Strategic B2B Credit Risk Management

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1 Strategic B2B Credit Risk Management Ron Wells International Trading Pte Ltd Singapore 1

2 PEOPLE 2

3 MANAGING THE FUTURE 3

4 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. 4

5 5

6 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. FUTURE 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 6

7 UNKNOWN UNKNOWNS 7

8 GUATEMALA SINKHOLE 8

9 AGENDA The Black Swan or Fat Tail Concept Credit Risk within the Risk Universe Physical Commodity Trading & Credit Risk Assessment in the 21 st Century 9

10 AGENDA The Black Swan or Fat Tail Concept Credit Risk within the Risk Universe Physical Commodity Trading & Credit Risk Assessment in the 21 st Century 10

11 11

12 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. 12

13 Sponsored by: The International Trading SMU (ITI) 13

14 AGENDA The Black Swan or Fat Tail Concept Credit Risk within the Risk Universe Physical Commodity Trading & Credit Risk Assessment in the 21 st Century 14

15 Credit Risk consists of two main elements; namely Performance Risk and Payment Risk. 15

16 Performance Risk 16

17 Payment Risk 17

18 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. 18

19 RISK TRANSFER COLLATERAL RISK PRICE OR MARKET RISK REPUTATION RISK CREDIT RISK RISK TRANSFER OPERATIONAL RISK 19

20 RISK TRANSFER COLLATERAL RISK PRICE OR MARKET RISK REPUTATION RISK CREDIT RISK RISK TRANSFER OPERATIONAL RISK 20

21 RISK TRANSFER COLLATERAL RISK PRICE OR MARKET RISK REPUTATION RISK CREDIT RISK RISK TRANSFER OPERATIONAL RISK 21

22 Other FRANCHISE SUPERMARKET INDEPENDENT NATIONAL GROUP NICHE Risks Concentration Risk 22

23 Concentration Risk Construction 30% Other 12% EXAMPLE Automotive 16% Packaging 15% Mechanical Engineering 14% Metal Goods 13% Source: 2004 AR EXAMPLE 23

24 Other BELARUS UKRAINE POLAND HUNGARY BULGARIA Risks Country Risk 24

25 AGENDA The Black Swan or Fat Tail Concept Credit Risk within the Risk Universe Physical Commodity Trading & Credit Risk Assessment in the 21 st Century 25

26 Credit Management The 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. 26

27 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 27

28 Credit & Competitive Advantage The modern credit management approach is a key part of business strategy, and provides competitive advantage. 28

29 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. 29

30 CREDIT STRATEGY Product Enhancement Comparative Cost of Money Administrative Efficiency Building Trust Business Development 30

31 Product Enhancement In 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. 31

32 Comparative Cost of Money If 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. 32

33 Administrative Efficiency In 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. 33

34 Building Trust Credit 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. 34

35 Business Development In 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. 35

36 How Much Credit? Camilo Gomez PhD Business Credit March

37 Credit Rating Limitations Only indicative of Probability of Default (PD) within a certain population, within a certain time horizon. Not fit for purpose. 37

38 How Much Credit? Camilo Gomez PhD Business Credit March

39 39

40 Basel II Credit Risk PD Probability of Default (PD) X EAD Exposure at Default (PFE) = EL X LGD Loss Given Default (LGD) Expected Loss 40

41 But what is the limit? 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... 41

42 PAYMENT TERMS & LIMITS Minimum Order Quantity Buyer s Customers Payment Terms Average Quantity Sold Daily by the Buyer Normal Delivery Transit Time 42

43 PAYMENT TERMS & LIMITS 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 + DAYS INVENTORY + DSO PAYMENT TERMS & LIMITS 43

44 AGENDA The Black Swan or Fat Tail Concept Credit Risk within the Risk Universe Physical Commodity Trading & Credit Risk Assessment in the 21 st Century 44

45 Current Developments in Corporate Credit Management 45

46 Where are we in terms of predicting corporate failure? 46

47 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

48 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 48

49 The common theme in this analysis is.. the PAST. However the future is where we will be paid or not paid. 49

50 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 50

51 THE AGE OF PROGRESS IS OVER 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. Leading the Revolution 2000 Gary Hamel Harvard Business School Press 51

52 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! 52

53 However sometimes the future simply leaps up and confronts us with something unimaginable, something that has never before occurred. 53

54 Why do companies fail? 54

55 Incompetent or Dishonest MANAGEMENT 55

56 Common Attributes of Failing Management 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 von Stein and Ziegler

57 Common Attributes of Failing Management Being out of touch with reality von Stein and Ziegler

58 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. 58

59 THESE ARE FAILURES OF STRATEGY. 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

60 SCENARIO PLANNING 60

61 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 Wired Digital Inc. 61

62 Noitanigami 62

63 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... Quotation from Russia 2010 and what it means for the World by Daniel Yergin & Thane Gustafson 1993, 1995 Cambridge Energy Research Associates. 63

64 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 World by Daniel Yergin & Thane Gustafson 1993, 1995 Cambridge Energy Research Associates. 64

65 The future is created through... VISION + PASSION & PERSISTENCE 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 65

66 Disclaimer Just 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 66

67 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 (Chinese version: for details. Ron maintains a free access, credit management resources web site at: He has delivered numerous presentations relating to credit and performance risk management, and taught several classes in related subjects; see 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 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, 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. 67

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