The one thing we know for sure is that it's all guesswork
This article first appeared in the NBR in July 2009
How to approve credit in today's economy
So it turns out that investing in houses isn't safe as houses, that General Motors isn't too big to fail, and that only about 3 economists in the world can spot a global financial crisis before it appears on the six o'clock news. If there is one thing that the current problems in the economies of New Zealand and everywhere else in the world have made sparkling clear, it's the difficulty of predicting the future.
Arguably, this is the fundamental problem of credit management, which is all about predicting the future. "Can Mary Smith pay her monthly power bill? Will Joe the Plumber pay his suppliers next month? Which airlines will survive the price war?" Who knows? Reliable crystal balls are very hard to come by. Most of the predictors in credit reports are of limited value. Often the best that can be hoped for is that we reject the most obvious bad risks.
In the brief space available, I'd like to make some very broad generalisations about how businesses should have been making credit decisions pre-global-financial-crisis, and how they should be making them now.
Let's consider, first, how most credit staff should have been making credit decisions in the boom times. Unless your customers were the dregs no-one else wanted, you probably would probably have found that most businesses and individuals paid most of their bills most of the time. In terms of business credit, between one-in-200 to one-in-100 businesses, by my rule of thumb, leaves a bad debt in a typical year.
What's more, it's hard to spot those few bad ones. So the credit staff in the "average" business should have been looking for particularly bad risks to decline - say, applicants with recent judgment debts - and approving most of the rest.
A big problem for credit decision makers is that, at best, they only get feedback about the people they approve who they should have declined, and not the people they declined who they should have approved.
There are sometimes ways around this. I can recall working with a business in the 1990s which delegated its credit decision-making to poorly trained front-line staff. These staff rejected 30% of applicants. They made decisions the way the previous credit staff had taught them, which was the way it had always been done, and management simply assumed that they knew what they were doing. Under the privacy laws that applied in that country at that time, we were able to get new credit reports on a sample of these rejected applicants 18 months later. In our sample we were unable to find an applicant who, with the benefit of hindsight, had been correctly declined.
So how should most credit staff be making credit decisions in the current economy. There are two key issues. The first is: why is this new customer coming to us? In particular, is it because they are desperate, now that their regular suppliers or lenders have pulled the plug? The second is: what's going to happen to the economy? How many more job losses? How many more business failures? A customer may look like a good risk today, but will they be overtaken by events outside of their control?
However, pessimistic your view, new customers are a scarce commodity. Most businesses will not want to turn many of them down. And it will still be hard to tell the good from the bad.
So a lot of the focus should be on finding ways to reduce risk - more directors' guarantees, bigger deposits, more security, and closer monitoring. It means demanding more information, particularly financial information, from your customers, and from guarantors. If your credit staff aren't doing at least some of this, you should be asking them why.
Some of these things will be new to many credit staff. They may not have the financial skills for interpreting company accounts, or appropriate documentation for guarantees, or the negotiating skills to get them signed. However, in the global financial crisis of 2009, "the way it has always been done" may not be good enough.
Peter Hattaway - peter@hattaways.com - is a director of Hattaway & Associates Ltd, specialists in credit management training and consulting - www.hattaways.com