CHAPTER 3 credit approval process optimized in terms of risk and efficiency.

Thus, the risk drivers in

CREDIT PROCEDURES AND CONTROLS carrying out a lending and rating process essentially shape the structure of this chapter.
Chapter Outline 1.2 Credit Approval Process

1 Learning Objectives First of all, we need to ask what possible sources of error the credit approval process
2 Topics must be designed to avoid. The errors encountered in practice most often can be put down
1.1 INTRODUCTION to these two sources:
1.2 CREDIT APPROVAL PROCESS
1.3 SEGMENTATION OF CREDIT APPROVAL PROCESSES — Substantive errors: These comprise the erroneous assessment of a credit exposure
despite comprehensive and transparent presentation.
1.4 IMPORTANT FACTORS FOR CREDIT APPROVAL
— Procedural errors: Procedural errors may take one of two forms: On the one hand, the
1.5 CREDIT APPROVAL PROCESS procedural-structural design of the credit approval process itself may be marked by procedural
1.6 ESSENTIAL AND BEST PRACTICES IN MANAGING CREDIT RISK errors. These errors lead to an incomplete or wrong presentation of the credit exposure. On
1.7 COMMON CREDIT MANAGEMENT STRATEGIES the other hand, procedural errors can result from an incorrect performance of the credit
1.8 CREDIT CONTROL TIMELINE: KEY STEPS approval process. These are caused by negligent or intentional misconduct by the persons in
3 Summary charge of executing the credit approval process.

Learning Objectives In the various instances describing individual steps in the process, this chapter refers
to the fundamental logic of error avoidance by adjusting the risk drivers; in doing so, however,
1. Identify the key procedures and forms needed to operate the credit function. it does not always reiterate the explanation as to what sources of error can be reduced or
2. Cite the key controls needed for the credit function, and note what they are eliminated depending on the way in which they are set up. While credit review, for example,
intended to accomplish. aims to create transparency concerning the risk level of a potential exposure (and thus helps
avoid substantive errors), the design of the other process components laid down in the
3. Evaluate the creditworthiness of customers
internal guidelines is intended to avoid procedural errors in the credit approval process.
1.1 Introduction
Still, both substantive and procedural errors are usually determined by the same risk
drivers. Thus, these risk drivers are the starting point to find the optimal design of credit
There is an old adage in credit that says a sale is not a sale until the invoice is paid.
Until that point, it is a gift. It is the primary responsibility of the credit department to make approval processes in terms of risk. Chart 1 shows how banks can apply a variety of
sure that the company converts all those gifts into sales. It is also the job of the credit measures to minimize their risks.
department to make sure that sales are made to companies that have both the ability and
the willingness to pay for the goods.
The individual steps in the process and their implementation have a considerable
impact on the risks associated with credit approval. Therefore, this chapter presents these
steps and shows examples of the shapes they can take. However, this cannot mean the
presentation of a final model credit approval process, as the characteristics which have to
be taken into consideration in planning credit approval processes and which usually stem
from the heterogeneity of the products concerned are simply too diverse. That said, it is
possible to single out individual process components and show their basic design within a
 The vast majority of credit institutions serve a number of different customer segments.
This segmentation is mostly used to differentiate the services offered and to individualize the
respective marketing efforts. As a result, this segmentation is based on customer demands in
most cases. Based on its policy, a bank tries to meet the demands of its customers in terms
of accessibility and availability, product range and expertise, as well as personal customer
service. In practice, linking sales with the risk analysis units is not an issue in many cases at
first. The sales organization often determines the process design in the risk analysis units.
Thus, the existing variety of segments on the sales side is often reflected in the structure and
process design of the credit analysis units. While classifications in terms of customer segments
are, for example, complemented by product-specific segments, there appears to be no
uniform model. Given the different sizes of the banks, the lack of volume of comparable claims
in small banks renders such a model inadequate also for reasons of complexity, efficiency,
and customer orientation. Irrespective of a bank’s size, however, it is essential to ensure a
1.3 transparent and comprehensive presentation as well as an objective and subjective
assessment of the risks involved in lending in all cases. Therefore, the criteria that have to be
taken into account in presenting and assessing credit risks determine the design of the credit
approval processes.

If the respective criteria result in different forms of segmentation for sales and
analysis, this will cause friction when credit exposures are passed on from sales to processing.
A risk analysis or credit approval processing unit assigned to a specific sales segment may not
be able to handle all products offered in that sales segment properly in terms of risk (e.g.
processing residential real estate finance in the risk analysis unit dealing with corporate
Segmentation of Credit Approval Processes clients). Such a situation can be prevented by making the interface between sales and
processing more flexible, with internal guidelines dealing with the problems mentioned here.
In order to assess the credit risk, it is necessary to take a close look at the borrowers Making this interface more flexible to ease potential tension can make sense in terms of risk
economic and legal situation as well as the relevant environment (e.g. industry, economic as well as efficiency.
growth). The quality of credit approval processes depends on two factors, i.e. a transparent
and comprehensive presentation of the risks when granting the loan on the one hand, and an 1.3.2 Accounting for Risk Aspects
adequate assessment of these risks on the other. Furthermore, the level of efficiency of the The quality of the credit approval process from a risk perspective is determined by the
credit approval processes is an important rating element. Due to the considerable differences best possible identification and evaluation of the credit risk resulting from a possible exposure.
in the nature of various borrowers (e.g. private persons, listed companies, sovereigns, etc.) The credit risk can be distributed among four risk components which have found their way
and the assets to be financed (e.g. residential real estate, production plants, machinery, etc.) into the new Basel Capital Accord (in the following referred to as Basel II).
as well the large number of products and their complexity, there cannot be a uniform process a. Probability of default (PD)
to assess credit risks. Therefore, it is necessary to differentiate, and this section describes the b. Loss given default (LGD)
essential criteria which have to be taken into account in defining this differentiation in terms c. Exposure at default (EAD)
of risk and efficiency. d. Maturity (M)

1.3.1 Basic Situation

 The most important components in credit approval processes are PD, LGD, and EAD. 3. The borrower’s repayment history and current capacity to repay, based on historical
While maturity (M) is required to calculate the required capital, it plays a minor role in financial trends and future cash flow projections, under various scenarios;
exposure review. 4. For commercial credits, the borrower’s business expertise and the status of
The significance of PD, LGD, and EAD is described in more detail below. borrower’s economic sector and its position within the sector.
5. The proposed terms and conditions of the credit, including covenants designed to
a. Probability of Default - Reviewing a borrower’s probability of default is basically limit changes in the future risk profile of the borrower; and
done by evaluating the borrower’s current and future ability to fulfill its interest and principal 6. Where applicable, the adequacy and enforceability of collateral or guarantees,
repayment obligations. This evaluation has to take into account various characteristics of the including under various scenarios.
borrower (natural or legal person), which should lead to a differentiation of the credit approval
processes in accordance with the borrowers served by the bank. Furthermore, it has to be Integrity and reputation of the borrower or counterparty as well as their legal capacity
taken into account that — for certain finance transactions — interest and principal repayments to assume liability.
should be financed exclusively from the cash flow of the object to be financed without the
possibility for recourse to further assets of the borrower. In this case, the credit review must 1.5 Credit Approval Process
address the viability of the underlying business model, which means that the source of the
cash flows required to meet interest and principal repayment obligations has to be included To make prudent credit decision, bank and other financial institution essentially should
in the review know the borrower well. Without these information bank cannot judge the loan application.
Credit worthiness of the applicants is evaluated to ensure that the borrower conform to the
b. Loss Given Default - The loss given default is affected by the collateralized standards prescribed by the bank. It can be said that a loan properly made is half-collected.
portion as well as the cost of selling the collateral. Therefore, the calculated value and type So, a bank should make proper analysis before making any credit decision. With increasing
of collateral also have to be taken into account in designing the credit approval processes. credit risks, banks have to ensure that loans are sanctioned to “safe” and “profitable” projects.
For this they need to fine tune their appraisal criteria. A mix of both formal and non-formal
c. Exposure at Default (EAD) - In the vast majority of the cases described here, credit appraisal techniques will go a long way to ensure perfection in credit appraisal.
the exposure at default corresponds to the amount owed to the bank. Thus, besides the type
of claim, the amount of the claim is another important element in the credit approval process. The credit evaluation process involves three steps:

Thus, four factors should be taken into account in the segmentation of credit approval 1. Gathering Credit information
processes: 2. Credit Analysis (credit worthiness of applicants)
3. Credit Decision
1. type of borrower
2. source of cash flows 1. Gathering credit information: The credit department of a bank collects various
3. value and type of collateral important information regarding borrower from different sources to evaluate the customer. A
4. amount and type of claim number of sources would available for gathering information which depends upon the nature
of the business, form of loan, amount of loan etc. these sources are:
1.4 Important Factors for Credit Approval
a. Interview: Interview with the borrower enables the banks to secure the detail
1. The purpose of credit and sources of repayment. information about the borrower’s business which can help in credit decision process. If the
2. The current risk profile (including the nature and aggregate amounts of risks) of applicant does not satisfy the credit norms, the lending officer may stop further procedure.
the borrower or counterparty and collateral and its sensitivity to economic and market In case of the success of preliminary investigation, as up to the standards, borrower may be
developments; asked to submit various financial reports.
 b. Financial statements: Financial statements include the balance sheet and the
profit and loss account. The financial statements of the last few years should be obtained. a. Character: The “character” means the reputation of the prospective borrower.
This analysis would provide an insight into the borrower’s financial position, funds This includes certain moral and mental qualities of integrity, fairness, responsibility, trust
management capacity, liquidity, profitability and repaying capacity of the borrower. worthiness, industry, etc. The honesty and integrity of the borrowers is of primary importance.
c. Report of credit rating agencies: The move is in line with the Credit Information So, credit character should be judged on the basis of applicant’s performance in bad times.
System Act (CISA) or Republic Act No. 9510, and Securities and Exchange Commission (SEC) b. Capacity: It is the management ability factor. It indicates the ability of the potential
Memorandum Circular No. 7, which laid down the rules for the accreditation of these firms. borrower to repay the debt. It also shows the borrower’s ability to utilize the loan effectively
The SEC memorandum said entities seeking to establish credit bureaus in the country should and profitably.
have a c. Capital: Capital refers to the general financial position of the potential borrower’s
minimum paid-up capital stock of P50 million and has the ability to operate a successful credit firm. It indicates the ability to generate funds continuously over time. Capital means
bureau. The applicant should likewise use updated technology, have a good governance investment represents the faith in the concern, its product and nature. Bank should also
structure and risk management framework, among others. CIC President and CEO Jaime P. determine the amount of immediate liabilities that are due. For the true estimate, market
Garchitorena earlier said that the firm is looking to accredit credit bureaus by yearend. He value of assets should be considered rather than book value.
earlier noted that CIC had been conducting orientations and technical trainings the past two d. Collateral: Collateral means assets offered as a pledge against the loan. It serves
years on setting up credit bureaus “to assist lending institutions in their compliance with the as cushion at the time of insufficiency of giving a reasonable assurance of repayment of the
law.” Under the CISA, lending institutions need to forward both the positive and negative loan.
credit information of their borrowers to CIC. These “submitting entities” will similarly be able e. Conditions: It refers to the economic and business conditions of the country and
to access the credit database or get the services of credit bureaus to establish the position of particular business cycle, which affect the borrower’s ability to earn and repay the
creditworthiness of their borrowers. debt. This is beyond the control of the borrower. Sometimes borrower may have a high credit
d. Bank’s own records: If the applicant is the existing customer of the bank, the character, potential ability to produce income but the condition may not be in favor. For the
banker can study the previous records, which provides an insight into the past dealings with proper evaluation, bank should have eyesight on the economic condition too.
the bank. Every bank maintains a record of all depositors and borrowers. The transactions of
borrower can give depth idea to banker. For this, they have to rate the borrowers in different categories like excellent, well and
e. Bazaar report: Report regarding applicant can also be obtained from various poor. Both the formal and non-formal tools combined would lead to perfection in credit
markets. The strengths and weaknesses of the borrowers are monitored by the markets appraisal and ward of increasing default tendency in credit. There are number of tools and
continuously. Market opinion can also predict the future of the business. Market intelligence techniques developed to evaluate the creditworthiness of the borrower like, ratio analysis,
can also be gathered through borrower’s competitors. It should be a continuous process on cash flow projections, fund flow statement, credit scoring etc
existing current account holders and other prominent businessmen.
f. Report from other banks: Bank credit department may ask to other banks in
which the applicant has dealings.
g. Other non-formal methods: There are other ways also which can give many
clues and make the judgment more accurate. The most popular non-traditional method is to
understand the personality, motive and the capabilities of the borrowers, based on non-verbal
clues as trying to predict the results of a human mind.

2. Credit analysis (credit worthiness of applicants): After gathering the credit

information, banker analyses it to evaluate the creditworthiness of the borrower. This is known
as Credit Analysis. It involves the credit investigation of a potential customer to determine the
degree of risk in the loan. The creditworthiness of the applicant calls for a detailed
investigation of the 5 “C” of credit – Character, Capacity, Capital, Collateral and Conditions.
 1.6 Essential and Best Practices in Managing Credit Risk
a. KNOW YOUR CUSTOMER. Knowing your Customer is an essential best practice
because it is the foundation for all succeeding steps in the credit risk management process.
To be successful, you must operate on pertinent, accurate, and timely information. The
information you gather and the relationships you establish are critical to positioning yourself
as a valued financial consultant and provider of financial products and services. Establishing
a good relationship can bring a long stream of equity to your institution.

A poorly planned and executed initial call could limit your opportunity for future
business. One of the best ways to get to know the customer’s needs and establish yourself
as a valued financial consultant is through face-to-face meetings to discuss the customer’s
history and future plans. Prior to meeting with the customer, you should find out as much as
you can about the company and its industry. This up-front exploration will allow you to make
the most of the time that you have with the customer and help you set up an effective calling
plan to guide you through the interview process. You should make sure that you elicit all key
3. Credit decision: After passing through whole this process, the banker has to take information, keeping in mind that the most important techniques you can demonstrate are
decision about sanctioning of credit facility. The creditworthiness should be matched against the ability to listen effectively and to respond to a customer’s needs. Listen for verbal cues
the credit standards of loan policy. The banker should be very conscious about this, for and watch for non-verbal cues to help establish a customer’s needs.
taking right decision to avoid the possible credit risks to arise in future.
During the initial interview, establish your credibility as a professional, knowledgeable,
and friendly businessperson. Ask questions and gather information about the company’s
products and services, customers, suppliers, facilities, management, ownership, and history.
This is when you can develop your initial observations about management’s behavior and
start to evaluate their qualifications and abilities to carry out the company’s business strategy.
 underwriting and credit approval criteria, properly analyzing these risks gives you the
On subsequent calls, investigate competition, market share, and the probable impact information to help structure the loan in a fashion that will ensure the highest probability of
of economic conditions on the business. And identify the company’s business strategy and repayment.
what the company must do to succeed.
Analysis of the industry, business, and management risks precedes or is concurrent
b. ANALYZE NON-FINANCIAL RISKS. Understand your customer’s business by with financial analysis of an individual company. If the financial institution has, or wants to
analyzing nonfinancial risks. Information gathered in this step is critical to positioning yourself gain, a significant exposure to a particular industry, it usually has industry experts on both
as a financial consultant to your customer and a valued member of your financial institution’s the lending and credit analyst teams. Industry experts provide an intimate knowledge of an
lending team. industry and will,
The concept of risk management can apply to a single loan or customer relationship • Identify, understand, evaluate, and mitigate risk.
(micro) or to an entire loan portfolio (macro). The whole concept of institutional risk • Provide expertise in the event of a loan workout situation with a customer.
management is to ensure that a particular issue has been identified as a risk. At the micro • Provide efficient marketing strategies in acquiring creditworthy and profitable clients
level, a loan is a risk. At the macro level, a portfolio of loans is a risk. Your credit policy within a particular industry.
department will identify risk factors and query the entire loan portfolio (macro) to judge
whether the particular risk is relevant to other customers of your institution. The key question An understanding of the economic and industry factors that influence a company’s
is, “How does this identified risk affect a company’s ability to repay debt?” financial stability and financing requirements is necessary before valuating the numbers.
Because you can’t analyze a company in a vacuum, it must be analyzed within the larger
Risk Management is a continuous process (not a static exercise) of identifying risks context of its industry and the world economy.
that are sometimes subject to quick and volatile changes. The identification of risks may result
in opportunities for portfolio growth or may aid in avoiding unacceptable exposures for the Industry, business, and management risks are inherently an important part of the
institution. overall credit underwriting process. A company’s financial statements are a
There is risk to every line item on the balance sheet and income statement and you must reflection of a company’s management decisions as that company interacts with the outside
learn how to evaluate those risks, which fall into the broad categories of: world. Industry, business, and management risks (nonfinancial risks) describe that outside
• Industry world.
• Business
• Management c. UNDERSTAND THE NUMBERS. There are many benefits and risks associated
with establishing a banking relationship with any entity or individual. As a lender, you should
The integration of the analysis of risks associated with the industry, business, and know:
management of a company is a critical piece in the overall credit underwriting process. From • How the requested funds are going to be used and how they are anticipated to be
your institution’s perspective, senior credit policy management wants to know: repaid.
• Is there enough capital available on the institution’s balance sheet to support the risk • Techniques to identify, categorize, and prioritize all of the risks inherent with the
being taken? customer that are known at the time of the analysis as well as those that are
• Is the institution being adequately compensated for the risk? anticipated to be in existence over the period of the relationship.
• Are there adequate controls in place at the institution to assure the proper tracking of
the risk and minimize the element of surprise? To understand the numbers, you should focus on the financial capacity of the company
as evidenced by the information provided and examine the accuracy of the information as
Evaluating industry, business, and management risks enables you to ask questions of well as the quality and sustainability of financial performance. Before beginning any financial
customers and prospects in order to fully identify, quantify, and if possible mitigate key risks. analysis, it is important to understand why companies and individuals borrow money.
As a result, you develop critical thinking skills and techniques that integrate economic, When dealing with new clients, it is doubly important to probe into how and why the
political, and market issues into the overall underwriting process. Assuming the loan meets loan request originated. When loaning to established relationships, your assessment of the
loan will be guided by your knowledge of the changes in your customer’s asset structure as it Learn what the company does and how it operates. Then examine how it fits into its
goes through its business cycle. industry and how it is affected by economic conditions. That information shows you what the
The reason for borrowing provides you with insights into the company’s ability to company’s business strategy should be and how easy or difficult it will be to carry out that
repay. A complete understanding of the historical and projected financial performance of your strategy. Finally, you can evaluate how competent the company’s management is to
customer is key to your analysis and overall credit risk management. accomplish the activities you have identified as crucial to the company’s success.
The loan request is generally the most scrutinized part of a credit write-up. Once you
are comfortable with the nature of the loan request, the process of understanding the Having completed the analysis of the business, you can then move to analyzing the
numbers can begin. The process includes: financial reports, historical and forecasted. Understanding profitability and cash flow, liquidity,
and leverage are key to structuring the facility.
• Knowing the Auditor – Analyze the competency and reputation of the firm or individual
preparing your customer’s financial reports. You cannot determine what product(s) fit the customer’s profile until these steps have
• Accounting Fundamentals – Review the auditor’s Engagement Letter, Financial been completed. Once this process has been completed, applying the appropriate structure
Statements, and Management Letter, as well as accounting fundamentals and becomes a simple procedure. By taking the time to understand the personal, financial, and
generally accepted auditing principles (GAAP). business strategies of the owners, you will have an easier time getting to “yes,” with a risk
• Balance Sheet Quality Analysis –Analyze the balance sheet along with relevant liquidity profile acceptable to your financial institution.
and leverage ratios.
• Income Statement Quality Analysis – Analyze revenues and costs along with income Once you have identified the underlying borrowing cause(s) and understand both
statement ratio analysis. primary and secondary repayment sources available, the next step is to structure the loan.
• Cash Flow Statement Analysis – Analyze operating cash flow, investing cash flow,
financing cash flow, and cash flow ratios. Loan structure is important because your customer needs to clearly understand the
• Analyzing Financial Efficiency Cash Flow Drivers – Use profitability ratios and turnover boundaries within which it can operate and continue to depend upon your institution for its
ratios to analyze a company’s cash flow drivers. financial service needs. The structure of the deal appropriately establishes your customer’s
• Developing Projections – Determine the reasonableness of assumptions behind expectations for how your institution will perform during the term of the relationship. Your
business fundamentals and swing factors. customer needs this assurance in order to run the business efficiently, i.e., if they operate in
• Personal Financial Statement Analysis – Analyze the personal financial statement and accordance with the terms and conditions of the loan agreement, your customer can expect
tax return in the event that you are lending directly to or seeking additional credit funding from your institution.
support from an individual.
• Company Financial Statements – Analyze the company’s financial statements and
By having an appropriate structure to the relationship, agreeable to both parties, you
provide an overview. Obviously, a small company will have a simpler chart of accounts, have established a mechanism for monitoring individual transactions within a relationship.
while a large domestic or international corporation will be more complex. This monitoring process can be accomplished in two ways:
d. STRUCTURE THE DEAL. The first step is to understand the business. Before • Have a loan covenant checklist that routinely tracks your customer’s adherence to
completing a financial analysis on the organization, you identify the characteristics that covenants.
influence a company’s success by studying: • Require that an officer of the company regularly (quarterly, for example) certify as to
1. The nature of the business. the company’s compliance with all of its outstanding agreements.
2. The nature of the industry.
3. The impact of economic conditions.
Failing to notify your customer of a covenant default may make your institution’s future
4. Its business strategy.
enforcement of the covenant difficult.
5. The competencies or deficiencies of management.
 e. PRICE THE DEAL. Determining the appropriate pricing is a critical credit risk
management technique. It ensures that your financial institution will be adequately f. PRESENT THE DEAL. Communicating your findings in a cogent and professional
compensated for the risk of the deal. manner is a critical practice in getting your proposal approved. Credit decisions should not be
made on financial statement analysis alone. A credit review would not be complete without
In the late 1970s, nearly 90% of all floating rate loans were linked to the prime rate an equally significant emphasis on the qualitative issues such as the ability of management,
and used as a benchmark for loan pricing. Adjustments to the incremental spread over/under the competitive business environment, and the economic issues relating to the business.
the prime rate generally signaled the softening or hardening of loan conditions. These
adjustments were not always closely synchronized with changes in short-term money market Whether you write the credit presentation or hold a credit discussion, the following
rates, such as the Fed Funds rate or other cost of funds indices. format will be equally applicable.

However, over the past 20 years, increasing competition from foreign financial The five key sections that are integral to any effective credit recommendation report
institutions seeking business in the U. S. through offshore branches and agencies and the or presentation are:
expansion of the commercial paper market have caused a movement from prime-based loans 1. Summary and Recommendations – A one-page summary of all the information that
to pricing based on money market base rates. As U.S. banks’ access to overseas sources of has been gathered in the analysis that supports the credit recommendations.
funds has increased, London Interbank Offering Rate (LIBOR) has become an increasingly 2. Economic and Competitive Environments – Analyses of the company’s current and
popular base rate index among customers of regional and even small banks. LIBOR is the rate evolving position in the industry and how susceptible it has been, and may be, to
that the most credit-worthy international banks dealing in Eurodollars (U.S. currency held in changes in the general economy.
banks outside the United States, mainly in Europe) charge each other for loans. 3. Management Assessment – Evaluations of the company’s operations and
management’s capabilities.
With money market rates of interest fluctuating dramatically over the past 20 years, 4. Financial Analysis and Projections – Analysis of the financial position of the company
banks’ loan pricing systems have become largely based on floating rates. This pricing tactic and evaluation of the projected performance of the company.
ties the loan rate to a base rate that responds to movements of money market rates. Financial 5. Sources of Repayment – Identification of all projected sources of repayment and the
institutions painfully learned their lessons with respect to managing interest rate risk in the appropriate loan structure.
early 1980s. Institutions with large portfolios of low fixed-rate loans found they were exposed
to considerable interest rate risk when variable funding costs rose sharply. Today, banks have g. CLOSE THE DEAL. Closing the Deal takes place after the analysis, structuring, and
created increasingly complex strategies for managing interest rate risk through the use of pricing have been completed. Do the following and it is more likely that your loan closing will
financial futures and options. Interest rate risk management and loan pricing are now highly be successful:
interrelated through the use of pricing models. 1. Prepare a closing memorandum or detailed loan documentation checklist.
2. Provide sufficient time for the borrower and any other parties involved in the
Traditionally, banks have used pricing models that parallel the format of their income transaction to gather documents.
statement. As the major source of profitability for many banks, loan interest income has 3. Provide the borrower and any other parties with instructions on how to complete your
played an important role in the banks’ return to shareholders. As the market for loans has standard documents and ensure that they return the forms to you for review prior to
become more competitive, banks have had to change the way that they look at profitability. the closing.
Many complex factors determine the final rate a bank charges its commercial clients. In 4. Prepare drafts of loan documents and deliver them to the borrower or other involved
addition to company-specific variables, factors that affect pricing include the parties prior to the closing with sufficient time for the recipients to have the documents
following: reviewed by their own legal counsel.
• Marketplace in which the bank operates.
• General economic conditions. h. MONITOR THE RELATIONSHIP. In today’s competitive environment, you cannot
• Matching of the pricing and maturity of the bank’s assets and liabilities, i.e., Asset afford to wait for your loans to be repaid and expect your clients to call you for other products
Liability Committee (ALCO) policies. and services. To have a competitive advantage in today’s market, you must continue to
monitor the risk profile of your client and, at the same time, pursue opportunities to develop has a track record of paying late – you’re forcing their hand to either clean up their act or go
and expand the relationship. elsewhere. Though the latter option seems counterproductive, you have to ask yourself how
valuable a customer they are if they don’t pay on time.
A profitable relationship can quickly turn into an unprofitable one. Loan payments may
be timely, but deteriorating collateral, idle equipment, or unpaid taxes can create serious risk 3. Credit reports. Credit reports are an excellent tool to gain a picture of a
for you. Periodic reviews, ratings, and audits can ensure that the client is one that will create prospective or existing customer’s creditworthiness prior to offering them credit terms. The
long-term profitability for your bank. outcome of the report can be used to determine the length of terms to supply, whether a
deposit should be taken up-front or whether you should trade with them at all.
Asset quality is one of the key success factors of a financial institution. Although every
bank is subject to scrutiny from state and federal regulatory agencies, most banks supplement 4. Suspending customer credit facilities. By refusing to extend credit terms to a
these functions with internal monitoring. customer, you remove the risk of them not paying at all. This decision can be based on your
previous experiences with that customer, or perhaps an unfavorable credit report being
In a recent survey of banks conducted by RMA, the following were determined to be obtained.
critical to a successful risk management strategy: However, it can lead to your business being less competitive and lead to that customer looking
• A quantitative risk-rating system with a wide range of grades, which includes elsewhere.
subjective factors, such as management quality. A wider range of grades allows the
bank to assign credit costs more precisely. 5. Court Judgments. Although it can be an expensive process, legal proceedings are
• An effective management information system to track credit exposure. available to businesses wishing to take a strong stand against a late paying customer. The
• Risk pricing based on required rates of return that are then used in customer sourcing. threat of court can sometimes be enough to encourage payment, but it can prove to be a
• A business strategy that reflects a proactive role in guiding relationship managers on stressful, drawn-out and costly method.
credit exposures in the portfolio.
6. Visiting debtors in person. Unfortunately, it can be quite easy for a customer to
1.7 Common Credit Management Strategies ignore phone calls, emails and letters requesting payment. Sometimes it can therefore be
worth knocking on their door to request payment and have a face-to-face conversation to
As much as businesses wish there was, there is no silver bullet or panacea when it demonstrate how valuable their prompt payment is for your business.
comes to credit management. Different customers and sectors will respond better to some
strategies than others, while some simply won’t pay on time regardless of your credit 7. Applying statutory late payment interest . Businesses have a legal right to
controllers’ efforts. What businesses can do, however, is have a clear picture about the charge their customers statutory interest and late payment compensation should they miss a
different strategies that could be used based on different eventualities. This not only provides payment deadline. This can compensate your business for the impact late payment has on
the best chance of getting paid, but also reduces the impact of late payment on the business’s your cash flow and additionally cover the cost of employing a debt collection agency to recover
all-important cash flow. Here, we look at some of the most common tactics employed by the full amount.
British businesses.
8. Written credit policy. More commonly used by larger businesses, a written credit
1. Constant reminding. Whether by phone, email, letter or in person, there are policy can be a great way to ensure your team goes about its credit management in a
always ways to contact your customers to remind them of the invoice. The secret is to contact structured, effective and consistent way.
them at the most opportune moments.
9. Early settlement discounts. In many cases it can be more beneficial financially
2. Suspending work/services. This is quite an extreme step to take, but it can to be paid a smaller-than quoted sum if it means payment is received after seven days instead
prove extremely effective. By refusing to trade with a particular customer – usually one which of 30. Any customer taking advantage of the offer also means that’s one less account your
credit control team has to worry about.
 10. Invoice finance. The nature of trading on credit terms means there will always
be a cash flow gap between providing a service and getting paid. Invoice finance enables
businesses to access up to 90% of their invoice value within 24 hours of an invoice being
raised, while facilities can also incorporate a sales ledger management service and bad debt
protection.

11. Credit insurance (bad debt protection). Bad debt protection can also be
provided on a standalone basis. By safeguarding your cash flow against late payment or
protracted default, if affords you peace of mind when trading on credit – particularly for larger
contracts.

12. Outsourcing. Chasing customers for payment can be an arduous task. As a

result, some businesses choose to instruct a debt collection agency to recover unpaid invoices
which are proving difficult and time-consuming to chase. Other businesses choose to
outsource all or part of their credit control function so that they can concentrate on running
their company.

1.8 Credit Control Timeline: Key Steps

SUMMARY
One of the most important but frequently overlooked elements of the credit control
process is the process itself. By clearly setting out a day-by-day strategy from the moment
In this chapter the decision-making processes used to assess individuals when they
the order is placed until the invoice is paid, your accounts receivables team can adopt a
apply for credit have been explored. Lenders attempt to forecast the likelihood that a potential
coordinated and professional credit control procedure.
customer will be a ‘good’ or ‘bad’ risk and make lending decisions based on this prediction,
with good and bad acting as approximations to profitable and non-profitable respectively.
Once you have agreed the timetable with all the relevant people in your company, the
Every lender has different overheads and operates at a different level of profitability.
next task is to ensure that the necessary levels of training are provided so that all stages are
Therefore, a customer who is deemed creditworthy by one lender, may be not be considered
adequately completed and meticulously stuck to at all times.
creditworthy by another.
There are no hard and fast rules that can tell you who is a good credit risk and who
Stages can include invoicing the day the order is fulfilled and courtesy calls or letters
is not. There are cases where the poorest of people pay their bills promptly, while the
that politely, but firmly, remind the customer of their obligation to pay. Should the invoice not
wealthy ignore them. As the owner of a small business, you must combine facts about the
be paid after a certain time, it may be beneficial to pass the debt over to a specialist
commercial debt collection agency. Below is an example timetable based on credit terms of applicant with common sense to determine those risks that appear reasonable.
30 days, but it should be adapted to your business’s experiences and needs: