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Third party risk in lending

Business, Finance, Risk /

How end use of a consumer loan impacts the credit risk

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Many lenders extend loans to consumers for specific uses – auto, property, education, etc. – and often in partnership with sellers and service providers. How does the performance of these partners impact the credit risk and repayment of such loans? 

I recently read about a major Indian ed-tech firm’s local lending partners pulling back on providing loans to their customers for purchasing their educational products. These are big ticket loans provided to a captive customer base for a product that most Indian families hold in high esteem. So, seems like a low-risk, high-demand loan product for the lenders. Then, why are the lenders moving away from this partnership? While we do not know the terms of their partnership agreement and how palatable it is for the lenders, but could it also relate to the negative sentiment developing around the ed-tech major’s sales practices and could that, perhaps, impact the willingness of some of the borrowers to repay the loan?

The delivery performance of the seller-partners has an impact on the repayment risk of the loans in such situation. This has been seen in other industries as well, such as housing. Many borrowers in China stopped repaying their home loans when the construction of their apartments stalled last year and the same has been repeated in many other countries and industries. What are some of the ways in which lenders can mitigate these risks?

Ideally, lenders should have a default-guarantee clause in their agreements with the seller partners, whereby some of the default is absorbed by the partners. This can be structured in many different ways – such as, first X% of default or any default beyond Y% – depending on mutual agreement and the economics of lending. Second, where possible, the lenders should avoid making lumpsum payments for products that are not fully delivered and should tie the disbursement to the delivery schedule.

It is also important that the lenders keep a close tab on the performance of their seller partners. While an objective credit risk assessment of the borrowers is imperative, the willingness to repay will be impacted by the perceived satisfaction of the borrowers to some extent. And if the borrowers feel cheated, pressured or misled, they may decide to stop repayments in protest, especially if the loans were fronted by the sellers and the borrowers do not fully realize that they are indebted to a third party. So, another thing to consider would be to be more visible in loan sourcing and ensuring that the borrowers understand who they are contracting with and what their obligations are.

The lenders may or may not have the leverage to force their seller partners to change tack, but they would do well to limit their exposure if there are concerns about delivery or reputation of the sellers. In the case of the ed-tech major, it seems that they are forced to lend from their own balance sheet to maintain their enrollment numbers and that has had an impact on their liquidity and financial performance.

What are some other methods that you have employed or seen in practice in such lending agreements?

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Governance in early stages

Business, Governance /
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Is it too soon to emphasize governance at early-stages of companies?

A string of scandals at celebrated start-ups have brought the spotlight on the lack of visibility into the operations of early-stage companies and their founders. Is it time for investors to focus on better governance at start-ups?

Start-up companies and their founders have captured the popular imagination and achieved the rock star status. But, sometimes this celebrity culture masks the dark side of things. A spate of scandals in recent years – Theranos, FTX, WeWork, to name a few – have illuminated the dodgy operations underpinning some of the most sought-after businesses. Many investors have lost a lot of money and some element of criminality cannot be ruled out. However, this also raises the question of whether investors need to start insisting on better governance at early-stage companies to protect their investment.

There are several reasons why start-ups get a long rope from the investors. They often deal with innovative business ideas that may have no precedent, they need to stay focused on their solutions, stay lean and agile, the investment is usually smaller and, generally, the higher risk of business failure is well accepted and even expected. However, this landscape has also changed with the global liquidity glut of the last 15 years. The investment sizes became bigger even in early rounds, investors chased higher returns and their risk appetite grew, there was a fear of missing out and investors were entering segments they didn’t understand well and had to rely on the representations of the founders. At the same time, there has been an exponential increase in the number of entrepreneurs and that has increased the competition among start-ups for funding and visibility.

All of this created an environment where raising ever larger funding rounds itself became a sign of success and the investors were either spread thin or only too eager to go after rock star companies and founders. But eventually when the day of reckoning came, many of these businesses were exposed as mismanaged, misrepresented, misguided or purely fraudulent. While many of the investors can afford to write off these losses and move on, what would it take to create a playing field that provides reasonable assurances to investors?

Good governance is not a luxury of the large, public companies. It needs to be a part of the DNA of every organization. While regulated industries try to ensure that through laws and regulations that create a Compliance burden, businesses of all sizes need to focus on checks and balances for probity. Investors must help instill the proper values in their portfolio companies – tracking of funds, investments and expenses, regular reviews of business results and practices and visibility into the activities and commercial interests of the management teams. For specialized sectors, involving experts would be crucial for critical evaluation of the products and technology. Start-ups at experimental stage or ones that may be at the seed stage may yet dispense with some of this structure as their viability is most uncertain. However, as soon as they take steps towards commercialization or raise significant rounds, they should start building the needed internal controls and proactively work to create visibility into their operations for their investors. Having proactive investors who keep a keen eye on the businesses they support will help reduce the chances of malicious, incompetent or disinterested founders damaging the start-up ecosystem.

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A seat at the table

Business, Risk /

How do you make the Risk teams an effective partner?

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While many organizations agree on the need for specialists to manage risk in the business, very few actually focus on how to make them successful. Does your Risk team deal with fait accompli all the time or do they have a seat at the table? 

The role of the risk teams and the Chief Risk Officer has evolved rapidly over the last few years. There was a time when risk management was a disjointed exercise with business units managing risks independent of each other and centralized teams such as Enterprise Risk and Internal Audit serving the senior leadership and the Board. However, over time there has been a recognition of the synergies, cost benefits and the impact that a combined Risk function can bring to the organization through standardized and consistent methods and a 360-degree view of the variety of risks faced.

As the businesses come to terms with dealing with a Risk team outside of their direct reporting line and with an independent mandate and point of view, there are also some challenges cropping up. The Risk teams are increasingly viewed as service providers to the business and many business owners tend to deal with them transactionally. The loss of control also tends to create a certain distance and the closeness that risk managers might have enjoyed earlier with business units also gets impacted. As a result, the business units might fret over the priorities of the Risk team, which may now be driven by overall risk concerns across the organization, and how well their risk partners understand their specific business model and objectives. At the same time, the Risk teams complain that risk management is no longer at the same level of priority for the business teams as before and that they always come into the picture when everything has already been decided or even executed.

A Risk team is most effective when they are not just securing the perimeter against threats but rather working in concert with the business units and leadership to help build a resilient strategy that can deal with future uncertainties. They should be helping the businesses leverage risk as a strategic advantage wherever possible (more on that in a future post). But, to do that they need to understand the business really well and need to have visibility to the working of the business – their objectives, strategy, product decisions, etc. Most of all, they need a seat at the table so that they can bring the Risk perspective during discussion and decision-making.

It is only fair for businesses to expect the Risk managers to align with the business targets and enable growth but on the flip side they also need to reciprocate with more risk awareness and consideration in their decisions. I guess a good place to start is with intentionally involving your risk partners in conversations, brainstorming and discussions and holding them accountable for active participation and inputs. Many organizations take a more structured approach through formal product reviews, audits and operational controls which are a legitimate part of the ERM framework but bigger benefits will accrue through close working relationships and a genuine say for your Risk professionals in the business matters.

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Risk Management as a strategic advantage

Business, Risk /
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Often, Risk management is viewed as a control function intended to prevent loss or failure. As such, most organizations expect their risk managers to focus on what can go wrong. But can they also create a competitive advantage?

The role of Risk Management in the modern organizations is evolving in a fascinating way. From being support teams minding the fences for specific business units, risk managers have now become resources for senior management to understand and mitigate the key risks that run across their businesses. As such, there has been a rising demand for professionals who can help companies identify, evaluate and address risks at both business unit level – first line risk – as well as at a corporate level – Enterprise Risk. But while they focus on protecting the business from foreseen and unforeseen risks, they can also be valuable resources for creating competitive advantages.

Enterprise Risk teams enjoy a unique vantage point where they have a fairly good overview of the businesses – how they run, what risks they face, how these aggregate at the corporate level, and best practices for mitigating common risks. And they can bring this view to create strategic advantages for the business in various ways.

First, the Risk teams can help the businesses review their view of risks applicable to them along multiple dimensions – financial, operational, market, reputational, technology, etc. – and help ensure completeness of their risk assessment. This can help uncover not-so-obvious risks for a business, such as impact of geopolitical risks on their reputation. Second, they can help them differentiate the consequential risks from inconsequential ones. This is important as the resources are usually constrained and understanding what to prioritize will enable the business optimize resources for growth.

Lastly, risk managers can help the businesses decide what, if anything, they should do about the various risks. This is a less recognized but very powerful activity that Risk teams can play for the organizations. The typical thinking about risk management is that once a risk has been identified as material, the business should try to avoid it through whatever means available. However, there are many different risk treatments that are each perfectly acceptable and can help the business take informed bets, optimize capital allocation and improve returns.

A business may choose to accept risk. For example, in restaurant business reservation cancellation is a known risk and most restaurants accept that risk as it is. Some restaurants may choose to avoid risk by not taking reservations at all. Others may even try to mitigate the risk by overbooking, expecting a certain number of cancellations. Some restaurants, especially the sought after ones, price that risk by taking a non-refundable booking guaranty. And if they’re using third party reservation services, they may even transfer the risk by asking their service providers to guaranty a certain number of reservations. The right course of action will differ for each business based on a variety of factors, but understanding the options and choosing the right one can meaningfully impact the business.

As with many business functions, it is really up to the organizations to decide how they want to utilize their risk management teams. However, those who can leverage their Risk teams beyond their traditional roles of putting up guardrails and enforcing policies can realize strategic benefits that give them an advantage over their competitors.

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