit agencies/financers refuses the loan altogether. This analysis is done to check the creditworthiness of the borrower, bond issuer, or an organization. It helps in showcasing that the debtor is in a position to pay the debts back, and the individual or the business will not become bankrupt. This kind of analysis ensures the financial stability of the economy too.
But, for carrying out credit risk analysis or assessment, the lenders need to know about specific tools and techniques and principles that prove quite helpful in giving accurate results.
Credit Risk Management Principles, Tools and Techniques
Credit risk evaluation is necessary to curb any type of monetary loss to the lenders. It involves many principles and tools and techniques to keep a check over credit risk management. Let us see one by one what principles and tools and techniques are included.
Principles of Credit Risk Management
- Maintain Credit Risk Exposure: Credit risk is related to the inability of the party to the loan agreement to meet its obligations, so here the credit risk management helps with adjusting the rate of return within the acceptable parameters. Here, the lenders that can be banks or financial institutions need to manage the credit risk in the entire portfolio or individual transactions. So, the lenders must manage the credit risk effectively to obtain long-term success.
Carry Out Sound Financial Practices: Credit risk continues to be a global problem, and in Malaysia, financial institutions and banks have witnessed. The banks must identify the portfolio with bad debts, measure the risk, monitor these types of accounts, and control the types of credit risk and possess enough capital against it.
Moreover, the Basel Committee reports are being taken under consideration globally, and they are issuing relevant documents to lenders to manage the credit risk. These documents contain the principles related to lending, but the activities that possess credit risk also fall under this category.
Establish Sound Credit Risk Environment: The Senior Management or the Board of Directors of the financial and banking institutions must review and approve the credit risk strategy periodically. It must reflect the bank's tolerance and profitability power. Here, senior management must implement the risk strategy approved by the Board of Directors.
Moreover, the banks must get the new activities or product credit risk strategies authorized in advance from the Board of Directors or the appropriate committee for maximized control.
Carry Out Operations Under the Credit Granting Process: Banks or other lenders must operate under a stringent "credit granting process" where they must obtain full information about the borrowers. The lenders about the borrower must understand the structure of credit and repayment sources. Even lenders must set the credit limit for the individual or group borrowers to mitigate credit risk.
It's necessary to have a well-established process for approving new credits, amending them, renewing, or re-financing them. There should be special regulations maintained for dealing with 'arm's length and non-arms length' types of lending.
- Control the Credit Risk: The superiors or Board of Directors must carry out the ongoing assessment of the credit risk and review the results. The "credit-granting function" must be appropriately managed according to the internal limits of the banks or financial institutions. Even the reports must be reported timely to take remedial action. Moreover, banks must frame a proper action for managing problematic credits and deteriorating credit conditions.
- Supervisor's Role: This is one of the useful principles as supervisors need to curate an effective system through which they can identify, measure, monitor, and put full credit control. They can create a full-proof approach to risk management. Supervisors must evaluate lending strategies, procedures, policies, and prevalent practices. Their responsibility is to restrict bank exposure to the defaulters or risky counterparties.
Tools and Techniques For Credit Risk Management
- The use of CRM tools and techniques provides insight into determining the value of state-backed and corporate bonds.
- Know your customer before proceeding with the lending procedure. The lender must check out the credit profile of the debtor by watching their credit score, history, collateral asset, etc. Even the use of CRM methods can also help in collecting useful data about customers.
- Evaluate the risk at micro and macro levels. The micro involves a single customer loan portfolio, and macro comprises the full customer investment portfolio. At the micro-level, a single loan may become risky, and at the macro level, a full loan portfolio may become unsafe. So, lenders need to analyze the credit risk by watching out the business, industry, and management.
- CRM Software and tools are trustworthy credit risk management platforms that are used by financial institutions, banks, and corporations to evaluate any type of credit risk. These Fintech platforms are integrated with the technology that renders warning against the potential risk involved with a particular client. Moreover, it helps to evaluate the associated credit risk and minimize it.
- A few money lending institutions are using AI and Machine Learning to acknowledge defaulters and to safeguard the banks and financial institutions against the market or credit risks.
By using these principles and techniques, the lenders can safeguard themselves and avert monetary losses. Neither sometimes, it can lead to business closure situations too.
The business closure may appear at any moment because of the sudden market change. If your company is Sdn Bhd (Private Limited Company), then the Companies Commission of Malaysia or SSM can close them, or Sdn Bhd can be closed through winding up.
Let's see how the closing down the procedure of Sdn Bhd works.
- SSM Role
SSM (Companies Commission of Malaysia) may ask for audited or unaudited accounts that do not show assets or liabilities. If SSM submits your closing up submission, then it may take 6 to 12 months to close the company. The closing down requests for those companies are accepted that have been inactive for long, dormant, or possess low paid-up share capital.
- Winding-Up of Sdn Bhd Companies
This procedure helps where the existence of Sdn Bhd Company comes to an end. It includes selling the company's assets, distributing revenue to shareholders, and paying liabilities. Now, the winding-up process can happen voluntarily or compulsorily. Below is how both these processes work:
Winding-Up through Liquidator
Voluntary Winding-Up of the Company: It involves several meetings held between directors and shareholders. The period of filling process ranges from 9 to 18 months, and its cost ranges from somewhere RM 10,000 to RM 20,000. The voluntary winding-up can happen by the members' voluntary winding-up or creditor's voluntary winding-up.
Members' Voluntary Winding-Up happens if the company is solvent, but still, the shareholders agree on its liquidation, and assets get distributed to owners. Creditors Voluntary Winding-Up occurs when the company is insolvent, shareholders and directors decide on the company's liquidation, but the final say remains with the creditors.
Compulsory Winding-Up of the Company: If the company is unable to settle the debts, then the court of law facilitates this process. Here, the creditor can send a Demand Note of RM 500 that needs to pay within 21 days. If this Demand Note remains unpaid, then the creditor can refer to Section 218 of Companies Act, 1965. With this, the creditor can request the court that will force the company to call itself insolvent and wind-up compulsory.
The liquidator is an independent entity that checks upon Sdn Bhd winding up. The liquidator takes over the company's assets, manages revenue distribution to shareholders, and looks after the company's complete winding-up. Here, the power of the Director in managing the company no longer prevails. But, the company will exist as a legal entity.
Even the liquidator has the power to conduct any type of internal investigation to find out the cause of insolvency. The court declares the company dissolved after the liquidator pays off the company's liabilities and distributes its residue assets. It completes the whole winding-up process.
If the companies are not aware of the business closure process, then they can take services from business risk Malaysia service analyst for acknowledging complete procedure. Moreover, if there are any bad debts left, they can guide you for the same too.
Debt Collection Malaysia
Bad debts can plague your business manifold if due care is not taken care of. Like, if we see the status of debtors in Malaysia, the Bank Negara Malaysia or Central Bank of Malaysia has provided complete reports on its debts in various sectors. To mitigate the risk of outstanding credit, debtors can take debt collection agency Malaysia services and take significant factors under consideration.
- Create a Complete Record of Debts: If you have documented everything related to debtors, then it will help with the legal cases related to debt collection. The lenders/businesses can hire an attorney or debt recovery lawyer to take legal action against the debtor. You need documents like statements of accounts, invoices, purchase and delivery orders, correspondence, and quotations shared between parties related to the debt. The debt case will strengthen if you will present the entire documents.
- Follow Practical Approach: Debtors may be broke or do not have enough money to make repayment of the installments or the loan. In this situation, you can negotiate on a particular amount to get some amount back. So, to get your full or part money back in all these conditions, consult a lawyer or get debt collection Malaysia agency's advice or support.
- Request Tactfully for Debt Payment: Businesses or lenders are sometimes reluctant to ask for the outstanding debts from the debtors. This can lead to substantial monetary loss too. So, ask tactfully for the debt payment from the debtor. The lender can send a reminder, drop a message, or Whatsapp the debtor, send a professional email asking about the installment or loan, etc. All these written documents, later on, prove helpful for any type of debt recovery action initiated towards debtors.
- Set Aside Budget for Debt Recovery: This is one of the crucial steps that lenders can take to obtain their debt amount if nothing else works. Set aside a budget so that you can spend later on over debt recovery by hiring reputed and professional debt collection agency Malaysia. The agency professionals will help with commercial-cost analysis, too, like whether a particular bad debt is worth pursuing or not.
Conclusion - Calculating Credit Risk
The credit risk is calculated on the borrower's capability to pay back the loan. Consider the borrower's taxation, current assets, and revenue-generating ability. Here's how you can calculate the credit risk:
- FICO Score: It helps in knowing the debtor's credit history, creditworthiness, and repayment capacity. This score can provide insight into the repayment of loans but does not ensure future repayments.
- Debt-to-Income Ratio: The monthly recurring debts of the company are divided by the gross monthly income of the company. People having less than 35% credit score are accepted for credit risk.
- Potential Loan: The debtor takes this type of loan based on his general creditworthiness or credit card. It showcases the potentiality of the debtor to repay the loan.
These calculations showcase the individual credit risk on each debtor. It helps magnificently to minimize the monetary losses. Even lenders can take services from CreditScan Malaysia to deal with unseen market challenges and get innovative solutions for credit risk management.