Exit Strategies In Credit Risk Management
Firms often give loans or extend credit over extended periods of time. The credit extended may continue for years and even decades. It is possible for the management of the company to change during this period. It is also possible for the cash flow position of the company to change during this period. Hence, it is important to have an exit strategy while extending credit.
Many multinational companies around the world have made it mandatory to have an exit strategy in place before making any investment. In this article, we will look at the various situations in which the exit strategy of the company is likely to change as well as the common mechanisms which are used to exit the investment.
Reasons Behind Exit
There are several reasons which could cause an organization to re-evaluate its credit risk profile and then decide to exit some of its current investments. Some of these reasons have been mentioned below:
- Imbalanced Portfolio: During the course of their timely audits, companies may find that they have taken on too much of a certain type of risk. They may realize that their portfolio has excessive exposure to a client, a product, or geography. Hence, they may want to exit some of the investments made by them in the past.
- Change In Risk Policy: It is also possible for the management of a company to change over a period of time. It is also possible for the new management to have a radically different view of risk as compared to the old management this is another major reason that companies may want to exit some of their investment mid-way.
- Change in Asset Quality: It is also possible that over the period of time, the credit profile of the borrower or the valuation of the collateral may undergo a change. As such, this would mean that the asset quality as a whole has changed. This would prompt the lending company to re-evaluate its decision and exit some investments.
Mechanisms to Exit
Exiting a debt investment mid-way is not easy. Particularly, if the possibility of such an exit has not been planned. In the mature capital markets of today, exiting investments is possible. Some of the common ways in which this is executed has been mentioned below:
- Transfer: The easiest mechanism to exit an existing credit risk is to transfer it to another party. This means that the counterparty to an agreement changes. This could happen in many ways depending upon the instrument in question. If the debt instrument is freely traded on a secondary market, then this can be easily done. On the other hand, if there is no active secondary market, liquidity can still be achieved by using the services of an investment banker to find a willing counterparty.
Lastly, there are many banks and financial institutions around the world which are engaged in processes such as factoring and forfaiting without recourse. The end result of each of these transactions is that the debt and the associated risk are soon moved off the books.
- Restructuring: Companies could use restructuring exercises to exit certain types of debt. The real use of restructuring is to make the debt viable once again so that it can be sold off at a later date.
For instance, when creditors start defaulting, many banks provide a forbearance period to their borrowers. Borrowers can then use this period to streamline their cash flow situation and make their debt viable again. In certain other cases, it is also possible for lenders to have the right to call on the entire debt. If the borrower is not able to pay, then the underlying asset may be sold off in order to recover the dues.
- Securitization: Many companies routinely use securitization to get the risk off their books. Securitization is similar to transfer in the sense that it gets the risk off the books of the company. However, it is different in the sense that instead of selling the entire debt in one piece, companies often create thousands of securities that are backed by the debt. These different securities are then sold to hundreds of different investors by listing them on the secondary market. It is common for many banks to use securitization routinely as a part of their day-to-day operations.
- Derivatives: Lastly, in the recent past, many credit derivative products have been created. This is because of the fact that there has been an increased need for companies to protect themselves against the downside risks of high credit exposure.
Products like credit default swaps, credit spread futures, and collateralized debt obligations have been on the rise in the recent past. These products act as insurance for the companies. Once they have purchased these contracts, they can stop worrying about the relevant credit exposure.
The bottom line is that organizations must have an exit plan in place while extending credit. In the absence of an exit plan, companies will be forced to hold on to their debts for long durations of time and their performance will be hampered.
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