Lesson 2

• Credit management


  The process by which risks that are inherent in the credit process are managed and controlled
• Risk


  The potential that events, expected or unexpected may have an adverse impact on earnings or capital
• Credit Risk


  The risk of repayment, i.e., the possibility that an obligor will fail to perform as agreed
• sound underwriting standards


  • The first defense against excessive credit risk is the initial credit-granting process
• Management of credit risk


  • Must continue after the loan has been made for sound initial credit decisions can be undermined by improper loan structuring or inadequate monitoring
• Interest Rate Risk


  The risk to earnings or capital arising from movements in interest rates
• Liquidity Risk


  The risk to earnings or capital of not having sufficient cash to meet financial commitments in a timely manner
• Liquidity planning


  • Should include the identification of loans that may be easily converted to cash
• Transaction Risk


  • Present primarily in the loan disbursements and credit administration processes
• Compliance Risk


  • The risk to earnings or capital arising from violations of, or non-conformance with, laws, rules, regulations, prescribed practices, or ethical standards
• Compliance risk exposes the institution to fines, civil money penalties, payment of damages, and the voiding of contracts
• Consequences of compliance risk

  • Diminished reputation
  • Reduced franchise value
  • Limited business opportunities
  • Lessened expansion potential
  • Lack of contract enforceability
• Lending activities encompass a broad range of compliance responsibilities and risks
• Reputation risk is the risk to earnings or capital arising from negative public opinion
• Consequences of reputation risk

  • Exposure to litigation
  • Financial loss
  • Damage to reputation
• When a lender experiences credit problems, its reputation with investors, the community and even individual customers usually suffers.
• Credit administration involves a department in a bank or lending institution that manages the entire credit process
• Banks generate revenue by charging a higher interest rate on loans than the interest they pay on customer deposits
• Role of the credit department

  • Selecting and vetting borrowers
  • Ascertaining borrower's competency to utilize funds and ability to pay back
• Functions of the Credit Department

  
  

  1. Setting credit policies

  2. Evaluating credit worthiness

  3. Monitoring credit risk

  4. Managing collections

  5. Reporting on credit performance
• Setting credit policies - The credit department is responsible for setting credit policies and procedures that outline the company's approach to credit risk management. This may include guidelines on credit limits, payment terms, and collections procedures.
• Evaluating credit worthiness - The credit department is responsible for evaluating the creditworthiness of potential borrowers by reviewing their financial statements, credit history and other relevant information. Based on this evaluation, the credit department will determine whether to approve or deny credit.
• Bank credit managers

  • Work in conjunction with loan officers and financial services staffers
  • Explain the bank's financial products to customers
  • Assess the creditworthiness of individuals and business customers
  • Evaluate credit reports, earning statements, bank records, and tax returns
  • Require good communication skills and the ability to speak in laymen's terms about complex financial scenarios
• Qualities of a Credit Man (The Cardinal CS of a Credit Man)

  • Competence and Capability
  • Communication
  • Constructiveness
  • Creativity
  • Conscientiousness
  • Consistency
  • Certitude and Celerity
  • Contact
  • Cost-consciousness
  • Character
  • Confidence
  • Considerateness
  • Computer literate
  • Congeniality, charming personality, courage
  • Common Sense
• Tests of Credit Department Operations

  1. Bad-Debt Loss Index

  2. Credit Sales Index

  3. Collection Percentage, Days to Collect and Turnover of Receivables

  4. Number of Accounts Opened

  5. Acceptance Index

  6. Past Due Index

  7. Aging of Accounts

  8. Cost Analysis
• Measuring the attainment of credit department objectives

  To test how the credit department is meeting its responsibility
• Tools or indexes for credit management

  • Designed to test the efficiency of credit operations
  • Help determine if departments are maximizing sales and minimizing losses
• Periodic calculation of ratios, percentages, and other figures is necessary to measure credit and collection results
• Keeping statistical records allows setting up standards or goals in each phase of credit and collections activity
• Accumulation of records enables comparison of current credit and collection performance with previous periods
• Comparisons may be made between different individuals in the firm's credit business
• Results shown in the firm's figures may be compared with those reported by other firms
• Records may be used to forecast future trends in credit sales volume, collections, and other aspects of the business
• Bad-debt loss index is computed by :

  
  

  bad debt loss / total credit sales
• Calculation of bad-debt loss index may vary among firms leading to a margin of error
• Credit sales index is computed by :

  
  

  credit sales / total net sales
• Rate of receivables turnover is found by :

  
  

  total credit sales / average receivables outstanding
• Seasonality of the business is important in determining how to compute the average of the receivables outstanding
• Collection Percentage - Activity of the investment in receivables may be expressed as a rate or in terms of the number of days required for one turn of the accounts
• Collection percentages, when decreasing, show an accumulation of poor accounts