July 12, 2019
In Credit Risk: Have you noticed that the Emperor is Naked?
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For those who had the privilege to read fairy tales, you may remember the one from Hans Christian Andersen, "the Emperor's New Clothes" that told the story of a vain emperor who was deceived by two weavers who promised him a new suit of clothes that they say is invisible to those who are unfit for their positions, stupid or incompetent, while in reality, the made no clothes at all, making everyone believe the clothes are invisible to them. When the emperor paraded before his subjects in his new "clothes", no one dared to say that they di not see any suit of clothes, until a child cries out "But he is not wearing anything at all".
I loved to read this fairy tale to my children and my grandchildren, but also I love to talk about them in politics (Remarkable similarity with what happens nowadays in the White House...) and in business. Here, I talk about business.
One of the fields of practice in my leasing and financing consultancy (The Alta Group) www.thealtagroup.com, is the practice of Business Quality Assessment, through which we undertake due diligence to assess whether a company (generally a lessor) is applying best practices and has sound policies.
Some months ago, we were retained to undertake such assessment in a Fortune 500 company's affiliate in charge of equipment leasing and financing. The client gave us access to a large library where all its policies and processes were clearly described in writing, to the point that I joked with our clients indicating that reading these manuals required longer time than reading Tolstoy's "War and Peace", until recently to my knowledge, the longest book ever written (I learned later that Marcel Proust actually wrote the longest book...).
My first worry, then was whether their staff around the world have taken care of reading these long manuals. My educated guess was no and proved to be truthful. My client had in theory, best practices fully documented. In practice, nothing implemented.
Perhaps one of the most important areas where this was apparent was in the risk management area. Besides the fact that the credit manuals were very well written, complete, provided a very clear guidance about who had which authority, the contents of the credit write-ups, etc., it had the description of the processes to use technology through interphases with Credit Bureaus, services such as Dun & Bradstreet, and incorporated the latest impressive developments of Moody's Analytics. All these should be a recipe for success, right?
Wrong. When we drilled down in our assessment, we unveiled a tremendous insatisfaction from their sales force and their customers about the inconveniently long times taken by this company to make a credit decision, which put that company as one of the worst compared with its competition.
And adding insult to injury, the delinquency of the portfolio of this company was also higher than the delinquency of its peers and competitors.
What went wrong? Clearly what went wrong is that the company over-engineered the credit policies and processes and did not care about whether the credit managers and all other stakeholders in the company would buy-in. Credit policies and processes were a given and nobody cared about whether or not anyone understood them. They were the invisible clothes of the emperor. Nobody dared to ask whether or not the credit policies and processes, the credit scoring the methodologies, the information emerging from all these robust data sources such as Moody's Analytics had a form to be understood and analyzed.
The short solution: Go back to basics and teach your credit managers and related stakeholders the fundamentals of credit risk management.
In other fields, with the advent of Artificial Inteligence, we are becoming subjects to the dictatorship of the algorithms. And we tend to forget that algorithms emerge from basic intellectual concepts. It is incredible to see how dependent we are in our daily lives of the algorithms invented by Bill Fair and Earl Isaac in 1956, today the FICO Score which is another invisible cloth of the emperor. Do the criteria and the weighing of each of them make sense in modern times? Does it really factor the key issues of credit risk? Everyone believes blindly on the FICO score, and no child has dared to say that "FICO is not wearing anything at all...".
We need to fix this. I am working on this and my campaign starts with a webinar that I will give (in Spanish at present) next July 23, 2019, details at http://www.thealtawebinars.com/index.php/webinars/webinars/webinar-administracion-de-riesgos-para-arrendadoras-empresas-de-renting-y-leasing
But I will keep working on expanding a better foundation of the key concepts of credit risk management. This platform in advisorycloud.com is going to be available for anyone who dares to recognize that in credit risk we do not understand the fundamentals to make the right decisions.
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