An introduction to credit risk in payments
In this article, we cover credit risk, what credit risk exists for payment processors and how it should be managed.
Credit risk is often overlooked by acquirers, and this can be catastrophic. In this article, we take a closer look at what credit risk exists for payment processors and how it should be managed.
What is credit risk?
Credit risk is the possibility of financial loss resulting from a corporate or consumer’s inability to fulfill its contractual obligations. For payment companies, credit risk arises following an initial extension of a credit line, and loss occurs when the merchant is unable to repay their facility.
Why is credit risk management important?
Payment companies offering card processing facilities do not extend credit facilities in the traditional sense. So why should payment companies worry about credit risk management?
This is an intriguing question and one that many payment companies, especially smaller start-ups and those operating independent sales organization and payment facilitator models, often fail to address properly. While other risk areas such as fraud, scheme, and reputational risk are prioritized, credit risk often gets forgotten about. This is usually because, until credit losses are seen, a lot of companies don’t realize this risk is present in their portfolio.
Although payment companies do not lend tangible amounts or extend a fixed “line of credit” to merchants, payment companies are contingently liable as soon as a merchant’s card transactions are processed and cleared through the card schemes. As such, credit risk includes a contingent liability in the event of a chargeback whereby the merchant is unwilling and/or unable to fund the amount of the receivable of the acquirer.
It's common for payment to be taken well in advance of delivery. Payment companies will often settle to the merchant a few days after the transaction, so the payment company has, in effect, pre-funded the merchant and offered a ‘line of credit’ on the premise that the merchant will deliver a purchased good as promised. If the merchant goes bankrupt between the initial purchase and the expected delivery date, consumers can go to their card issuer and request a chargeback.
As a payment company, we in essence indemnify that consumer and, in turn, are required to repay funds. The payment company can then try to reclaim the funds from the merchant. However, if that merchant is no longer trading, this could prove impossible, incurring a credit loss.
Types of credit risk
There are three distinct types of credit risk faced by every payment processor:
1. Credit default
Credit default occurs when the borrower simply cannot repay their loan. The risk of credit default is dynamic, often reliant on the customer’s changing financial situation. For a payment processor, it’s critical that they can accurately calculate credit default risks for every borrower.
2. Concentration
Concentration risk occurs from failure to diversify loans. Concentrating lending on a small number of merchants or industry sectors increases the risk and impact of default. Diversifying across borrowers and industries will help to contain risk in the event of default.
3. Country
Political instability and macroeconomic factors affect borrowers' capacity to repay. This is particularly true when lending to foreign markets. Payment processors must be able to accurately assess local factors before lending to ensure they can implement suitable mitigations, or service merchants that are deemed too risky.
Choosing the right financial services solutions is critical to managing and mitigating each of these risks.
The role of credit risk in payments
A common misperception is that a credit risk team, as well as wider risk functions, is there to prevent loss, which is not strictly true. The function should be to understand and manage credit risk within the risk tolerances of the business. Trying to prevent all loss is not only impossible but would also require such strict and overbearing risk rules that the business would be uncompetitive. As such, every payments company must accept a degree of acceptable loss, and the key is to understand what is considered acceptable.
How to assess credit risk
Payment providers can use the ‘Five Cs of Credit’, a well-known credit risk best practice framework to define “acceptable risk”:
Capacity
Capacity measures the borrower’s ability to repay a loan based on income relative to existing debt obligations. Capacity is calculated by analyzing cash flow, debt-to-income ratios, and overall financial stability to determine if the borrower can meet additional debt payments.
Capital
Capital represents the borrower’s financial resources and net worth, including savings, investments, and other assets that could be used to repay the loan if primary income sources fail. This provides a cushion that reduces the lender’s risk.
Conditions
Conditions encompass external factors such as economic environment, interest rates, industry trends, and the specific purpose of the loan. These factors can significantly impact a borrower’s ability to repay, regardless of their individual financial strength.
Character
Character refers to the borrower’s reputation and record of repaying debts, typically assessed through credit history and payment patterns. The borrower should demonstrate a history of reliability in meeting financial obligations.
Collateral
Collateral consists of assets that secure the loan and can be seized if the borrower defaults on the loan. This tangible backing reduces the lender’s potential losses and often allows for more favorable loan terms.
How Paysafe assists with credit risk assessment
Paysafe focuses on two critical components for credit risk assessment: exposure calculation and likelihood of failure analysis. Exposure represents the total potential loss if a merchant becomes insolvent, typically calculated as the value of processing during a merchant’s average delivery period. Likelihood of failure assessment uses financial analysis, external credit ratings, and internal rating methodologies to predict merchant default probability.
Mitigating credit risk
While there is little a payments company can do to change the likelihood of failure, the credit risk function can reduce exposure across a portfolio to more acceptable levels, commonly referred to as ‘risk mitigation’. Paysafe offers multiple risk mitigation options, including cash collateral, bonding, insurance, trust arrangements, letters of credit, and guarantees. Paysafe’s approach considers merchant profitability a mitigating factor and avoids unnecessary terminations that could, in turn, trigger the failures it aims to prevent.
If securing against a risk is not a viable option, then the clearest way to remove exposure from the portfolio is to terminate a merchant relationship. However, this presents its own risk. Removing payment facilities can often mean the merchant is no longer able to trade or they see a significant impact on their liquidity, especially if they fail to obtain facilities elsewhere. Thus, the merchant may, through the action of termination, subsequently fail.
You may think that upon termination, this failure would no longer be an issue for the payment company. But even upon termination, the payment company is still liable for the transactions processed previously. As such, termination is the last resort and can, in some instances, cause the very thing you are trying to avoid: merchant failure and credit loss.
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