Best Practices in Managing Credit Risk: Relationships and Transparency Complement the Fundamentals
The financial crisis has had significant effects, not only for the banking industry but in the way that banks and their small business, commercial and corporate clients interact. Within these relationships management of credit risk has re-emerged as a core discipline requiring attention across the spectrum from bankers to finance and treasury executives.
The crisis in 2008 brought into sharp focus that risk is still a reality in cross-border commerce and has highlighted the importance of risk mitigation disciplines, practices and solutions in the conduct of international business, including international trade. Clients and bankers must leverage proven risk management solutions, while at the same time devise new risk assessment and management tools to meet the changing sourcing patterns and trading mechanisms that facilitate international commerce today. There is now a heightened awareness of risk in international commerce and this is driving a requirement to refocus on quality relationships, credit analysis and adjudication, appropriate risk optimisation, and mitigation strategies and solutions.
Credit risk, including sovereign/country risk, foreign bank risk and counterparty risk are high on the agenda with companies and banks also looking at the degree of concentration of their risk. Post-crisis, it has become evident that the global banking model is broken and, following the harsh lessons that have been learned in recent years, risk needs to be managed more effectively. The clearest path to this is by spreading risk around numerous banking partners, choosing best of breed providers in each region. Consequently, corporates are no longer looking to use one global provider to fulfil their cross-border business requirements as before the crisis.
While bankers and finance executives lost sight of the risk element – and prudent risk management in the context of trade – the imperative to refocus on effective credit and risk management in banking, treasury and financial management will prove beneficial to the successful conduct of business across the globe. We have seen a flight to quality as bankers and business clients carefully select the relationships they wish to focus on, and take a much more partnership-oriented, less opportunistic and transactional approach to those relationships.
Part of this relationship process involves greater dialogue and increased transparency between bankers and their clients, particularly in the context of credit adjudication, risk assessment and overall relationship management. While there has been some reticence in certain client segments and in some regional markets about complete disclosure to bankers, and some sense that banks are making increasingly intrusive demands upon clients, the reality is that regulatory pressures and reporting requirements, in addition to a heightened sensitivity around risk, are at the root of such demands. Small business, mid-market and corporate clients whose finance executives appreciate these realities are developing robust partnerships with their bankers.
A clear illustration of this evolution in bank partnerships is the relatively new form of partnership between large global or quasi-global banks and local or regional institutions. Such alliances, historically dominated by the larger institutions, have become more like strategic alliances, with each bank bringing complementary value to the table, in service of commercial and corporate end-clients.
Large global institutions realise that, while they have the capabilities and technologies in place, they do not know the local market as well as regional banks. A partnership with local institutions dramatically enhances the services and advice that can be provided to corporates who are able to use local partners’ greater understanding of their businesses and the individual market.
With impending regulation, such as Basel III, impacting not just banks, but the way in which they manage commercial relationships, corporates now need to be aware themselves of the impact that these new regulations will have on them. As a result, banks increasingly need to understand the supply chain context for their clients, and exactly how clients operate in these chains.
Paramount to this greater need to understand clients is an increasing emphasis on transparency, which is best achieved via partnerships. Banks and corporates now realise that the more informed banking partners are, the better the risk mitigation solutions and products they provide in order to enhance its client’s success.
By developing strong and transparent partnerships corporates are able to mitigate risk and operate with greater efficiency. The greater the depth of a bank’s knowledge of a corporate’s business the more effectively it will be able to provide and position appropriate solutions. The more transparent treasurers and finance executives are in communications with their banks, the more the banks will be able to integrate their ability to provide solutions into corporate activity.
Transparency subsequently plays a key role in mitigating risk. While corporates may wish to completely eliminate risk this is realistically unfeasible, and as such they need to seek risk mitigation solutions that are appropriate to their business and balance any approach to risk. Such solutions need to optimise risk, striking a balance between acceptable levels of risk and the cost of mitigating risk appropriately, given risk appetite and target return parameters.
Developing strong partnerships and open communication between partners plays a key role in generating effective risk mitigation solutions. Emerging from these strengthened partnerships are improved processes, better visibility within the business and further transparency both at the strategic level, in terms of business objectives and direction, and at the transaction level, such as working capital and cash positions. In turn, we see this leading to more effective cash management and ultimately optimisation of working capital. Well-informed banks are far better enabled to offer cohesive solutions to the problems that are facing corporate executives and act as ‘trusted advisors’.
At times we have seen a degree of reluctance among finance executives and treasurers to divulge more information than deemed necessary, preferring to give banks the information they feel is needed, but little beyond this. It is important for corporates to realise that the more that banking partners know about their business, the challenges they are dealing with and the strategies that they have in place, the better equipped we are to come up with solutions.
Not only is transparency key in partnership with banking providers, but its relevance is also important internally within corporates. Again this is another area in which banks can provide solutions. For example, the enhanced visibility of cash, alongside more optimised working capital is crucial in streamlining and safeguarding process within clients’ businesses. Corporates are recognising that in order to optimise their working capital they need to maximise the efficiency of their cash management across the spectrum.
As risk has risen on the agenda, access to credit has only become an issue since the financial crisis, with small business and mid-sized corporates in particular encountering significant difficulties. Innovative funding solutions are now needed in order to service credit needs. Protecting the supply chain by ensuring processes are more robust helps mitigate the risks associated with its sustainability.
One area in which this is being seen is trade finance. Greater transparency plays an important role in trade finance and we are finding that by integrating trade further with treasury functions efficiency is increased. Traditional trade finance has a long track record of effective risk mitigation across a wide variety of markets, economic conditions and trading partnerships, and alongside solutions emerging in supply chain finance, it is bringing risk management back into focus.
Within the context of transparency it is important to highlight that not only can banks provide and facilitate solutions, they are also able to advise what effective solutions should look like. Banks are able to help clients look at appropriate products and transaction solutions and discuss with finance and treasury departments some of the risk management solutions available.
Further to this, banking partners need to be flexible and realise the needs of clients depending on their trade and business flow. Banks need to use their expertise, infrastructure and knowledge to help corporates meet the challenges that they are facing, solutions need to be such that they can integrate smoothly into client operations and processes.
The financial crisis exposed risks in trade-related supply chains and operating cycles and these have taken on increased importance and significant for corporates. Counterparty risks have become a major concern – these risks have the potential to have a greatly detrimental impact on cross-border trade; as such the solutions that banking partners can provide for these problems are now high on the agenda for clients.
Trade finance and emerging solutions, such as supply chain finance (SCF) programmes, are playing important roles in bringing risk management to the top of agenda for corporates working with their banking partners. There is no single solution to eliminate risk; each corporate requires different and bespoke solutions. However, if corporates unite their regional banking partners on a global scale, build deep and transparent relationships with their banks and engage in the range of solutions they provide, they can go a long way to mitigating risk.