From the Analysts



 Managing Acquiring Portfolio Credit Risk:

by Jennifer Kane

There are two types of merchant portfolio risk: fraud risk and credit risk. Fraud risk is the risk of uncollectable chargebacks due to criminal or collusive merchant behavior. Fraud risk tends not to be correlated with portfolio size; it is often unpredictable and is managed by monitoring merchant behavior vigilantly and by taking swift action when warning signs appear.

Credit risk is the risk of uncollectable chargebacks and lost fees due to merchant bankruptcy. Unlike fraud risk, acquirers can often predict credit risk as it is a function of merchant size, the merchant's financial condition and the merchant's chargeback profile. Sometimes credit and fraud risk can be intertwined. For example, a cash-strapped merchant may turn to fraudulent behavior, such as processing a transaction before shipping goods, before going bankrupt.

As the economy softens, many acquirers have a heightened awareness of credit risk. This article discusses credit risk and ways in which acquirers can mitigate credit risk.
Credit risk is a function of three different factors:

    Volume of chargebacks and returns - merchants with higher levels are more risky than those with lower levels as there are greater dollars at risk in the event of a business failure.
    Prevalence of business failures - some industries are more susceptible than others to business failure.
    Financial condition of counterparty -- when a merchant's financial condition deteriorates, there is a greater risk of non-collection of funds.

Acquirers can offset risk in several ways. Acquirers can establish collateral on the merchant's account to serve as a safeguard against latent claims. Acquirers can ask for merchant reserves at the time of account establishment or can hold back reserves from deposits. Second, if the acquirer works with ISOs, the acquirer can ask ISOs to provide a guarantee against merchant losses through letters of credit or other types of collateral. The success of this recourse is dependent on the creditworthiness of the ISOs. A third way to offset risk is by terminating or selling high risk segments of the portfolio to reduce aggregate portfolio risk. A fourth way that acquirers can offset risk is by implementing risk-based pricing. Though higher pricing will not reduce risk, it may make sure the risk/reward trade-off is sound.

In addition, acquirers can mitigate credit risk through back-end monitoring. For example, acquirers can analyze a merchant's financial condition periodically by requesting and reviewing financial statements. Acquirers can also collect fees on a daily basis to mitigate losses in the event of a merchant's bankruptcy. A third tactic is managing merchant settlement. Acquirers can generate float against which they have the right to offset to hedge against business failure. The float can be the result of an acquirer's funds availability policy or of back-end monitoring where an acquirer suspends funds.

Mitigating risk is an ongoing process that acquirers cannot neglect. The tactics described above, if employed regularly, should help acquirers reduce the riskiness of their portfolios.

Jennifer Kane is a senior consultant at First Annapolis Consulting, Inc. She specializes in the merchant acquiring industry.

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