Improving Risk Management to Lower Financial Supply Chain Costs
Financing the supply chain has always been a risky business, with so many unpredictable factors to consider. The supply chain can encompass numerous suppliers, distributors and buyers, and a problem with just one link in the chain can result in non-payment elsewhere. There are many types of risk involved in supply chain finance including operational non-performance risk, sovereign risk, transfer risk, currency risk and interest rate risk, but one of the principal risks is corporate credit risk.
The increasing sophistication and electronification of supply chain data are key enablers in enhancing corporate credit risk assessment and performance monitoring, which are dependent on the advanced risk models of banks. Basel II has now provided a framework to better incorporate the various risks measured by banks into the calculation of their capital, which is necessary in supporting the business.
There are several current trends in the supply chain process that are leaving corporates – and the banks that fund their trade flows – open to risks. The following section highlights some of these trends.
One of the major trends within the financial supply chain is the move from trade finance done through documentary credits, such as letters of credit (LCs), to trade done on open account. The move to open account settlement creates several issues for corporates to contend with. For example, the LC was created to mitigate the risk of country and counterparty default in the trade transaction, but corporates trading on an open account settlement basis need to find other ways of obtaining payment security.
A particular issue resulting from the move to open account settlement is the change in counterparty credit risk where suppliers must deal with the credit risk of their buyer, rather than relying on the buyer’s bank to do this.
A further challenge is that electronic payments done on an open account basis are much faster than the LC method: payments are now made electronically within one day compared to a week or more with the still largely paper-based LC process. As a result, there is less time for verification of documents, which could expose corporates to the risk of fraudulent authorisations or inaccurate data.
Finally, LCs provide visibility from the issuance stage through to final delivery of documentation and payment; financing is dependent upon that process. There is much less visibility in open account settled trades so financing cannot easily be tagged to phases such as production, storage, shipping and delivery of the goods. It is important to make open account trading as visible and transparent as possible in order to find ways to efficiently finance it.
For most corporates, however, it still makes sense to use LCs when large transactions are involved and secured payment is vital. For the daily flow of smaller transactions, supply chain finance based on open account data is a much sought after alternative simply because of the lower process cost.
Corporates involved in cross-border trade need to manage various risks simultaneously, such as country risk, bank risk, currency risk and interest rate risk. Hedging currency risk is particularly important with the current volatility between the euro and the US dollar, which also affects exchange rates with Asian currencies. In addition, interest rate risk also affects funding risk. The popular argument to deal in the ‘home’ currency does not mitigate risk per se, it just transfers it to the trading partner – and at the cost of transparency. In this situation, offering optional currency pricing and finance periods could be a potential solution.
Basel II has played an instrumental role in improving regulatory capital requirements in the working capital-related credit space (financing in the supply chain is also a part of this). It enables banks to utilise their internal models to calibrate risk (within certain limits), calculate expected and unexpected losses, consider the value of collateral and incorporate positive risk experiences based on detailed historical data. Experience has shown that the default rate of trades supported by documentary credit is significantly lower than those supported by unspecified working capital funding.
In trade finance, each stage of the financial supply chain, such as purchase orders, sourcing, production, storing, shipping, invoicing and settlement, is associated with different levels of generic risk. This can often be mitigated by using specific financial instruments, which result in lower risk profiles. For example, a bill of lading supported financing provides a low level of risk while goods are being shipped. Likewise, an invoice issued by a supplier and accepted by the buyer diminishes various dilution risks. The lower level of risk means that the bank can finance larger volumes in that specific stage of the supply chain and potentially offer a more beneficial rate compared to a usual cash loan. This is because, in compliance with Basel II risk models, the bank needs to allocate less capital to back assets with inherently lower credit risk. This more efficient use of capital usually makes it easier to fund customers and their partners in the supply chain (banks tend to offer this type of funding through specific funding programmes).
The key to risk management is the availability of, and access to, transactional finance data, having the right risk calibration models and being able to continuously monitor the established profiles. That helps to calibrate product-inherent risk and, in the case of supply chain-linked financing, improve the risk profile. Besides that, enhanced information and data play a further role. In trade finance, banks traditionally measured political and counterparty risk – usually that of other banks and the risk of the bank’s clients whom they finance. The latter involves analysis of the counterparty’s balance sheets, profit and loss accounts, and budgets. The result of this assessment determines the credit appetite and hence the credit availability, which was often not available at the required amount and to the right partner in the overall supply chain.
With the additional assessment of supply chain data, the determination of performance reliability and judgement on past delivery and payment experience, banks now have the potential to add all of these to the traditional counterparty risk assessment. This, coupled with lower (product) risk of financing tightly connected to the underlying trades, creates room for increases or additional credit facilities tailored to specific links in the supply chain. Since banks can follow the financing of each single trade, profile it against benchmark parameters and monitor payment resulting from the underlying transactions, credit performance now tends to be more performance-based and linked to the real flow of assets (being the underlying goods for which there is offer and demand). In this way, Basel II and data management help to better assess the combination of performance and payment risk.
Now turning from theory to more practical terms, how do banks actually access the data and information? Initially, there was the analysis of the trade finance business, i.e. the LC and documentary collection portfolios. Banks who can access their transaction data from previous years have an advantage over those who have to start collecting data – a process that takes years. The historical trade data can be used to set up initial models that can be continuously enhanced and adjusted according to more refined data parameters. Banks can also use these models to create industry-specific profiles that can be benchmarked against individual historical data. This makes it possible to create financing (within certain limits) for new suppliers as well as within a given supply chain.
It is important for buyers, suppliers and banks to consider the financial supply chain in its entirety across the multiple layers of suppliers, manufacturers and clients’ clients, as well as how each party links its performance with the next segment of the financial supply chain, in terms of process, cost and credit availability.
In the past, each buyer and seller in the chain sought financing from its own bank, which meant that each bank based its credit assessment on the relevant business of its client alone. Now the whole supply chain is presented to the bank, usually by the final product owner who typically negotiates a supply chain financing programme, which would include funding for its suppliers. Each supplier then has the choice of either participating in the funding programme, or using other existing means of financing. Overall, with the support of web-based transaction platforms this procedure streamlines the process, reduces operational risk and aligns partners equally.
In order to efficiently establish a supply chain financing programme, capture the necessary data and interact seamlessly with all suppliers as well as the buyer, it is necessary to employ a collaborative platform that actually links suppliers with their buyers and the bank. Such a platform allows the exchange of trade-related data such as purchase orders and invoices electronically. The most advanced platforms are accessible through the Internet and accept data directly via the user’s ERP system. There are several ways in which such a platform reduces risk:
SWIFT’s Trade Services Utility (TSU) enables the transfer of standardised purchase orders and invoice data that can be linked to payments. This forms the basis for cross-border data matching between trading partners, transaction-linked financing and easy straight-through reconciliation. In connection with bank-operated platforms, it creates a powerful proposition that goes well beyond mere financing and provides reconciliation and dispute settlement services as well. Around 60 banks have now signed up to the TSU and more will.
Cost in the financial supply chain can be reduced if there is transparency and co-operation between the larger importing companies and their smaller suppliers (who are likely to have lower credit ratings). As long as the suppliers deliver the contracted goods, the buyer will pay for them. The difference between the lower funding rate of the financially stronger importer and the higher rate of the small cap supplier provides the potential to create attractively engineered packages. The advantage for the importer is that, on the back of such financing programmes, it becomes possible to extend payment terms and re-shape the balance sheet and liquidity position.
Basel II and electronic data management have provided a model for banks to improve their risk assessments and capital allocation in the financial supply chain as well as better measure particular product risks. As a result, they are able to offer more efficient products and create cost advantages for their clients and partners in the supply chain.
When considering the current liquidity crisis in the financial markets, it is vital for corporates to think about diversification of funding sources including supply chain finance alternatives, as such programmes are more likely to be sustained by banks during difficult times, compared with typical commercial lending propositions such as short-term loans and overdrafts.
While achieving lower-cost financing will always be at the top of every corporate’s agenda, there are three key factors that they must acknowledge if they want to significantly improve risk management and efficiency in the financial supply chain. First, they must ensure that they consider the supply chain end-to-end. Second, working within the financial supply chain means sharing advantages; no partner will give up a benefit without something in return. Third, transparency is paramount and that is only achieved by making the relevant transaction finance data available to banks. The initial efforts of setting up ERP interfacing and gaining supplier participation in collaborative funding platforms will eventually facilitate visibility in the supply chain.