Identifying Lender Risks – Identifying and

Mitigating Risks in Lender Finance

by Joey Shadeck

Lender Finance: A Fast-Paced Frontier in Lending

All financing institutions know that they must accept a certain amount of lender risks
when lending to factors, asset-based lenders, and entrepreneurs. But in the fast-paced
environment of lending to factors and asset-based lenders, evaluating potential clients
requires thorough investigations of their assets and company holdings to identify and
mitigate potential lender risk. Because of the pace in which funds are dispersed by
factors, it is incredibly important that factors understand everything at play in a
company’s books before lending.

Risks for Factors

There are several different categories of risk that factors must take into account before
lending to a fellow factor. First, conducting basic background and financial checks can
help to mitigate risk and avoid high-risk agreements.

Before entering an A/R lending agreement, factors should take multiple aspects of a
company’s overall state of financial health and viability into consideration:

Counterparty Credit Risk

Counterparty risk is defined as the possibility that a debtor you do business with will be
unable to meet the obligations that they have agreed to. If a debtor is unable to fulfill
their obligations in some way, it is important that a plan is set in motion to mitigate and
minimize losses. Counterparty risk can present a serious problem for factors and can be
difficult to foresee due to its technical nature. Typically, A/R lenders see increases in
counterparty risk when customers and those with outstanding invoices start behaving
differently than they have in the past. They may begin paying late, avoid paying at all, or
have sudden changes in their credit status. Counterparty risk is always present for
factors, who should remain vigilant in identifying potential situations that could increase
counterparty risk.

Fraud Risk

For factors, there is always the risk that a company you reach an agreement with may
commit fraud in an effort to avoid paying the agreed upon amounts. Reducing the risk of
fraud begins with evaluating the company’s character, but even that can only produce
so much faith. For larger agreements, lenders may want to consider performing in-depth
audits, as well as ensuring that your organization has the proper fraud insurance
policies in place to mitigate risks.

According to an IFA Business Profile and Performance Survey for Factoring Firms, in
the US, 83% of factors reported that they had encountered some sort of fraud within the
last five years of operation. Only 17% of all factoring firms reported that they had never
encountered fraud at all. There are a few ways in which factors typically see debtors
committing fraud:

Fake invoicing. Creating invoices for services or products that were not actually
delivered in an attempt to secure larger sums of cash from a lender. This is a common
practice among fraudulent borrowers and can typically be spotted with an audit, or by
digging deeper into their accounts receivable history. Fake invoicing is only worthwhile
to fraudsters when done to facilitate large increases from a factor. Keep an eye out for
clients with large invoices that are out of character for their clients, based on their
history with a company.

Misdirected payments. Misdirected payment fraud typically takes place when a debtor
instructs their clients to post their payments for products or services rendered to
someone other than the lender to whom they sold their accounts receivable obligations.
These misguided attempts are often easily spotted as the factor begins to reach out to
parties to settle their invoices, only to find that they believe that they have already paid.

Pre-invoicing. Pre-invoicing is a very common form of fraud that factors deal with on a
regular basis. This occurs when a company creates invoices for future products or
services before they have been delivered and before they have officially reached an
agreement with a company. In the case of a manufacturing company, they may create
invoices for customers that have yet to place their order, but are planning on placing it in
the near future. Pre-invoicing can also include real invoices that have been backdated
to fall within the scope of the agreement with a factor.

There are multiple steps that any lender finance company can take to mitigate fraud
risk.

At Hitachi Business Finance, we work with factors to help them to identify and mitigate
potentially risky situations with clients. Fraud is more common in certain industries.
According to an IFA Business Profile and Performance Survey, transportation is the
largest industry for factors, accounting for more than 26% of invoices funded during that
year. The simplest way for factors to mitigate fraud risk is to ensure that they have
secured a fraud insurance policy that covers these common types of fraud. Many
factors also institute policies that require full audits of clients prior to entering an
agreement.

International Legal Risks

Another common risk for business financing companies that offer their financing
services to companies in other countries is the instability and lack of familiarity of foreign
laws and regulations. Before entering into an agreement with a company in any foreign
country, it is important that you are able to identify the potential legal risks that A/R
lending creates, and speak with qualified legal experts in the region to gain deeper
insight. It is important for factors to seek out legal representation with knowledge of the
lending laws in a specific country before entering into any lending agreements.

Operational Risks
Operational risks are a common risk for lenders, but can be avoided or mitigated with
excellent planning and client onboarding processes. Most operational risks come in the
form of contract disputes, and can occur between both a factor and their client, or a
factor and invoiced debtors. By taking time to go over agreements line-by-line with
clients, you can ensure that both parties are aware of the details of the contract and
avoid potential contract disputes before they arise.

IRS Lien Risk

When clients are forced to pay IRS liens associated with payroll taxes, it can negatively
affect your ability to collect on outstanding debts from customers. A pre-agreement audit
can expose when a business is at risk for IRS liens and allow you to avoid potential risk.

Avoiding Risk

Evaluate a Company’s Character

Although factors typically lend based on accounts receivable assets, evaluating a

company’s character is always a worthwhile step before entering into an agreement. We
go through an in-depth vetting process when evaluating clients, including lender finance
companies that we partner with. You must have faith that a company has been honest
about their business and has not “cooked the books” in some way to make their
accounts receivable seem more valuable than they actually are. Just taking a small
amount of time to get to know a company and better understand their business
processes can help limit bad loans.

Conduct In-Depth Audits

Although many factors will perform an audit of any business before entering into a
lending agreement, not all go to great lengths to ensure that they know each client
inside and out. An in-depth audit of accounts receivable and other relevant portions of
the business can help expose risks and allow factors to make smart decisions regarding
which companies they enter into agreements with. Audits can expose companies that
might be in poor financial positions, which may increase their likelihood of committing
fraud or placing a factor in a risky situation.
All lending companies must agree to take on certain levels of risk when entering into
agreements with borrowers. The risk profile of a specific borrower will affect the
agreement in place and the control over collateral that is exercised by factors. Accounts
receivable lending services often require that lenders and borrowers enter into
agreements more quickly than traditional loans would allow in order to provide a
stimulus of cash flow that allows a business to grow and reach their goals. The speed in
which this lending takes place can lead to lenders overlooking potential risk factors.
However, with in-depth evaluations and audits, factors can mitigate risk and identify
exceptionally risky borrowers.

Hitachi Business Finance offers a full complement of lender finance solutions for factors
in the manufacturing, staffing, and transportation industries. We focus on educating our
clients so they can maintain a strong portfolio of healthy loans. Call us today to see
which of our flexible lending solutions is a good fit for you and your clients.
A credit risk is the risk of default on a debt that may arise from a borrower failing to make required
payments.[1] In the first resort, the risk is that of the lender and includes lost principal and interest,
disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an
efficient market, higher levels of credit risk will be associated with higher borrowing costs.[2] Because
of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels
based on assessments by market participants.[3][4]
Losses can arise in a number of circumstances,[5] for example:

 A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or
other loan.
 A company is unable to repay asset-secured fixed or floating charge debt.
 A business or consumer does not pay a trade invoice when due.
 A business does not pay an employee's earned wages when due.
 A business or government bond issuer does not make a payment on a coupon or principal
payment when due.
 An insolvent insurance company does not pay a policy obligation.
 An insolvent bank won't return funds to a depositor.
 A government grants bankruptcy protection to an insolvent consumer or business.
To reduce the lender's credit risk, the lender may perform a credit check on the prospective
borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance,
or seek security over some assets of the borrower or a guarantee from a third party. The lender can
also take out insurance against the risk or on-sell the debt to another company. In general, the
higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt.
Credit risk mainly arises when borrowers are unable to pay due willingly or unwillingly.

A credit risk can be of the following types:[6]

 Credit default risk – The risk of loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on any material credit obligation;
default risk may impact all credit-sensitive transactions, including loans, securities
and derivatives.
 Concentration risk – The risk associated with any single exposure or group of exposures with
the potential to produce large enough losses to threaten a bank's core operations. It may arise in
the form of single name concentration or industry concentration.
 Country risk – The risk of loss arising from a sovereign state freezing foreign currency payments
(transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk is
prominently associated with the country's macroeconomic performance and its political stability.

Assessment[edit]
Main articles: Credit analysis and Consumer credit risk

Significant resources and sophisticated programs are used to analyze and manage risk.[7] Some
companies run a credit risk department whose job is to assess the financial health of their
customers, and extend credit (or not) accordingly. They may use in-house programs to advise on
avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies
like Standard & Poor's, Moody's, Fitch Ratings, DBRS, Dun and Bradstreet, Bureau van
Dijk and Rapid Ratings International provide such information for a fee.
For large companies with liquidly traded corporate bonds or Credit Default Swaps, bond yield
spreads and credit default swap spreads indicate market participants assessments of credit risk and
may be used as a reference point to price loans or trigger collateral calls.[4][3]
Most lenders employ their own models (credit scorecards) to rank potential and existing customers
according to risk, and then apply appropriate strategies.[8] With products such as unsecured personal
loans or mortgages, lenders charge a higher price for higher risk customers and vice versa.[9][10] With
revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit
limits. Some products also require collateral, usually an asset that is pledged to secure the
repayment of the loan.[11]
Credit scoring models also form part of the framework used by banks or lending institutions to grant
credit to clients.[12] For corporate and commercial borrowers, these models generally have qualitative
and quantitative sections outlining various aspects of the risk including, but not limited to, operating
experience, management expertise, asset quality, and leverage and liquidity ratios, respectively.
Once this information has been fully reviewed by credit officers and credit committees, the lender
provides the funds subject to the terms and conditions presented within the contract (as outlined
above).[13][14]

Sovereign risk[edit]
Sovereign credit risk is the risk of a government being unwilling or unable to meet its loan
obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in the late-
2000s global recession. The existence of such risk means that creditors should take a two-stage
decision process when deciding to lend to a firm based in a foreign country. Firstly one should
consider the sovereign risk quality of the country and then consider the firm's credit quality.[15]
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:[16]

 Debt service ratio

 Import ratio
 Investment ratio
 Variance of export revenue
 Domestic money supply growth
The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance
of export revenue and domestic money supply growth.[16] The likelihood of rescheduling is a
decreasing function of investment ratio due to future economic productivity gains. Debt rescheduling
likelihood can increase if the investment ratio rises as the foreign country could become less
dependent on its external creditors and so be less concerned about receiving credit from these
countries/investors.[17]

Counterparty risk[edit]
A counterparty risk, also known as a default risk, is a risk that a counterparty will not pay as
obligated on a bond, derivative, insurance policy, or other contract.[18] Financial institutions or other
transaction counterparties may hedge or take out credit insurance or, particularly in the context of
derivatives, require the posting of collateral. Offsetting counterparty risk is not always possible, e.g.
because of temporary liquidity issues or longer term systemic reasons.[19]
Counterparty risk increases due to positively correlated risk factors. Accounting for correlation
between portfolio risk factors and counterparty default in risk management methodology is not
trivial.[20]

Mitigation[edit]
Lenders mitigate credit risk in a number of ways, including:

 Risk-based pricing – Lenders may charge a higher interest rate to borrowers who are more
likely to default, a practice called risk-based pricing. Lenders consider factors relating to the
loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield
(credit spread).
 Covenants – Lenders may write stipulations on the borrower, called covenants, into loan
agreements, such as:[21]
 Periodically report its financial condition,
 Refrain from paying dividends, repurchasing shares, borrowing further, or other specific,
voluntary actions that negatively affect the company's financial position, and
 Repay the loan in full, at the lender's request, in certain events such as changes in the
borrower's debt-to-equity ratio or interest coverage ratio.
 Credit insurance and credit derivatives – Lenders and bond holders may hedge their credit
risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk
from the lender to the seller (insurer) in exchange for payment. The most common credit
derivative is the credit default swap.
 Tightening – Lenders can reduce credit risk by reducing the amount of credit extended, either in
total or to certain borrowers. For example, a distributor selling its products to a
troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net
15.
 Diversification – Lenders to a small number of borrowers (or kinds of borrower) face a high
degree of unsystematic credit risk, called concentration risk.[22] Lenders reduce this risk
by diversifying the borrower pool.
 Deposit insurance – Governments may establish deposit insurance to guarantee bank
deposits in the event of insolvency and to encourage consumers to hold their savings in the
banking system instead of in cash.