Managing Risk in Trade Finance
Bankers have ceased to be surprised when a customer in Germany says that his main warehouse is in Rotterdam not the Ruhr. European integration has truly eroded lines on the map as far as many businesses are concerned and in Germany, in particular, the distinction between domestic and cross-border trade is vanishing fast. What is now the world’s largest exporter sits in the middle of this European market dominating EU trade and is increasingly pivotal in commerce with the fast growing nations further east.
At the same time integration, the advent of the euro and moves to a single payment system have combined to untangle much of the bureaucratic string that once tied exporters and importers up in knots. Where an exporter might once have had to fill in 16 different forms, customs paperwork, certificates of origin and all the rest, now just one can sometimes be enough, at least within the EU.
Life has rarely looked better for the export sales manager of a German company. But for his or her corporate risk colleague handling the company’s credit exposure, life is not so straightforward. The excited sales manager has found a new customer in Poland, for example, but the risk manager, paid to worry about such matters, points out that they have little idea of the customer’s creditworthiness. And on top of this counter-party risk, there still remains political risk even in these days when globalisation is the buzzword on everybody’s lips.
Even where the eager sales manager wants to sell more to a known rather than a new customer the risk manager may still be concerned. After carrying out all the usual due diligence into the off-taker’s creditworthiness the risk manager has most likely set prudential concentration limits on the customer’s purchases or on all sales to the country concerned. After all it is not so long ago since overstretched Polish distributors of imported consumer electronics caused major headaches for their suppliers.
What the sales manager is now proposing means that the risk manager has to scrap the limits – or find a more creative solution in which the limits are retained but risk is laid off above this level.
At one time the risk manager might simply have demanded a letter of credit, bank guarantee or other bank instrument. But there has been a marked decline in the use of tools like these which in oiling the wheels of trade also provided a measure of risk protection. Cross border trade flows now total $7.3 trillion. Of this some 85 per cent is now conducted on an “open account” basis. And almost all domestic commerce is carried out the same way. This is obviously attractive for the purchaser of goods, less so for the seller, the German company, concerned over the risk that his buyer may become insolvent before paying for the shipped goods.
In order to give his or her sales manager at least a qualified “yes” in setting a credit limit for the new Polish customer, the German risk manager has of course been able to turn to purchasing credit insurance to provide some protection against default.
There is too the option of factoring the exporting company’s accounts receivable. But factoring is aimed largely at smaller companies and in any case is used mostly in domestic, not cross-border trade. Risk mitigation can be offered as part of factoring but it is not the essential feature of a complex product whose main attribute is providing finance together with helping companies with ledger management and accounts collection.
Receivables-based finance provides the risk manager with a third option, one which is simpler than factoring. Major banks provide receivables-based finance in ways that mitigate the risks involved in “open account” trading. This can be funded or unfunded depending on whether the German exporter or, in the example, his Polish customer does or does not need credit.
Managing risk in trade finance is in effect part and parcel of the way banks are increasingly involved in financing supply chain management. All companies wish to sell more but at the same time there is increasing pressure to manage working capital including accounts receivable. Buyers push their suppliers to accept payment terms pushed from 30 to 60 or even 90 days even though the supplier may now have to finance a larger inventory to meet just-in-time delivery.
Banks square the circle, injecting liquidity into the supply chain so that the supplier is able to withstand the pressure to provide more and more of his customer’s working capital.
The German exporter enters into an agreement with his bank to mitigate the risk and supply finance to underpin sales to the new Polish customer. After it has shipped the goods and the Polish importer has accepted them, the German company in effect sells the related account receivable, in this case the invoice, to the bank on a “limited recourse” basis.
The company has got its money upfront, the full value of the invoice less the discount applied by the bank, and has also obtained cover against the big risk, that of insolvency. The German company has also covered itself against other possibilities, for example the risk that the importing nation imposes a freeze on overseas payments.
The seller has not covered against the risk of a commercial dispute – for example the possibility that the Polish buyer disputes the quality of goods and withholds eventual payment. In such a case the bank may reserve the right to reclaim its funds from the German seller. But it is important to remember that commercial risks are hardly absent in other risk mitigating techniques. Credit insurance is also typically invalidated in commercial disputes.
The German company may be able to negotiate a favourable deal with a bank offering such arrangements. There may be a credit arbitrage opportunity for the seller if the intermediary bank reckons the buyer of the goods is a better risk. The seller is in a sense borrowing his customer’s better credit rating and paying less as a result. This will increasingly be complemented by the proposed Basel II agreement on regulatory risk capital, which will have the effect of encouraging banks to lend against receivables since such exposure will require less capital backing than hitherto.
Invoice discounting is not the only risk management tool in receivables finance though it is likely to be particularly suitable for the German exporter. The other main alternative is “forfaiting” where the bank discounts not the invoice but a bill of exchange, promissory note or draft. The selling company can endorse these “without” recourse, because the bills evidence the buyer’s unconditional promise to pay. The German seller obtains its money and covers itself against all risks, including commercial disputes.
However the scope for relying on bills discounting is limited. At one stage bills were common but their widespread use is now restricted to Latin American and some parts of central Europe.
Exporters can also tap into distribution finance arrangements in which the bank, rather than provide finance to the exporter, in effects funds the importer. Such arrangements are ideal in rapidly growing consumer markets like those in Central and Eastern Europe where distributors of consumer goods may lack ready sources of finance to stock the market’s growing needs.
Again the bank is helping mitigate risk and providing finance in circumstances where both the exporter and distributor wish to expand sales. In return for advancing money to the distributor the bank may in the early stages insist on full recourse to the exporter but as the relationship develops there is frequently a risk sharing agreement between exporter and bank.
The risk manager may be fortunate enough to work for an exporting company that is flush with funds or is such a good name in credit markets that it can fund itself at low rates. The company may nonetheless have an appetite for risk mitigation. In these circumstances the risk manager can obtain a payment undertaking from a bank, an arrangement that typically is renewable every 12 months.
In a payment undertaking the risk manager obtains the assurance that in return for a fee based on the total value of invoices in the year the bank will buy defaulted receivables if the buying company fails to pay within a certain time. A payment undertaking can be an attractive alternative to conventional credit insurance where claims can take up to 180 days to settle and where coverage is usually limited to 80 per cent of the loss, although fewer losses are typically covered.
Other unfunded arrangements that mitigate risk include maturity factoring where a bank agrees to pay for assigned invoices only on the due date, taking the insolvency risk of the buyer. In all cases, the risk manager will find banks anxious to tailor arrangements to his particular needs.
By opting for a payment undertaking or receivables-based finance programme the risk manager is tapping into a resource that helps his company reduce risk or increase sales without increasing risk. The manager is buying in an additional credit facility where mitigating risk is paramount. Such arrangements are easily revised if, after increasing sales to a customer and experiencing no problems, the seller develops a greater appetite for risk.