Portfolio Risk Management-An Evolving Approach

Article excerpt

Credit is an integral part of commerce, and the management of credit risk has evolved from individuals' interpreting broad corporate policy to sophisticated methodologies that enforce consistent analysis and decisions. It is interesting to note the rather striking difference in the sophistication of credit risk management techniques in different types of corporations-- manufacturing, retail, leasing, insurance and banking. For example, the mission critical nature of credit in the financial services sector has given rise to substantial information technology infrastructure investments surrounding the credit granting process. Whereas, to date, in the manufacturing trade credit arena, many organizations lag behind in their IT infrastructures that support automated credit processing.

Increasingly, across all industries, management sees rapid advances in technology, and the increasing 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. With the vast capabilities of today's technology, credit decision processes are likely to change more rapidly in the future.

Of course, technology, in and of itself, is only the means to the end. With all of the exciting possibilities that are offered by technology, it is important that the credit department of the future adopt a long-term, building block perspective if technology is to be used effectively. Emphasis must be placed on the engineering of 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

The management of credit risk has three major dimensions-the 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 and competitive pressures, credit will receive more scrutiny as an area that can contribute to market share growth.

This changing environment necessitates that management 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 point in 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 grow markets in the face of increasing competition continues, the portfolio perspective is likely to grow significantly in importance in the future. Thinking of credit risk management as a portfolio issue will represent a major shift for many in the traditional manufacturing trade credit world.

Once again, new advancements in technology can be deployed to aid organizations in the aggregation of similar customer groups and the benchmarking of those customer groups' performance against one another. …