Beware the credit risk iceberg

4 November 2021

  • There are new forms of credit risk in the UK’s post-Brexit, post-lockdown trading environment, and much of the danger is below the surface.

  • Customers who have paid on time for years may now be a credit risk.

  • Additional information, through trade credit insurance, is the best way to avoid the credit risk iceberg.

 

UK businesses face a new threat as they trade out of the pandemic: the credit risk iceberg.

Just like the real-life icebergs that sank the Titanic and countless other vessels, the real danger of the credit risk iceberg is that much of the threat lies unseen.

In today's turbulent post-lockdown, post-Brexit environment, companies may significantly underestimate their credit risk because there are new, unpredictable and difficult-to-forecast ways for their customers to fail — leaving them with unpaid invoices.

Companies that have paid on time for years may, without warning, be unable to pay for a whole host of reasons, including disruption to their supply chain, profit collapse due to higher raw material or energy costs, or being unable to repay financing taken out to survive during lockdown.

Michael Hart, senior risk underwriter for Euler Hermes UK & Ireland, comments: “There will be lots of unexpected business failures caused by issues people won't have thought of before.”
 

Credit risk in UK business

Michael says there is a "perfect storm" for UK businesses. On the operational side, firms are struggling with delays from both domestic and international supply chains. Any company reliant on supplies from overseas remains at risk of disruption from overseas lockdowns, such as the partial closure of China's second-busiest container port for two weeks after a single dock worker caught Covid-19.

This is what The Economist has dubbed "The shortage economy". The challenge for any company wanting credit risk mitigation is the difficulty of predicting secondary impacts. For instance, the CO2 shortage in September would clearly hurt makers of fizzy drinks, but few would realise it could disrupt medical equipment supplies and even some nuclear power plants (which use the gas for cooling).

Michael comments: "You might have a customer that fully intends to pay your invoice when it falls due, but can't because of something out of their control — perhaps their supplier's supplier has an issue, or one of their customers further up the supply chain doesn't pay." In an extreme case, a customer may fall victim to the Covid-19 domino effect, becoming part of a chain reaction of failures.

Credit risk and rising interest rates

These operational issues are combined with a harsh financial environment too. Prices, especially for energy, are rising while consumer demand remains subdued. Financial markets expect there will be two interest rate rises by March 2022.

An interest rate rise is bad news because many firms now have a more fragile balance sheet. According to the Bank of England, in March 2021 the UK’s SMEs had 25% more debt than before the pandemic, with many taking on debt for the first time. And a survey by BVA-BDRC showed 30% of SMEs who had taken on finance for the first time during the pandemic were concerned about their ability to repay.

Another part of the hidden risk is that many firms have been dubbed “zombie companies”, barely paying their overheads and at risk of failing from a single adverse event. "There are so many companies that aren't prospering; they're just surviving," says Michael.

"They have no flexibility in their balance sheet, no access to new capital; they're just covering their interest payments. And as prices increase, it's going to be more and more difficult for them to cover their interest payment every month."

Business insolvencies have been rising and are now at pre-pandemic levels. This is despite restrictions on winding-up orders that keep many zombie companies from the grave. However, these protections are time limited. From 1 April 2022, landlords will, for the first time, be able to wind up tenants who didn't make rent payments during lockdown — potentially leading to a further surge in insolvencies.

The challenge of credit risk mitigation

This is a long list of reasons why companies may be unable to meet their payment obligations. But one shared factor is that these below-the-surface risks are difficult to predict using easy-to-access information.

To avoid hitting the iceberg, companies need a more proactive and information-led approach to credit risk mitigation. Marine Bochot, CEO of Euler Hermes Northern Europe, has described how to identify the warning signs of insolvency, such as a trend towards invoice disputes, a request to negotiate contracts, or C-suite resignations.

Extra information that can help detect below-the-surface credit risk is an additional benefit of trade credit insurance. While financial protection after a customer default is the most significant benefit, it also offers information to help with credit analysis and identify trading partners that may appear safe but are in reality at risk of collapse.

This includes both comprehensive, sector-level data on trends and specific intelligence on individual customers. It's the business equivalent of the International Ice Patrol, an organisation set up after the sinking of the Titanic that even today warns shipping in the North Atlantic about icebergs. Any ship’s captain in treacherous waters needs alerts to avoid icebergs - any business owner needs alerts to avoid the credit risk iceberg.