Builders need good tools to build great things: their hammers and wrenches, their screwdrivers and saws. But they also need a container for all those implements, a box for all those tools. A carpenter who carries his or her expensive tools in an old paper bag may well be able to cut a board or hammer a nail, but the whole operation is, well, riskier. Especially as he or she moves higher and higher off the ground.
This is the metaphor we keep returning to when looking at credit risk management in asset finance: the tools and the box. On one hand, managing credit risk is a technical exercise. You ask questions, analyze data, turn assets on or off and keep an eye on the dials. But these are just tools; they need to be used within an overall risk management framework— a toolbox, if you will. And through our work with asset finance providers to optimize their credit management, we see that it is the toolbox that is lacking, not the tools.
CGAP has spent several months working closely with asset finance firms that were eager to receive external feedback on their credit risk management. We also worked with the Frankfurt School of Finance & Management, which conducted the external credit risk assessments. We are currently halfway through this process and are ready to offer some early insights, while acknowledging that more experience may prove us wrong.
The main finding is that asset finance firms, including but not limited to pay-as-you-go solar companies, have sophisticated tools for managing credit. They generate terabytes of data from their assets and customers, visualize the data in powerful ways, use sophisticated machine-learning algorithms to derive insights and possess remotely securable collateral. Many of these tools are as cutting-edge, if not more so, than those used by commercial banks operating in the same markets. But the box could use some work.
When we talk about the "box,” we mean the structures that lenders use to manage credit risk: culture, governance, oversight, audits and the setting of appetites and limits. These are the aspects of managing credit that are missing or still being developed in some asset finance firms. This is not necessarily a surprise. Many firms that were created to sell a product, for example, do not have the same risk culture that lenders do.
“Risk culture” simply means the values, attitudes and behaviors that inform decisions around risk. That culture comes from the top down, and it must be embedded in every job description and onboarding experience, while being regularly reinforced. “Toolbox talks” are regular, informal safety meetings in sectors that deal with high levels of occupational risk. Asset finance could use more toolbox talks around credit risk.
Our recent work with asset finance companies and conversations with other industry stakeholders have shed light on specific examples of how companies can build a better credit risk toolbox. They include the following:
- Strengthen credit risk governance. Too few companies, even large providers, have a chief risk officer — someone who reports directly to the board of directors and is responsible for managing the various risks of a particular business, including credit risk. In early-stage firms, this responsibility may be borne by an executive like the head of credit or chief financial officer. However, larger firms need a designated chief risk officer. Many firms have credit committees rather than officers specifically responsible for risk. However, in some cases, the committees are responsible for making loan-level credit decisions rather than holistically overseeing credit risk.
- Set risk appetites/limits. Setting a company-level risk appetite means making hard decisions about where to sell and what type of clients to reach. In socially minded businesses, this can be an extremely difficult conversation to have, as the accumulation of risks may force a company to not finance assets for people who need them. Yet if the firm incurs too much risk that is realized in the form of defaults, there will be no firm left to sell assets to anyone. Visions of universal energy access and large-scale asset ownership are vitally important. Setting a risk appetite is an admission that not everyone can access that vision through a purely commercial model right now.
- Start provisioning for defaults. One fund manager we spoke to estimates that only 20 to 30 percent of the firm's asset finance clients were setting aside their full expected losses when they originated a loan. To manage a business and make reasonable projections about how much cash will be generated from a given loan (as well as to comply with IFRS 9), firms need to provision an amount equivalent to their expected loss. As issued loans become less likely to be paid off, the amount that is provisioned must increase. Provisioning is the cost of credit risk, and firms need to be upfront with themselves about that cost and absorb it upfront if they are to manage risk appropriately.
A final point: one response to these issues, as outlined in Strange Beasts: Making Sense of PAYGo Solar Business Models (CGAP and IFC 2019), could be to pursue a more clear-cut separation between the product and financing aspects of asset finance companies. That is, there could be a product company and financing company that operate at some distance from each other. The two companies would potentially be better able to allocate costs, structure incentives and raise capital. But whether they have separate financial statements doesn’t really matter: every component in the asset, every widget and wire, still represents a repayment risk for the lender. If the assets stop working, people stop paying. Managing credit risk in asset finance begins in the factory and carries all the way through to your reputation.
This is an exciting time for asset finance companies. The combination of digital and analog services allows them to manage risk in new and exciting ways. But those tools require a sturdy toolbox.