Credit risk is like syphilis, but more contagious and unpredictable.
No harm intended with the above comparison, but for all my life the best way to understand a phenomenon was by finding parallels from real life or nature. The thing that intuitively drops to mind is something contagious, with dire consequences and that limits the benefits of (financial) interaction, thus comparison with syphilis.
To be more specific, here are in short a few reasons why credit risk resembles syphilis.
It’s purely a negative experience
Getting infected is synonymous with your client defaulting. It is purely a negative experience. Namely, credit risk in contrast to other types of risks faced by companies such as price risk, FX risk, commodity risk etc. exclusively causes only negative financial impact. Consider for example price risk: an increase in price of goods sold will (in general) result in an increase in profit, a reduction in price results in a decrease in profit, whereas realization of credit risk results (assuming no long position on credit risk via financial instruments) can only have negative financial impact. It’s also heavy tailed and not in our favor.
It’s highly contagious – codependent, in worst case everybody is infected.
For all practical purposes you can replace codependent with correlated if you assume that the correlation takes place in the tails. In layman’s terms your worst-case scenario with respect to exposure is extremely correlated, when people start catching syphilis it can spiral out of control becoming a global pandemic.
Then no matter how robust your business model you are likely heading for default. Your sales are going down, accounts receivables are worthless and very likely your suppliers are also in default.
For the purposes of understanding possible remedies for credit risk exposure it is important to underline one more thing related to credit risk.
Since we are not worried with one or two clients getting infected from our portfolio but with a risk of widespread contagion, one might ask what are the factors that most strongly affect it. In short, leverage (which would for the purposes of our example translate into average health – fragility of our counterparties), more in detail on the overall leverage in the economy, specific leverage of counter-parties and on the amount of credit limits outstanding (which is hidden leverage, not often reported).
Interaction is fun, so why limit it? We have to increase our sales so why are you standing in our way?
How do you mean we should limit our sales or credit limits to client XYZ? How are we going to reach our quarterly results? And what did you mean by diversifying our supply base, isn’t company ABC the cheapest one?
I know, being prudent and avoiding disaster didn’t make anyone rich or getting him a promotion, so why would you care. Lets consider an example.
John and Jim are twin brothers. John was always more aggressive, loud talker, has a way with ladies:). Jim on the other hand is more conservative, borderline paranoid, hasn’t had a date in 5 years. They are hired by two different companies that compete in the same sector for setting up a model for determining credit limits for their counter-parties.
John is very bullish on the economy and increases credit limits for 80% of counterparties, and leaves the other 20% unchanged, Jim on the other hand by having done the analysis finds out that the previous credit limits for counterparties are ok for about 80% of the clients, whereas for 20% of clients he severely restricts sales and credit limits.
For 3 years John’s Company is significantly increasing market share and profit (although profit is increasing at a slower pace than sales). John is being hailed by his management. Soon he gets a raise and a promotion. Jim’s company is stagnant in terms of sales; the profit barely budges (for 1-2% per year). The whole marketing team is yelling at Jim and if it were not for his guardian angel (the CFO) he would have been fired at an instant. It is even harder since John is at a center of each party bragging about his new car and increase in salary whereas Jim feels he lives in a world he doesn’t understand, it’s all about short term greed and no responsibility.
After 3 years the default of one of the oil suppliers causes havoc in financial markets that causes increase in oil prices and a spiral of defaults in the sector. John’s portfolio suffers a default rate of 30% and his company goes belly up, Jim’s company suffers only a 3% default rate on their counter party portfolio.
How to protect yourself – should we stop having financial interactions?
The answer is no, but you should choose your partner wisely and consider what kind of protection you are using.
So how does one approach the problem of being alive – interacting and minimizing (within reasonable limits) the exposure to credit risk. Those rare few that have a diversified portfolio of customers, high margins, no debt and no fixed cost can easily skip to the next post. For the rest of us here is a short list of tips:
1. HAVE AS MANY LOW COST EVALUATIONS ABOUT COUNTERPARTY RISK AS POSSIBLE. Why? Since credit risk is an asymmetrical heavy tailed risk, having many checkups is akin to checking your client for any sign of disease. Of course the testes should be cheap and not time consuming. The cost of false positive is your margin; cost of false negative is 100%. Therefore false negative costs way more than a false positive and you should treat any sign of infection as an exclusion criteria.
2. FOR THE BIGGEST CLIENTS/ COUNTER-PARTIES have a more detailed checkups. Bigger clients can have bigger consequences in terms of financial impact, thus they should be monitored more carefully. But how? To have a small test, first 3 readers that send me an email get this advice for free:); this allows me to see how many people read the post.
3. HAVE AN EARLY WARNING (ONLINE MONITORING) SYSTEM, offered by several providers. Any real time information about the client being late for a payment is akin to having the first sign of infection. If Johnny ain’t paying Mary we are not getting paid either. It should result in immediate action, reduction of limits and requirements for additional collateral.
4. HAVE A FACTOR FOR LEVERAGE IN THE ECONOMY! OR LEVERAGE IN THE SECTOR. The risk of overall contagion depends to a large extent on fragility of participants. An increase in the overall leverage should result in the reduction of limits outstanding.