Preparing corporates for credit risk challenges ahead
Increased volatility in financial markets is one of the factors that have driven corporate treasurers to become more aware of the importance of risk management.
Although most of the treasury effort in mitigating risk is geared towards FX management, credit risk is not to be forgotten. Regulatory changes, such as the Base erosion and profit-shifting (BEPS) initiative and the anti-tax avoidance (ATA) directive, as well as accounting reforms such as IFRS 9, are currently priorities for CFOs. Since some of these changes directly relate to credit risk, it should be one of treasury’s key priorities as well.
Proactive credit risk management
According to several studies, around 25 per cent of companies go bankrupt due to bad debt losses alone. It is with good reason that many annual reports state that credit risks are often the biggest threat to business continuity. A company’s financial continuity is contingent on its profitability, solvency and liquidity. Consistent and transparent credit risk management that proactively supports sales is therefore critically important. Often, however, risk management is still reactive and aimed primarily at collecting outstanding accounts receivable. While this is, of course, extremely important, it is an approach that is not sufficiently proactive in terms of seeking to acquire solid, healthy customers.
Implementing and correctly using credit ratings to assess a counterparty’s creditworthiness is the first step towards effective credit risk management. The next step is linking credit limits to the credit ratings of these companies. At portfolio level, concentration limits for each class of rating, industry and country can be used for steering purposes. Often, a lot of different departments within a company are responsible for the execution: treasury, local business units, working capital, finance, credit risk, etc. In general, there is a trend towards more central coordination by treasury at most corporates.
Sound credit management requires sound tools. A growing number of large corporates use rating models to manage credit risks. The resulting rating is, preferably, directly linked to a probability of default (PD): the likelihood that a borrower will default within a period of one year. Combined with an estimate of the exposure at default (EAD) and the loss percentage given default (LGD), this is known as a ‘best-in-class’ approach. The expected loss (EL) on an outstanding debtor is then the product of these three parameters.
The key requirement of credit risk management is effective interplay between sales and risk. This can be illustrated by means of the credit cycle (see figure 1). In this cycle, credit ratings can be applied various ways to promote sustainable sales, a healthy debtor portfolio and improved working capital.
Figure 1: Credit cycle
Implementing a proper use of rating models and a credit portfolio management framework helps reduce debtor losses, create greater consistency and transparency between sales and risk. Besides, it improves efficiency and accuracy in business processes. Furthermore, it translates into healthier turnover, lower operational costs, improved working capital and – ultimately – better business continuity.
Multinational companies, partly due to the financial crisis, are increasingly faced with regulatory requirements from tax authorities worldwide regarding the pricing of their inter-company loans. Tax authorities require, amongst others, that pricing of these inter-company loans is set at arm’s length as if they were provided to an independent market party.
To support the Arm’s Length Principle (ALP), the company must show that inter-company loans with terms and conditions comparable to external loans, carry comparable interest rates. Therefore, an adequate assessment of the credit rating of the subsidiary and related parties, as well as consistent pricing of the loan, are often required by tax authorities. Hence, corporates increasingly use internal PD, EAD and LGD models to determine the arm’s length interest rate for each individual inter-company loan.
In 2015, the OECD launched an action plan which should eliminate any possibilities to exploit local tax laws. Corporates are about to see a whole new set of compliance obligations following the BEPS action plan. One of the major topics addressed by the OECD initiative is inter-company financing transactions. The action plan will restrict interest deductions in certain situations, for example ‘hybrid mismatch arrangements’ for dual-residence entities.
Corporates will also be confronted with additional reporting requirements. The BEPS guidelines provide a template for new minimum standards on ‘country-by-country’ (CbC) reporting. This should give tax administrations a global picture of the operations of multinationals. CbC disclosure requirements apply for financial years commencing on or after 1 January 2016. The CbC reporting is due within one year, so ultimately from 31 December 2017. BEPS will not have the same effect for every corporate. One thing is sure though: BEPS will affect the treasury department, which should prepare as soon as possible.
The OECD is not the only regulatory challenge. Inter-company loans will also be affected by IFRS 9 Impairment. This implies that provisions on these loans must be based on Expected Credit Loss (ECL) calculations (see figure 2).
Forward-looking provisions of IFRS 9
Starting in January 2018, new accounting rules will come into effect for companies reporting under IFRS with respect to the measurement of impairments. This means that provisions for trade receivables and other financial instruments must be based on the aforementioned ECL model rather than the current incurred-loss model. In the latter model, loan losses often come to light too infrequently and too late, a lesson taught by the credit crisis. Implementing the new model can have a major impact on the profit and loss account, including balance sheet ratios. IFRS 9 will affect business models, risk awareness, processes, analytics, data and systems.
So far, only a few corporates are early adopters; most choose to be late followers, and ‘watch the hare running’, or wait for new legislation to be put in place. The new rules are principle-based and simple. The design and implementation, however, can be very challenging, especially the implementation of the required forward-looking aspects.
Most corporates are struggling to work out how to implement the new impairment rules. Insecurity over how to use ECL, taking into account the macroeconomic outlook as required by IFRS 9, means credit risk modeling experts and finance experts are in uncharted waters.
The new accounting rules regarding provisions will make reserves more timely and sufficient. However, with the new standard, companies are squeezed between P&L volatility, model risk, macroeconomic forecasting and compliance with accounting standards.
IFRS 9 requires companies to adjust the current backward-looking, incurred-loss based credit provision into a forward-looking ECL. There are some difficulties to overcome to determine the loss. A solid forward-looking ECL calculation should be based on an accurate estimation of current and future PD, EAD, LGD, and discount factors.
IFRS 9 distinguishes three stages. The picture below shows the so-called stage transition. If there is a significantly decreased credit quality (as reflected by the PD) since initial origination, calculation of provisions will be based on a Lifetime ECL instead of a 12-month ECL.
Figure 2: Stages
Incorporating forward-looking information means modeling business cycle dependency in the PD and LGD. For significant drivers, future macroeconomic scenarios are required to calculate ECL.
Macroeconomic forecasting concentrates mainly on country-specific variables. Growth of domestic product, unemployment rates, inflation indices and interest rates are typical projected variables.
Aside from macro scenarios, industry specific scenarios can be important. Industry risk models enable a company to make forecasts for a certain industry segment, e.g. chemicals, automotive or oil & gas. Industry models are often based on variables such as market conditions and barriers to entry.
Because of the forward-looking character of IFRS 9, and the increasing role of risk models, a transparent and robust governance framework will become more important. This also depends on the number of stakeholders: coordination and communication are required across risk, finance, business units, audit and IT.
It is strongly recommended to prepare in good time for IFRS 9 and have a deep and thorough understanding of the impact, as well as robust tooling and processes in place. Companies are advised not to wait and ‘watch the hare running’, but to start ahead of time and at least run a ‘shadow period during daylight’.
Robust rating models
Implementing and using credit ratings is the first step towards effective credit risk management. Another, equally important step is determining whether the rating models are fulfilling expectations. The robustness of models, i.e. the performance over time, can be determined and improved by model validations. Particularly when large numbers of customers are involved, it is necessary – and financially worthwhile – to validate models in light of their actual performance.
An analysis based on back-testing ratings against actual defaults yields essential information that can be used to improve the model’s performance. Statistical analysis can be carried out into aspects such as discriminating power (“is there sufficient granularity, are customers with low credit ratings singled out?”) and calibration (“are the realized defaults, or RDs, close to the expected PDs?”). A reliable model benefits the interplay between sales and risk.
It should be noted that the importance of rating model validation is often highly underrated by many corporates. It is recommended that rating models are validated at least annually. This not only improves the performance of the rating model, but also mitigates potential model risk.
Supplier risk management
Procurement at large companies regularly uses credit rating models to mitigate their supplier risk. Scorings of (potential) suppliers are often used as one of the main selection criteria and to monitor the ongoing performance of the risk of suppliers, such as the risk of non-delivery. The aim is to improve the overall financial performance and mitigate the overall risks of the supply chain.
Treasury and procurement currently take a more active role in supply chain finance (SCF) management. SCF management refers to financial arrangements in the form of debt, equity or financial contracts used in collaborations by at least two chain partners and facilitated by the ‘focal company’.
Currently, most SCF solutions are based on collaboration between the focal company and direct supplier relations. Most potential for supply chain finance solutions are when the difference in credit standing between the focal company and the supplier is large. Therefore, for example, reverse factoring solutions are focused on suppliers in emerging countries in South America and South East Asia as arbitrage potential due to difference in interest rates in connection with relatively weak credit ratings.
The benefits of SCF include reduced financing costs for the supplier, and increased resilience of the supply chain. Credit rating models can help to detect arbitrage opportunities in the supply chain and monitor changes in credit quality.
Corporate treasury and procurement are well-positioned to take a leading role within the organization and help work towards a more efficient allocation of cash within the supply chain, while at the same time increase supply chain resilience by proper use of credit rating models.
Implementing and using robust credit rating models helps to reduce debtor losses and supplier risk. Besides, it improves efficiency and accuracy in business processes. This translates into healthier turnover, lower operational costs, and – ultimately – better business continuity.
Because of the increasing role of risk models at large multinationals, and also because of IFRS 9 Impairment, a transparent and robust risk governance framework will become more important. The regulatory and accounting changes affect multiple departments in different ways. Therefore, coordination and communication across risk, finance, business units, audit and IT are required.
The corporate treasurer should play a coordinating role. Zanders is able to facilitate every aspect of this process, drawing on extensive credit risk experience as well as a BEPS and IFRS 9 implementation track record. Corporates would be wise to take action now and prepare in advance.