Risky Business: Credit

In times of financial turmoil, no trade entity is impervious to the threat of credit risk. Credit risk can disable a supply chain by highlighting the poor financial health of its weakest link – thus exposing even financially-sound corporates to disruption. In addition to maintaining creditworthiness, corporates must therefore exercise caution when choosing counterparties, bank partners and when deciding on trade practices.

Doing the Groundwork

The knowledge of whether or not a supplier is financially secure and has access to funding is pivotal to a corporate’s business sustainability. Companies must do their groundwork and thoroughly evaluate their counterparties – both initially and at regular intervals throughout the duration of their commercial relationships.

During the primary evaluation, a corporate can judge whether it should execute – or terminate – the proposed business transaction. Certainly, it must confirm the creditworthiness of its counterparties prior to engaging in the business of buying and selling and seeking ancillary judgement is a key way to enrich this assessment. Put simply, the more external sources used to verify the reliability (or not, as the case may be) of the trade partner in question, the less credit risk taken by the corporate.

Additionally, companies ought to examine not only their counterparties’ financial stability, but also their ability to cope with any unexpected circumstances that may have adverse effects on their business capability and continuity. This is essential as key supplier failure has the power to break supply chains and bring even the strongest of corporates to its knees.

External Market Challenges

From both a financial and practical standpoint, counterparty capability is a crucial issue. After all, an over-ambitious transaction heightens credit risk – regardless of the counterparty’s fundamental creditworthiness. Corporates must therefore stay conscious of the credit intensity, related capital and underlying liquidity of the transaction(s) at hand. In order to further mitigate counterparty risk, companies would be wise to have a broad range of trading partners so as to spread the risk across several parties, rather than concentrate it on one single supplier.

Once again, this also has its more practical purposes. Supplier diversity means that companies can ensure that they have sources within reach of the markets they serve and minimise the threat of commercial disruption. Such disturbance may be caused by any number of arising changes and challenges in the financial environment, making it vital that companies continually monitor external market developments and assess the threat they may pose to both themselves and their trade partners.

To give an example of the ways in which circumstances may change, what may once have been a safe economic environment could quickly become a perilous purchasing market, and a corporate’s counterparties must have adequate liquidity and a solid capital base if they are to avoid becoming too great a trade risk. Corporates should also remain conscious of the impact that non-economic external factors (such as natural disasters) could have on the supply chain, and take precautions to prepare for the knock-on effect this could have on credit risk.

Yet conducting such evaluations and keeping a constant eye on market developments (and, more specifically, counterparty responses to these developments) can be obstructed by low levels of transparency, which are at risk of becoming lower still as commercial networks become increasingly complex.

One way for corporates to remedy this situation is through the increased sharing and centralisation of data. By extracting and collecting data from the various transactional systems in the supply chain, corporates can have a single seamless view of all the necessary information. And this may flag-up potential problems that could otherwise have gone unnoticed until it was too late. In addition to increasing how regularly this information is checked, corporates should also seek to increase the number of people checking. In doing so, the corporate can improve transparency, and subsequently the quality of its counterparty analysis.

A Daring Move Versus Safety and Security

In today’s global economic climate, the decision of whether to trade via open account or by using letters of credit (L/Cs) should be an easy one. Trading on open account has become the norm, although usually involves credit insurance and is most usually between long-standing trade counterparties. Yet as the risks in the economy increase, so does the attraction of many companies towards the security of L/Cs. Of course, open account is both cheaper and simpler than L/Cs. Yet staking business security and survival in exchange for convenience, or even higher yields, can seem reckless, and leaves the corporate defenceless against credit risk.

L/Cs, on the other hand, offer advantages to all parties in the supply chain – guaranteeing payment, and helping to reduce production risk. Furthermore they offer stability amid a turbulent economy – keeping the exchange rates between currencies the same as that specified in the L/C at the time of its creation. Given this, their use is a vital practice in mitigating credit risk. Similarly, a corporate should consider requesting some form of collateral in every transaction – regardless of the strength of its relationship with the counterparty. Even the best intentions can be forgotten in the face of adversity, and the risk is again, too high to leave to trust and hope.

Joining Forces

Many companies wishing to trade through L/Cs would prefer to work with local banks, rather than global banks – least to ensure the consigned L/C is valid. Local banks offer physical proximity to their domestic corporate clients and a historic presence in their home market. However, one area in which many fall short is risk assessment. This comes as a result of the rise in trade by open account, as well as the subsequent centralisation of bank lending decisions, which has adversely affected the capabilities of local branches to perform this task. In light of this (not inconsiderable) disadvantage, many corporates that would rather partner with a local bank are now using the services of a bank that operates collaboratively with its global counterparts within the industry. In working with a local bank that has teamed up with a global bank, companies have access to the benefits both scales can offer. At the same time, they also overcome the hurdles that a local bank may struggle with alone.

In short, corporates can mitigate credit risk through improved counterparty communication and evaluation, increased transparency and better risk management generally – which includes the use of L/Cs. Certainly, this can be achieved through the gathering of banks into what may be termed a ‘transactional ecosystem’ that can adapt and grow as the economic environment changes. Furthermore, the use of an ecosystem encourages data sharing and thus increases transparency. Through joining forces, local banks are better able to ramp-up corporate defences to the threat of credit risk. As a result, partnering with a local bank that, through collaboration with a global player, is able to combine local expertise with global reach and capability, is perhaps the best effort a corporate can make towards safeguarding its business, despite the uncertainty of the current economic climate.

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