Creating a Credit Culture

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Creating a Credit Culture

• Joseph N. Boland
• Principal
• The Alta Group
• Miami LAR Meeting
• November 13, 2008

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Why Risk Management is Important

• Essential factor for success in any financing
  business
• Controls losses/supports profit targets
• Good credit process enables pricing to the risk
• Helps avoid catastrophic risks/bad publicity
• Maintain own ability to attract funds/support own
  credit rating/positive reputation
• Well developed/pro-active credit function can
  help target opportunities and increase marketing
  efficiency
• Managing risk better is a competitive
  advantageknown risks can be prudently taken, not
  just avoided
• Strong risk management process enables company to
  more confidently attack new markets and segments
  eg Emerging countries, SMB segment etc

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Key Elements of a Strong Risk Culture

• Risk management positioned as integral part of
  business
• Fixed in corporate priorities
• Regular input to overall business direction
• Robust RM infrastructure
• Policies
• Processes
• Attitude of taking full responsibility for RM
  results
• Agency Ratings and sponsor/lead bank endorsements
  as inputs, not substitute for own decision making
• Retaining vs selling risk
• Active participation by Senior Management in
  design and operation of risk management
• Knowledge of deal flow
• Included in approval process
• Periodic senior management review of common
  sense level of risk/reward levels

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Business Strategy Objectives
Credit Policy Methodology
Feedback
Asset Management Accounts Receivable,
Loans/Leases and Other Exposures
Credit Assessment Structuring
Portfolio Performance Measurements
Systems Strategy Audit/Business Controls
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Considerations When Developing/Applying Credit
Policy
Lower Risk
Higher Risk

• Strong legal protection for creditors
• Enforceable pro-creditor statutes
• Culture of satisfying financial obligations
• UCC filings or equivalent

• Undefined or weak legal protections
• Uneven legal process

Legal Business Environment

• Comprehensive and frequent corporate disclosure
  requirements
• Available and accurate credit bureau information
• Active and reputable credit rating agency
  presence
• Compliance with local GAAP rules
• Strong auditing culture

• Few corporate disclosure requirements
• Unavailable or unreliable credit bureau
  information
• Absence of external credit rating agencies
• Rampant noncompliance with accounting standards
• Absence of active and reputable auditing firms

Quality of Credit Information
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Considerations When Developing/Applying Credit
Policy
Lower Risk
Higher Risk

• Companies with well-established presence in the
  markets in which they compete, having strong
  balance sheets, positive cash generation and
  financial flexibility
• Diversified across industries
• Customers whose performance is less vulnerable to
  economic cycle

• Startup companies
• Companies with untested business models
• Companies whose performance is cyclical
• Companies with a history of default
• Companies whose medium-term financial viability
  is questionable

Credit Quality of Customer/Leads Base

• For medium and long-term transactions, products
  whose break even is front-loaded
• Transactions requiring very little upfront
  investment
• Sale of products that can be repossessed in the
  event of default

• Low profit margin transactions
• Medium and long-term transactions where the
  break-even is backloaded
• Unsecured products/services that offer no
  possibility of repossession in the even of
  customer nonpayment

Business Segment Profit Margin

• Predominantly smaller deals that are handled by
  automated decisioning and
• Higher potential for small frauds that could
  become material on a portfolio basis

• Predominantly large deals requiring detailed
  analyst review

Deal Flow Characteristics
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Key Components of Credit Policy
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Simple Credit Rating Scale
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Complex Rating Approach
Country/Macro Rating
Industry Risk Rating
Blended Final Rating
Customer Risk Rating
Transactional Structure Rating
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Sample Delegation
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Key Components of Credit Policy
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Key Components of Credit Policy
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Credit Decisioning Process

• Strategic Direction
• Drive all credit decisioning for Enterprise
  (trade, financing, services etc) into centralized
  Financing credit organization
• Base decision on exposure, not transaction
• Promote fromulatic/automated processes

Sources of Financing Requests
3P/ Business Partners
Financing Marketing
Parent Marketing
Telecenters
Credit Request Received
Formulatic/Automated Processes
Analyst
Large of transactions Small of financed
amounts Internal and Credit Bureau Data
Algorithms High Risk Detection
Smaller of transactions Vast majority of
financed amounts Handled by Industry Specialists
(Tracking, Tools, Contacts) Evaluate Country,
Industry, Company and Transaction
Risk Traditional Financial Statement Analysis
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Credit Decisioning Process Analyst Evaluations
Transaction Information Reviewed
Customer Information Reviewed

• Type of content
• Parent/Non-Parent
• Secured / Unsecured
• Collateral value over time
• Term of Financing
• Payment Structure
• Straight Amortization
• Bullet payments
• Front end loaded steps
• Credit Enhancements
• Guarantees
• Letters of Credit

• Financial Statements
• Historical Trends
• Public Ratings
• Industry Information
• Payment history internal and external
• Company news
• Balanced with industry analysts perspective
• Business plans
• Financial projections

Credit Decision

• Assign Ratings (1 gt 7)
• Default Rating
• Pricing Rating
• Collateral Rating (as applicable)
• Terms and Conditions
• Content limitations
• Term limitations
• Required credit enhancements

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Credit Decisioning Process Formula/ Automated
Evaluations
Credit Scoring
High Risk Detection (Fraud)

• Leasing/Financing Transactions
• Purchase Transactions
• Utilize combination of internal and external
  scoring models

• External Generic Model
• Internal Custom Model/Lists

Collections

• Small account receivables
• Prioritizes order of collections

• Payment History
• Internal and External
• Negative payment experience
• Time in business
• Time as a customer
• Industry
• Geography
• Presence of Suits, Liens, Judgments
• Financial Data

• Time as customer
• Source of transaction
• Time in business
• Size of business
• Financial Data
• Number of employees
• Request
• Amount
• Content

• Variability of payment history
• Type of invoice
• Existing delinquency
• Amount of existing delinquency
• Amount of current invoices
• Number of open invoices

Select Model Factors
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Pricing for Risk

• Deals are priced to deliver appropriate reward
  for the risk being assumed
• Three main factors effecting pricing are
• ROE target
• Adjustment for credit default risk of the
  customer
• Based on market spreads and historical experience
• Adjustment for transaction risk (expected loss in
  the event of a customer default)
• Secured transactions have widely varying residual
  values
• Unsecured transactions (e.g. software or
  services) have little marketable value
• Additional pricing considerations include
• Term of the transaction
• Collateral enhancements
• Bank Letters of Credit
• Parent Guaranty
• Unique structures
• Balloon payments
• Step structures

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Fraud Concerns

• Fraud is unfortunately a normal risk in
  financing
• Inaccurate financial statements
• Collateral shrinkage / misrepresentation
• Misappropriation of funds
• Risk can be inadvertently increased by business
  strategy change, such as a move to increase
  indirect selling, telemarketing, use of
  re-sellers or formula/automated decisioning
• PROTECTIVE STEPS
  
• Emphasize customer validation requirement (by
  Company rep and/or business partner) Know your
  customer/business partner
• Develop high risk databases
• Companies known to be high risk
• Experienced a loss
• Confirmed misrepresentation
• Principals associated with high risk companies
  (easy to start new companies)
• High Risk scoring modeling the
  characteristics of companies causing losses due
  to misrepresentations
• Qualify the source of the opportunity e.g.
  Business Partner
• Aggressive legal pursuit of defaulting companies

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Portfolio Performance Measurements Summary

• Financing Portfolio
• Regularly scheduled portfolio reviews
• (by type of financing and by geography)
• Customer Exposures
• A/R Balances (both current and overdue)
• Changes in Customer Credit Ratings
• Industry Trends
• Performance Review of Credit Scored Customers
• Focus Account Reviews
• Large Exposure Companies
• Investment Grade and Speculative Grade
• Project reserves required
• Early Warning Report
• Review Customers having Signs of Distress
• Before A/R or Financials Signal a Problem

• A/R Portfolio
• Monthly and quarterly A/R reviews
• (by business segment and by geography)
• Delinquency (gt90 days, gt180 days)
• Root cause analysis
• Dispute analysis
• DSO (days sales outstanding)
• DDO (days delinquency outstanding)
• Special Account Issues

• Concentration Review
• Quarterly review of customer exposures,
  consolidated across business segments and
  geographies.
• Customer balances (both current and overdue)
• Customer credit ratings
• Change in ratings
• Positions at or exceeding hold levels
• Industry trends
• Geography trends
• Country Risk reviews

Special Handling Regular review of problem
accounts, either due to decline in
creditworthiness alone (e.g. declaration of
bankruptcy) or due to default on IBM
obligation. Most likely a special reserve will
be taken for these accounts.
Information collected is used to drive future
credit policy actions.
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Risk Management Business ControlsKey Elements

• Clear, written policies, well distributed and
  understood by the organization
• Documented processes and clearly defined
  positional responsibilities
• Periodic process checking---self assessments,
  company audits etc, with resulting improvement
  plans, timelines and responsibility
• Senior management involvement in decision making
• Monthly/quarterly measurements reported to
  management against targets( eg turnaround time,
  delinquency, concentration limits etc)
• Root cause analysis on loss accounts
• System testing/audits at last quarterly

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Systems Strategy

• Link closely to business plan
• Nature/variety of transactions
• Types of customers
• Expected growth in numbers of transactions
• Geographic spread---currencies, language etc
• Funding available
• Long lead times, so long term business view is
  important
• Ideal Developing/purchasing one global system
  for all credit operations
• Support one global credit process while allowing
  customization for local differences
• Quickly and efficiently implement
  credit/collection policies
• Consistent application of controls
• Standardize automatic decision processes
• Obtain global exposures in real time
• Supports efficient expansion into new markets and
  segments
• Single system will reduce maintenance and upgrade
  cost

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Considerations for Systems Strategy

• Large vs moderate number of accounts and deal
  flow
• Reliance on formula/automated decision making
• Timely/accurate reporting to regulators, owners,
  vendors
• Regular feeds from external systemseg DB,
  SinoTrust etc
• Need to interface with other Parent Company/Bank
  systems (eg Accounts Receivable, Customer Master
  Records)
• Importance of timely/detailed portfolio review
• Daily/weekly position monitoring
• Multiple transactions and exposures to same
  enterprise customer
• Organizations propensity for buy/make in
  systems area

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Country Risk Framework

• While the banks have a history of focusing on
  country risk, corporates and finance/leasing
  companies are now increasingly trying to
  formalize their approach as well
• Operating in increasing number of countries
• Emerging markets generally growing faster than
  OECD economies
• Drive for new markets/segments within markets
• Recognition of need for differentiation of
  approaches and conditions, and adjust model
  appropriately
• Drive for globalization/standardization of
  business processes
• Historically, some bad experiences and surprises
• Methodologies tend to be combination of
  quantitative and judgmental factors----a client
  example follows

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Country Risk Framework

• Key Premise Elements affecting risk of doing
  business in a country extend well beyond
  Sovereign risk metrics
• Sovereigns ability to service debtreserves,
  taxing ability, strength of economy
• Political stability etc
• Other risks include
• Transparency / reliability of financial
  information
• Banking system efficiency/credit culture
• Effectiveness/fairness/timeliness of the legal
  system
• Business and governmental corruption
• Business friendliness of a country

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Country Risk Framework

• Application of Country Ratings
• Policy
• Country Limits
• Scope/Types of business/ROE targets
• Portfolio Targets
• Operations
• Decision methodology
• Delegation
• Marketing targeting and approach

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Summary

• Well conceived Risk Management organization
  reflects, in structure and scope, the realities
  of the legal and business environment in which
  the business operates, and contributes to the
  organizations financial results
• Has a high degree of integration across business
  strategy, credit policy, "decisionmaking",
  receivables management, and portfolio/asset
  performance measurements
• Sets policy on a globally consistent basis
• Makes credit decisions in a highly controlled and
  consistent basis, guided by key credit policies,
  such as standard rating scale, delegation, and
  hold levels
• Executes collections and monitors receivables
  quality using standard processes and systems
  across the geographies and business segments
• Requires strong systems support from business
  management
• Results and issues are reviewed on a regular
  basis, at least quarterly, by senior management

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BACKUPS
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PTI IMPACT OF IMPROVED RISK MANAGEMENT
1 Day DSO Improvement _at_ 5 rate
Reducing credit losses 10 (assume write off rate
of .5 AR/Fin assets/yr)