Strategic B2B Credit Risk Management - BarrettWells

THE PUBLISHER OF ‘GLOBAL CREDIT MANAGEMENT – AN EXECUTIVE SUMMARY’ IN THE CHINESE LANGUAGE

www.T3PLIMITED.com and www.T3PLIMITED.net

© Copyright 2011 BarrettWells Credit Research

Sponsored by: The International Trading Institute @ SMU (ITI)

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Strategic B2B Credit Risk

ManagementRon Wells

International Trading Pte Ltd

Singapore





PEOPLE

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MANAGING THE FUTURE

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RISK MANAGEMENT( MANAGING THE FUTURE )

Managing the risk of not being paid in the future for cargoes delivered, or not being compensated for transactions repudiated

in the future.

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‘There can be no vision of the future, but there can and must be a vision for the future: a new barbarian vision.’

‘A future that isn't there yet can't be discovered.

It is created by men and women of vision, who are faced with the simple choice: to create their own future, or fall into somebody else's (and) be at the mercy of another's whim.’

The New Barbarian Manifesto - How to survive the Information Age 2000 Ian Angell

FUTURE





UNKNOWN UNKNOWNS

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GU

ATEM

ALA

SIN

KH

OLE





AGENDA

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• The Black Swan or Fat Tail Concept• Credit Risk within the Risk Universe• Physical Commodity Trading & Credit• Risk Assessment in the 21st Century





AGENDA

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The Impact of the Highly Improbable- The Black Swan -

Nassim Nicholas Taleb (NNT) draws together a large number of references and anecdotes to illustrate his points. He repeatedly attacks the received wisdom of those who model the future and who, being lulled into a false sense of security by the elegant mathematics of their models, are repeatedly surprised when the future does not adhere to their script.In essence NNT persuades the reader that the most impactful social and technological changes – the changes that will drastically alter the course of future history - cannot be predicted since they are ‘unknown unknowns’. Such events –which he calls Black Swans – will happen for the first time so cannot be imagined in advance, and cannot be predicted by models that extrapolate forward the past. The past cannot be a basis on which to predict the future; ask any turkey just before the butcher’s cleaver falls if he thought his today would be any different from the preceding 1000 days when he ate heartily and potted around a garden or dozed in the sunshine….





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AGENDA

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Credit Risk consists of two main elements;

namely Performance Risk

and Payment Risk.





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Performance Risk





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Payment Risk





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Credit Risk cannot be eliminated it can only be either retained or changed into another type of risk; a class of

risk judged to be easier to bear safely.





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PRICE OR MARKET

RISK

CREDIT RISK

OPERATIONAL RISK

COLLATERAL RISK

RISK

TRA

NSFER

RIS

K T

RA

NSF

ER

REPUTATION RISK





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REPUTATION RISK

PRICE OR MARKET

RISK

CREDIT RISK

OPERATIONAL RISK

COLLATERAL RISK

RISK

TRA

NSFER

RIS

K T

RA

NSF

ER





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REPUTATION RISK

PRICE OR MARKET

RISK

CREDIT RISK

OPERATIONAL RISK

COLLATERAL RISK

RISK

TRA

NSFER

RIS

K T

RA

NSF

ER





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Other Risks

Concentration Risk

FRANCHISE SUPERMARKET INDEPENDENT NATIONAL GROUP NICHE





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Construction 30%

Other 12%

Automotive 16%

Packaging 15%

MechanicalEngineering 14%

Metal Goods 13%

Concentration Risk

Source: 2004 AR

EX

AM

PLE

EX

AM

PLE





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BELARUS UKRAINE POLAND HUNGARY BULGARIA

Other Risks

Country Risk





AGENDA

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Credit ManagementThe traditional view of credit management is associated with ‘sales prevention’ and ‘collections’. In this view credit controllers are charged with minimizing credit risk, minimizing days sales outstanding (DSO), and sorting out invoice disputes.

However there is a more positive approach to corporate credit management, which perceives credit management in two steps; first the strategic decision to grant credit or not, and second the payment risk mitigation activity. Consequently in the modern view granting credit is a function of a company’s strategic self-interest alone.





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Credit Powers Commerce and Industry

Establish confidence you will pay and be paid, and you will be able to expand your business aggressively, yet safely.

Effectively harness Credit and it will prove the foundation of your success.

However fail to control Credit and it could destroy all your efforts to build a flourishing enterprise.

Ebisu san / The Deity of Business Prosperity





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Credit & Competitive Advantage

The modern credit management approach is a key part of business strategy, and provides competitive advantage.





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What happened to ‘Cash is King’?There are five strategic reasons to grant credit. If none of these drivers is applicable then a company is well advised to ‘sell for cash!’

One or more of these should be identified as the driver for any decision to grant credit to buyers.





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CREDIT STRATEGY

Product Enhancement

Comparative Cost of Money

Administrative Efficiency

Building Trust

Business Development





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Product EnhancementIn order to differentiate a product from similar

competitor products a special credit term may be added to the product specification.

Examples are the offer of ‘0% financing’, or ‘no payments for a year and a day’, or simply the offer of terms of ‘45 days after date of invoice’

when the competition selling an otherwise similar product require cash paid in advance.





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Comparative Cost of MoneyIf a supplier company has a credit rating superior to that of its

customer, the cost of the capital it must utilize to finance ‘supplier credit’ will be lower than the cost of funds its buyer would have to

borrow in order to pay promptly.

Therefore a win-win opportunity arises.

In such a case the supplier could offer credit terms sufficient to cover the period required by the buyer to sell the goods supplied, and collect funds from the ultimate consumers. Hence the buyer would not have to borrow funds, avoiding bank interest costs, while the supplier would incur a comparatively low cost of funds. The net saving (as a result of a higher achievable price) could be retained by the seller, or shared

between seller and buyer, through a price adjustment.





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Administrative EfficiencyIn many cases the cost of collecting cash in advance, in respect of

many relatively small orders, will outweigh the risk of granting credit terms to an extent sufficient to allow monthly billing. In others the cost of issuing and administering numerous invoices will drive a decision to

grant credit. Comparative storage costs can also be an important consideration, in respect of this strategy. Manufacturers of agricultural fertilizer, for example, find it is cheaper to deliver fertilizer to farmers

throughout the year rather than only delivering it just prior to the time it is needed. Farmer customers each build stocks of fertilizer close to

their fields prior to use, instead of the manufacturer accumulating huge stockpiles remotely, and then delivering supplies to numerous farmers over a short period. The manufacturer reduces storage and transport

costs in this way.





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Building TrustCredit is an excellent means through which to build trust into a seller-buyer relationship. Trust in the quality of the

product and trust in the supplier’s ‘after-sales’ service offer. Providing credit enables a seller to signal to a

buyer that it has every confidence that the product will perform as promised, and that it wants to establish a long term relationship with the buyer. It also encourages the buyer to believe that the seller will not ignore any needs

that the buyer may have for repair or replacement of faulty product after delivery.





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Business DevelopmentIn cases where a supplier wishes to assist a distributor (usually in an emerging market) to grow its business more quickly than the

distributor’s own financial resources would normally allow, ‘supplier credit’ is a useful strategic tool.

Extended supplier credit will allow a distributor to recycle sales revenues collected (cash) within its domestic operations; to meet fixed expenses, finance its own receivables, and build necessary

infrastructure.

Naturally an arrangement such as this would have to be closely managed, and calls for a high degree of trust on the supplier’s side

and transparency on the distributor’s side.





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How Much Credit?Camilo Gomez PhD

Business CreditMarch 2007





Credit Rating Limitations

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Only indicative of Probability of Default (PD) within a certain population, within a certain time horizon.

Not ‘fit for purpose’….





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How Much Credit?Camilo Gomez PhDBusiness CreditMarch 2007





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Basel II Credit Risk

PD

EAD

LGD

X

X

Probability of Default (PD)

Exposure at Default (PFE)

Loss Given Default (LGD)

= EL

Expected Loss





But what is the limit?

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Double, double toil and trouble; Fire burn, and caldron bubble. Fillet of a fenny snake, In the caldron boil and bake; Eye of newt, and toe of frog ...





PAYMENT TERMS & LIMITS

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Minimum Order QuantityBuyer’s Customers’ Payment Terms

Average Quantity Sold Daily by the BuyerNormal Delivery Transit Time





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The ‘cash flow cycle’ is the time required to convert goods into cash; from the date the company pays the costs of acquisition of the goods to the date of receipt of the

cash from related sales.

- DAYS PAYABLES + DSO

+ DAYS INVENTORY

PAYMEN

T TERM

S & LIM

ITSPAYM

ENT

TER

MS

& L

IMIT

S





AGENDA

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Current Developmentsin

Corporate Credit Management





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Where are we in terms of predicting corporate failure?





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When the scale of Parmalat’s problems emerged, Standard & Poor’s was forced to downgrade the company’s stock from investment grade by eight notches, later abandoning a rating altogether. Investors are wondering if the agency’s other ratings are now to be trusted. The credit-rating industry … suffered a damaging blow to its credibility. *

* The Sunday Times on January 4 2004





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Why have traditional credit analysis methods failed?

• Financial analysis, including ratio analysis

• Track record, including credit references

• Substantial net tangible assets

• A well understood, tried and tested business model





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The common theme in this analysis is …..

the PAST.

However the futureis where we will be

paid or ‘not paid’.





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There can be no vision of the future, but there can and must be a vision for the future: a new barbarian vision.

A future that isn't there yet can't be discovered. It is created by men and women of vision, who are faced with the simple choice: to create their own future, or fall into somebody else's (and) be at the mercy of another's whim.

The New Barbarian Manifesto - How to survive the Information Age 2000 Ian Angell





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THE AGE OF PROGRESS IS OVER

Leading the Revolution © 2000 Gary Hamel – Harvard Business School Press

We now stand on the threshold of a new age – the age of revolution. In our minds we know the new age has already arrived; in our bellies, we’re not sure we

like it. For we know it is going to be an age of upheaval, of tumult, of fortunes made and unmade at

head-snapping speed.

For change has changed. No longer is it additive. No longer does it move in a straight line. In the twenty-first

century, change is discontinuous, abrupt, seditious.





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We know the future will not be a repeat of the past.

We know the future will not be predicted by drawing a straight line from the past, slightly inclined to represent continuous progress.

However we cannot deny that the future ‘comes from the past and present’.

The future usually creeps up on us day by day as one thing leads to another, or one thing is led to another!





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However sometimes the future simply leaps up and confronts

us with something unimaginable, something that

has never before occurred.





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Why do companies fail?





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Incompetentor

Dishonest MANAGEMENT





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• Being out of touch with reality• Large technical knowledge but poor

commercial control• Great talents in salesmanship• Strong-willed• Sumptuous living and unreasonable

withdrawals of cash from the business• Excessive risk-taking

Common Attributes of Failing Management

von Stein and Ziegler 1984





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• Being out of touch with reality

Common Attributes of Failing Management

von Stein and Ziegler 1984





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Being out of touch with reality could include ….

Failure to react appropriately to changes in the general economy or the company’s market.

Failure to recognize new forms of competition in good time.





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THESE ARE FAILURES OFSTRATEGYSTRATEGY

…………………. a set of analytical techniques for understanding better, and so influencing, a company’s position in its actual and potential

market place.*

* Financial Times Mastering Strategy – Pearson Education Limited 2000





SCENARIO PLANNING

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Scenario planning derives from the observation that, given the impossibility of knowing precisely how the future will play out, a good decision or strategy to adopt is one that plays out well across several possible futures. To find that robust strategy, scenarios are created in plural, such that each scenario diverges markedly from the others.

These sets of scenarios are, essentially, specially constructed stories about the future, each one modelling a distinct, plausible world in which we might someday have to live and work.*

* How to Build Scenarios – Lawrence Wilkinson 1994-98 Wired Digital Inc.





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Noitanigami





Conventional forecasting (corporate planning) .... is pretty good at predicting

continuing or patterned activities.

Its great weakness ... is in discerning the turning points ... yet it is those

points, the big changes, which matter most because they take us into a

different world...

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Quotation from Russia 2010 and what it means for the Worldby Daniel Yergin & Thane Gustafson © 1993, 1995 Cambridge Energy Research Associates.





Scenarios are learning stories ... the process of working through them

(and) experiencing them, is as important as the conclusions.

Quotation from Russia 2010 and what it means for the Worldby Daniel Yergin & Thane Gustafson © 1993, 1995 Cambridge Energy Research Associates.

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VISION + PASSION & PERSISTENCE

The future is created through ...

The Future is where we will be paid or not paid hence studying,

anticipating and creating the Future are activities

fundamental to effective Risk Management





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DisclaimerJust to emphasise that the opinions, ideas and suggestions expressed throughout this presentation are mine alone. In making this presentation I do not represent any other organisation, my employer, or any other person.

This presentation is simply a sharing of ideas with a view to stimulating a debate, which may lead to the widespread adoption of a holistic, future-oriented approach to counterparty risk management.

Ron Wells





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Ron Wells is the author of Global Credit Management, an Executive Summary published by John Wiley & Sons. This concise work describes the essence of effective credit management, which too often is a passive and reactive discipline within a company. It includes practical guidance to equip a reader with the basic tools necessary to establish a holistic credit management discipline within a business.The Mandarin Chinese (simplified characters) version of Global Credit Management was published in July 2007, titled Huan Xin Ping Heng Biao Shang De Shui Shi – Awaken the Sleeping Lion on the Balance Sheet. See www.t3plimited.com (Chinese version: www.t3plimited.net) for details.Ron maintains a free access, credit management resources web site at: www.BarrettWells.co.uk. He has delivered numerous presentations relating to credit and performance risk management, and taught several classes in related subjects; see www.barrettwells.com for details. Ron is a Certified Credit Executive (CCE), a Chartered Management Accountant (ACMA), a qualified International Banker (ACIB) and a Chartered Corporate Secretary (FCIS). He participated in the NACM Graduate School for Credit and Financial Management in 1996/97, passed with distinction and was elected Best Student.Ron joined Cargill International Trading in Singapore as Asia Credit Manager for Energy, Transportation and Industry in February 2011. He was Vice President - Credit Risk Management of RBS Sempra Commodities in London from October 2007, and became Executive Director of Counterparty Risk Analysis and Portfolio Management EMEA, when J.P. Morgan’s Global Commodities Group purchased RBS Sempra on July 1, 2010. Previously Ron was Credit Manager for Global Supply & Trading with Chevron Corporation for 16 years. Ron earlier worked for various companies and commercial banks becoming a specialist in financial analysis, corporate credit management, trade operations management and trade finance-related marketing.

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Strategic B2B Credit Risk Management - BarrettWells