Portfolio Risk Management-An Evolving Approach

Article excerpt

The management of credit risk has evolved over time from individuals interpreting broad corporate policy to the use of sophisticated methodologies that enforce consistent analysis and decisions. But this is not true throughout the business world. There are noticeable differences in the sophistication of credit risk management techniques in different industries. For example, the mission critical nature of credit in the financial services sector has given rise to substantial investments in information technology (IT) infrastructure surrounding the credit granting process. On the other hand, in many organizations in the manufacturing trade credit arena, the IT infrastructures that support automated credit processing are nowhere near the state of the art.

Increasingly across all industries, management sees rapid advances in technology and the sophistication of software applications as an opportunity for improving the management of credit risk. The collective promise of these developments is substantial. However, to fully realize their potential, it will be necessary to look at broad approaches that fully integrate software and hardware technologies such as relational database, decision support and client/server systems. With the vast capabilities of today's technology, credit decision processes are likely to change in the future.

Of course, technology is only the means to an end. For it to be used effectively, the credit department of the future must adopt a long-term, building-block perspective. Emphasis must be placed on engineering credit risk processes using technology as a tool. To be truly effective, the technology framework must be capable of supporting rapid changes in credit risk management processes.

Information Architecture for Credit Risk Management

The management of credit risk has three major dimensionsthe transaction level credit decision, the management of the credit risk portfolio and value-added services.

The transaction level credit decision represents the traditional view of credit. The acceptance of a customer order and subsequent granting of credit initiates the acceptance of risk by the organization. The objective in managing individual credit transactions is largely to determine the risk-return tradeoff in granting credit to each customer. The risk tolerance or preferences of the organization are driven by a number of factors. Typically this includes the competitiveness of its markets, its cost of capital and the profitability of its products and services. As organizations look more closely at ways to compete effectively in the midst of increasing global competitive pressures, credit will receive more scrutiny as an area that can contribute to market share growth. This changing environment also means that management must look at a broader view of risk preference. In response to the portfolio view of risk management, credit is taking on increasing importance in today's market. At any given time, the credit manager is really managing a portfolio of credit risk. The portfolio perspective is quite different from the individual credit transaction. It allows credit to be viewed from the standpoint of pooled risk. The opportunity takes on a slightly greater risk in an individual transaction and becomes acceptable provided the overall risk pool stays within an acceptable tolerance level. As the need to glOW markets in the face of increasing competition continues, the portfolio perspective is likely to grow in importance. Thinking of credit risk management as a portfolio issue will represent a major paradigm shift for many in the traditional manufacturing trade credit world.

In some corporations. credit has the opportunity to provide value-added services to customers and internal groups, such as sales and marketing. For example, frequently the corporation has an intermediate distribution channel where the nature of the business relationship between the distribution channel and the corporation is usually quite strong. …