The Evolving Role of Credit Risk Management

Getting paid for delivering products or rendering services is not something most businesses would like to worry about. With so many other challenges to face, prompt payment is the kind of detail firms would like to think will take care of itself with the help of forthright clients. But the reality is that managing accounts receivable is becoming an issue of increasing importance not just to companies’ financial personnel but to risk management as well.

Few risk managers have much background or experience in credit management. Generally, they come from backgrounds of treasury, insurance or risk mitigation. Traditionally, though, risk managers have been concerned with keeping DSO (days sales outstanding) low and managing bad debt levels, which are also the two main concerns of credit managers. In other words, both focus on getting paid faster and not losing money.

It makes sense then for the risk manager to ask the credit manager to do a better job of bringing the numbers down, but to be really effective, the risk manager should do more than this, says Paul Beretz, founder and managing director of Pacific Business Solutions and a partner with Q2C of Clayton California. Risk managers, Beretz says, should look at the whole “quote-to-cash cycle,” because this is where there are tremendous opportunities.

Ryan Lee, Ph.D., a professor in the Haskayne School of Business at the University of Calgary in Alberta, also sees a role for risk management in credit management. “As the concept of enterprise risk management expands, you will find that more and more risk managers and credit managers are working closer together,” he says. “For example, our risk management curriculum is focused on the concept of ERM and encompasses financial issues. Students can take half of their courses in financial risk management and the other half in operational/hazard risk management.”

According to Lee, risk managers can help credit managers understand that the contracts they are creating with customers and the risk profile of a customer organization will definitely affect the credit risk that you end up taking on.

But before a risk manager and credit manager can begin working together, they need to identify a common language. Currently, each discipline uses different terminologies. “I think that it will eventually converge around financial risk terminology, because this is already being used by shareholders and regulators,” says Lee. “Most of the terminology used in the insurance field tends to be quite narrow. It doesn’t have a very broad application. As such, it would be worthwhile for risk managers to become familiar with financial and credit risk management terminology.”

Beretz has already experimented with the concept of risk managers and credit managers working together, in the sense that, in one organization where he worked, he assumed both roles in terms of credit risk management. “When I was in the telecommunications industry, I had a position with the title ‘director of customer administration,’ which was somewhat of a risk management position,” he says. In that position, Beretz had responsibility for the whole process from order to collection: credit approval, order entry and administration (for domestic and international), invoicing, accounts receivable, cash application and collection activities.

In this role, he was thus able to exert influence on the whole process. Today he suggests risk managers do  not approach the credit manager and ask questions such as, “Why is DSO at 90 days instead of 70 days? You need to do a better job of collecting.” The reason is that the problem may be on the front end, not the back end.

“I realized that in my position, I could control the front end,” he says. This is where some root-cause issues existed, such as a purchase order not always being accepted. Along with his order entry manager, Beretz would then begin a root-cause analysis to determine how they could do a better job of accepting orders. They found that some of the people sitting in front of computers or taking calls from customers were a little lax and would take orders under pressure at month-end or quarter-end without purchase orders. “As such, we needed to address this problem before we put four more people on the phone to call for collections,” he says.

To address the problem, they asked the collectors for one month to write down each reason they heard from customers as to why they were not paying. They then focused on the 10 most frequent reasons, which included: no purchase order, product not working correctly, pricing was wrong, quantity incorrect, did not get enough copies of the invoice, having problems with cashflow and thus unable to pay. “When we looked at these 10 issues, we found that cashflow problems were usually only 10% to 15% of the reasons,” he says. “Most were things that we could fix.”

They went through all of the root causes, identified solutions, then implemented them. For example, a government customer said that it needed five copies of an invoice, but Beretz’s company was only sending three. “We then went to the IT people to change the system so that the government customer could get five copies,” he says. “We were then able to pick up that receivable in an average of 15 days.”

International Trade Credit Risk Management
One of the most significant ways risk managers can work with credit managers is to create and manage a system for international credit and collections. “Risk managers often have more information on other countries in general that can help the credit manager,” says University of Calgary’s Lee. “In addition, they can conduct a risk analysis of a customer organization to identify their exposures the same way they do for their own organizations.”

International business represents a substantial portion of total business for a lot of companies. This can be a benefit and a drawback. On the one hand, the substantial business is good for the company’s growth. On the other hand, it can also expose a company to more risks than exist with domestic credit management and collections.

For example, one big challenge is managing country risk—changes in economies, governments, currency issues, etc. “It is difficult to stay on top of all this,” says Beretz. “For example, you may have a customer who pays like clockwork every 30 days, but if something changes in his country, this can jeopardize those payments.”

Another challenge with international credit and collections is that there is very little generic knowledge that will help in all countries. Each area of the world is unique in many ways, so once a firm learns the few basics, it still has to gain expertise in each country, region or continent.

“When we look at risk management in the global accounts receivable area, we look at three things,” says Forrest Old, executive vice president for D&B Receivable Management Services in Bethlehem, Pennsylvania. First, it is important to understand what it means to collect money in a given location. “You have to think globally and act locally,” he says. Second, learn the regulations and customs of collecting money in different countries. Third, leverage technology to operate smoothly, both in terms of interacting with local operations and also ensuring global consolidation. This can include ERP systems, multi-currency tables, and a collections system that operates across multiple countries.

Julian Chen, vice president, global marketing - Asia, for ABC-Amega, Inc. in Buffalo, New York, also sees a role for the risk manager in managing international credit risk, especially in Asia. That is, as risk managers assess country risk for their own company’s global operations, they can provide assistance to credit managers in assessing customer risk in those countries. “The biggest risk in Asia is culture difference,” says Chen. “For example, financial and accounting systems are very different. It is not always easy to read and understand a company’s financial information.” In addition, according to Chen, it is often not easy to gain access to their financial information in the first place. “In some cases, you may be doing very well if you can get nothing more than a company’s 1998 financial statements and 2000 trade references.”

How can risk managers begin to wrap their arms around international trade credit risk? Beretz encourages them to first become familiar with what are called the “five C’s of credit.” These are character, capacity, capital, conditions and collateral. Then, realize that there are three more “C’s” in international trade credit risk management: currency, country and culture.

Currency. This relates to fluctuations in currency in countries where profits can be eroded when rates change or even collapse.

Country. “You can sell into a country where everything seems fine, but you can’t always predict or foresee what will happen in that country,” says Beretz. For example, a number of years ago, when he was in the forest products industry, his firm was selling to five companies in Venezuela, all of which were well-financed, strongly rated and paid their bills on time. “I wish we had more customers like them,” he says. The total outstanding combined obligation was between $7 and $8 million.

But without warning, the Central Bank of Venezuela froze all money leaving the country that was earmarked to pay creditors. The bank promised to work out a payment plan over five years, but suppliers might not see their money for several years. This presented Beretz with two problems. One was the basic receivables issue. The other was how he could continue to sell to these customers, because it was not even certain that his company would get paid for current business. “I happened to know the country manager who was in Venezuela, who knew people in the Central Bank,” he says. “We talked with the people in the Central Bank, and I brought in a major bank from New York who, for 90 cents on the dollar, bought the receivables and paid me in 60 days. “We came up with an agreement where the customers would pay the New York bank, and the New York bank would pay us.” Meanwhile, Beretz’s competitors waited five years to be paid.

Culture. Finally, you need to understand internal and external customer cultures; this includes how to send e-mails, meeting and greeting people, exchanging business cards, eating and drinking habits. “In Japan, if you ask if everything is okay with a contract, and they say yes, this doesn’t mean they accept it,” says Beretz. “It just means that they understand it.” Meanwhile, in China, negotiations begin after contracts are signed, so firms need to leave themselves some wiggle room on pricing and credit terms. “When everything is done and signed,” Beretz says, “nine out of 10 times the Chinese will come back and want to negotiate price and other issues.”

Additional Strategies
The maze of international credit and collections issues calls for additional strategies. Below are just a few.

Education. The first step is to gain some basic background information on trade credit risk management. One way to accomplish this is to seek education from your company’s credit manager and representatives from any third-party organizations with which that manager works.

Another source is third-party education. “While there are some good education programs on international credit and collections, such as seminars on what’s going on across the world, widespread education is still lacking,” says Beretz. “In addition, it is difficult for credit people to get together and talk about international trends.” One program Beretz recommends, both in terms of education and the ability to network, is a three-month online certificate course by FCIB/Michigan State.

Internal teamwork. You need to be 100% accurate when dealing with other countries. Customers will often take any opening to delay or withhold payment, which is difficult to resolve  from thousands of miles away with a 12-hour time difference. As such, different functions in the organization should work together, primarily credit/collections management, risk management, customer service management and sales/marketing management. A customer service department that does not make mistakes, for example, will reduce a lot of problems with international collections. You can also stay on top of customer and country risk information by working closely with the sales force that is in place in each country you do business.

Vigilance. Pay attention to documentation. One major difference between international and domestic credit is that the former requires significantly larger volumes of documentation. There is a variety of terms of sale, only one of which is the letter of credit. In addition, transmitting documents electronically can reduce inaccuracies and time delays.

Third-party assistance. It is no shame to lack comprehensive international expertise on staff. Most companies find it to their advantage to utilize a variety of third party providers who specialize in various aspects of international credit and collections.

Letters of credit have so many intricacies that it is easy to end up with discrepancies. “Few companies want to hire a specialist on staff to handle this responsibility,” Beretz says. “One alternative is to use third party providers that specialize in handling letters of credit.”

Some large banks are also excellent sources of assistance. A number of banks these days, especially the “big money center” banks, are getting into the business of managing international credit and collections activities for companies as part of their receivables management services. Services include the creation of export documents as well as taking the receivables created from those documents and providing discounted financing.

William Atkinson is a freelance writer based in Ohio. He is a frequent contributor to Risk Management Magazine and has written on risk management for over 25 years.