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The primary purpose of credit risk management is to avoid credit losses i.e. credit events that negatively impact the cash flow of the lender. However, since managing credit risks is not a perfect science, there is always a possibility that all credit risks will not be avoided. Some of these risks will actually materialize and lead to financial losses for the company. This is where the second objective of credit risk management comes into play.
Credit managers are supposed to be able to predict with a reasonable degree of accuracy, the amount of debt that will not be repaid. Also, they are supposed to ensure that these credit loss events do not rattle the cash flows of the company. In order to smoothen the blow of these credit events, a method called provisioning is used.
In this article, we will have a look at what provisioning is and how it helps in mitigating the credit risks that are faced by any organization.
Provisioning is the act of keeping aside small sums of money from the profits generated by the firm in anticipation of future losses. For instance, if a company generates annual credit sales of $1 million and they know from experience that on average 5% of these outstanding debts will not be repaid. Therefore, the company is likely to face a $50,000 loss over the period of the next year on account of unmitigated credit losses.
Now, sometimes these losses may come all at once. Paying $50,000 at one shot will make the companies finances look unstable. This is because the expenses will vary wildly from month to month and so will the earnings. In order to avoid this sudden shock, companies tend to keep aside a fixed amount of money every month.
For instance, in this case, the company can keep around $4125 in reserves every month. Hence, by the end of the year, the company will have $50,000 held in a reserve account and will be able to make good its loss without having any impact on the profit and loss and balance sheet of the firm.
In many years, the company may face lower credit losses than expected. For instance, in the above example, the company may face only $20,000 bad debts instead of $50,000. Hence, at the end of the year, the fund will already have $30,000. The company can then decide whether they want to add more money to the fund. If so, how much more money needs to be added and when. These decisions can be taken by the firm based on the dynamic changes in the value of their portfolios and their expected loss figures.
As mentioned above, provisioning is the act of keeping money aside on a regular basis to meet foreseeable credit risks. Some of the benefits derived from this process are:
Provisioning has been made mandatory for financial institutions by the Basel norms. The Bank of International Settlements has acknowledged the fact that the only way to truly manage credit risk is to have reserve funds. The only question is how much should those reserve funds be. This is being updated in the various versions of the Basel norms as well as by the International Financial Reporting Standards (IFRS)
It is important to understand how accountants treat credit loss provisions. On the income statement, the credit loss provisions are shown as an expense item. This is the amount of money that is set aside every period to meet contingencies.
This same money is deducted from expenses and added to the contra asset account in the balance sheet. The money is held in this account. Hence, if any credit manager wants to check how much money they have in reserve, they need to look at the balance in this account.
This money is periodically removed from this account and applied to absorb the losses whenever the credit losses occur. If no credit event occurs, the money is held in that account. Sometimes, companies stop adding more money towards loan loss provisions if the amount that they have is already adequate to meet the regulatory standards imposed by various agencies as well as the standards imposed by the company’s own policies.
Some companies operate in different places around the globe. In some parts of the world, the Basel norms have to be followed to meet regulatory standards. At the same time, in other parts of the world, the IFRS norms have to be followed.
Both these norms provide a very stringent step-by-step method that needs to be used in order to calculate the provisions.
In some cases, these numbers differ from one another. In such cases, companies have to prepare two sets of accounts in order to accommodate both the regulatory norms. Some companies also provide statements that help the investors reconcile between the two provision calculations.
The fact of the matter is calculating provisions as per regulatory and internal norms is one of the main objectives of credit risk management. Hence provisioning is an activity that is fundamental to credit risk management.
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