Just what is a credit risk strategy?
This article first appeared in MG Business in May 2009
Here's one of the things most people don't understand about credit management. Every creditor business will have some sort of credit risk strategy, even if they don't put it into words, and even if it's not very good. Sometimes the strategy is common to an industry, sometimes it's specific to a particular business. As a consultant coming into a business, one of my challenges is to work out the strategy for that industry and that business, and see whether it makes sense, then to work out whether my client should copy any of the elements I've seen from other strategies.
One of the traps for credit managers who move from one industry to another is that they assume that the strategy for the business they are moving to should be the same as that for the industry they are familiar with. So you might have, say, an ex-banker who knows that directors' guarantees and security over the business-owner's home is normal and works well for bank loans. He therefore tries unsuccessfully to impose these in a new industry where he has been appointed to a credit manager's role, even though it's not the norm there.
On the other hand, I see some situations where trade creditors don't realise that they are in much the same position as a bank in respect of a particular customer. In those cases, it should therefore make sense to demand the same sort of security that a bank would get.
Let's take the credit risk strategies for New Zealand electricity retailers in respect of their residential customers from say 1996 to 2005 as an example. I worked with most of them over this period. It was a simple strategy, so I'm giving away no trade secrets. Bear in mind that I'm generalising furiously, and that things changed significantly after the Muliaga tragedy.
An important feature of power companies, as with most utility companies, is that they have very, very large customer-bases which they regularly bill relatively small amounts. The sheer numbers tend to determine what is believed to be feasible in terms of credit strategy. The profit margins on electricity are low, but there is an awful lot of it sold, and most customers are honest and pay on time. Unlike many other businesses, powercos don't grant credit as a marketing strategy to encourage customers to buy more. It's simply that they don't know in advance how much a customer will want, so they let them use it, then they bill them monthly for the amount they've used. In Australia, some power companies still bill - or did until recently - on a two or three monthly cycle, which is an appalling system for both customer and power company.
So how did our power companies try to judge and reduce the risk? Unlike most consumer creditors, many utility companies had no application form and no identification check for residential customers. Instead, most applications were done over the phone, on the assumption that most people are honest. This was a cost-saving measure which has probably lost them much more money than they realise over the years. People are less likely to worry about leaving a bad debt if they know they gave a false name when they applied.
Of course, as time goes on, more systems are put in place to stop the cheats, but traditionally, most power companies didn't carry out a credit check on a database like Veda. Instead of a credit check, they looked for a reference from the customer's previous power supplier. For customers with no previous power company history, they might have just charged a bond, though bonds are messy to administer and hard to extract from hard-up customers. In some cases they judged risk based on whether the customer was renting or owned their home, a home owner being seen as a good risk. Most power companies also had a prepaid option where customers would pay in advance for a certain amount of power, but the cost of setting up this type of meter almost certainly meant that they would lose money on these customers.
An important piece of the puzzle for most power companies was (and still is) a substantial prompt payment discount. Disconnection and reconnection fees also provided an incentive for customers to do the right thing.
When customers defaulted, power companies would send a letter (because the numbers of defaulters were thought to be too high to phone) then cut off the power. As that was the norm and as each power company was a monopoly in its own area for most of the period we're talking about, they could get away with this. Close to 100% of customers would quickly pay to get the power turned back on, so losses were relatively low. The greater proportion of residential bad debts was probably from people who were up to date when they moved house but, by oversight or design, never paid their final bill.
Increased use of direct debit and automated credit card payments reduced the "whoops, I forgot" defaults over the years, but on the other hand, the Muliaga tragedy, increasing competition from other power companies, and the constraints of the Electricity Commission have created new challenges.
So in summary, the risk strategy for power companies in respect of non-business customers until recent times could be summarised as: try to get bonds from the riskiest customers, set up automated payments if possible, give an incentive to pay on time, and cut off the power quickly when people default. That's a credit risk strategy at its most basic, and, for most power companies (and most customers) it worked well.
Interestingly, some power companies have had another credit risk strategy that they offer for a relatively small number of fixed income customers. Each month those customers paid an estimated monthly average by automatic payment, evening out the low bills of summer and the high bills of winter. This suited low-income people with little disposable income to meet peak costs.
Once a year there was a wash-up; the powerco adjusted the regular payment to reflect the actual usage, and might refund any overpayment or ask for cash to meet an underpayment. In theory, a more fine-tuned version of this could work for the entire residential customer-base, especially if combined with new meters which report power usage to head office every 15 minutes.
Credit strategies don't have to be fixed in concrete. They can change to reflect new ideas, new technology, and, at the moment, the global recession. The first step, however, is to understand what your current strategy is.
Peter Hattaway is a director of Hattaway & Associates Ltd, Credit Consultants - www.hattawaysconsulting.com and can be contacted at peter@hattaways.com