Key Factors in Implementing Effective Risk Management in Asset-Based Finance
Risk management is a constant challenge for all financial institutions. It is particularly tasking in asset-based lending and invoice factoring due to the multiplicity of risks which banks and other financial firms that provide this service face.
The repercussions of loose risk management include fraud, commercial default, bankruptcy, operational error, and financial penalties stemming from a weak compliance environment, to name check just a few.
Risk management in the asset-based lending area is a constantly evolving discipline, says Kevin Day, CEO of HPD Software. There are many and varied views as to what constitutes best practice to minimise losses. Key areas worth investing in include the best technology; ensuring cybersecurity systems are up-to-date; constantly monitoring data flows and credit risk while recognising that different aspects of risk management take priority in different countries and jurisdictions. One of the biggest risks of all is people, so ensuring education and skills development plays a central role is just as important as bolstering technological protection.
The sheer range of risks is daunting. They include buyer credit risk – the risk that the buyer won’t pay due to financial inability; supplier fraud risk – the risk that the PO or invoice presented to the lender for financing may be fake or duplicative or may have been altered; receivable title risk – the risk that the supplier may have already assigned or pledged the receivable to another financial institution; and receivable transfer risk – the risk that applicable law may not allow the lender to take good and marketable title to the receivable.
Another risk lenders must deal with is understanding whether the buyer can settle the invoice fully and on time. Non-performance on the part of the supplier leads to commercial disputes – the risk that the buyer may claim that the goods or services provided by the supplier did not satisfy the requirements of the PO and refuse to pay (legitimately or otherwise). Another common issue is dilution risk – the risk that the buyer will not pay the full amount of the invoice. This may be due to credit notes issued to resolve commercial disputes, not necessarily related to the supplier’s performance in connection with the transaction at hand, or discounts taken for early settlement, volume purchases, loyalty programmes etc. There are payment risks too, such as payment delay risk – the risk that the buyer won’t pay in a timely fashion; and payment direction risk – the risk that the buyer will make the payment to the supplier or some other party instead of the lender.
Investigative operating cycles, collateral assessment and market monitoring will ensure a level of vigilance, helping a provider to profile their asset-based lending clients.
Invest in the best technology
Today the starting point of any effective risk management is technology. Financial institutions need to implement systems that can detect deteriorating profiles or fraudulent client activity significantly earlier than manual processes to mitigate potential losses. Gathering daily risk metrics to track trends and changes as they occur is ideal as it allows risk managers to constantly monitor client risk and instantly detect adverse trends. This also helps lenders to take a risk-based approach to portfolio management and target the ‘highest risk’ clients, so that users can manage larger portfolios and dedicate resources to the highest risk clients. Best practice is to centralise all information, giving lenders a single view of risk across the business. This helps lenders gain efficiencies and eliminate manual processes, freeing up time for value add tasks and increased customer engagement.
Our own HPD Lendscape platform offers such capabilities, allowing automation and streamlining of your data capture requirements so you can deliver a fast, hands-free funding product to your customers and real-time risk management information to your operational team. It also offers analytics and insight reporting via a smart dashboard for informed business finance management.
Cybersecurity is a key element of risk management
Cybersecurity is one of the key areas that any financial institution involved in asset-based lending needs to address. It is critical that a provider addresses the security of their data sources, where proper measures, including password protection, data encryption and secure communication channels are in place. Lenders must block the possibility that ABF accounts of their SME borrowers are hacked and information stolen which can be used by criminals to fraudulently request further funds from lenders to be sent to their own accounts.
Asset-based lenders and providers also need to constantly evaluate the safety of the environment of the outside company, as well as consider how they interface with the back-ups and safety systems they install. Smart secured lenders use multi-factor authentication for access to key information and are evaluating cybersecurity risk at all phases of the due diligence process, including evaluating client practices as a part of underwriting and field exams.
For those who operate across continents, it is important to understand the risk management culture in the markets to which they are looking to expand.
Investment in monitoring
Being able to accurately monitor, assess and analyse the streams of data that banks receive from their asset-based lending and factoring clients is another key area for risk management. Data on drawdowns on facilities, changing credit quality of the business, slow down in receivables and other business-critical factors can provide excellent insight into any potential fraudulent activity while also assessing any financial pressures or stress faced by the borrower.
Investigative operating cycles, collateral assessment and market monitoring will ensure a level of vigilance, helping a provider to profile their asset-based lending clients. Providing a streamlined, intuitive interface onto which a provider can visualise their borrower’s accounting activity, including accounts receivables and invoicing, can alert a provider to any adverse activity and market performance, enhancing their ability to assess risk. A well-structured, properly underwritten facility will help providers recognise, assess and mitigate risks unique to asset-based lending.
Having good quality source data also helps to ensure that any machine learning or AI techniques which can attempt to analyse and associate patterns of behaviour in diverse data sets will support data-driven decision making based on new knowledge and understanding that is as effective as possible.
Recognising regional priorities
It is not only market operations that need to be considered when it comes to managing risk for asset-based lenders. For those who operate across continents, it is important to understand the risk management culture in the markets to which they are looking to expand. For example, a recent report by the Institute of International Finance found that in the Asia-Pacific region, asset-based lenders are primarily concerned with business model viability, while African and Middle-Eastern regions are more concerned about third-party failures and ransomware, and North American providers place more importance on protecting a firm’s reputation. Ultimately, it is how financial institutions streamline these different priorities into one functional hub that will determine the success of lenders, where cross-industry, cross-border considerations can be centralised to provide accurate, monitored forecasting and data visualisations.
Risk management can never deliver a completely risk-free environment in today’s very fast-moving and interconnected markets, however, implementing the above initiatives will ensure that it is as effective as possible for the benefit of the financial institution involved and also its asset-based lending and factoring corporate clients.