ITI @SMU Guest Lecture Series Strategic B2B Credit Risk ...ITI @SMU Guest Lecture Series Strategic B2B Credit Risk Management 30 Assertion It is evident that the risk that a buyer

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

ITI @SMU Guest Lecture SeriesStrategic B2B Credit Risk Management

1

Part 2Performance Risk

Assessment & Management

in the 21st Century Ron Wells

International Trading Pte Ltd

Singapore





AGENDA

2

• Part One Revisited Briefly• Measuring Performance Risk• Assess & Manage Performance Risk• Margining & Liquidity Risk





REDUCE RECEIVABLE BALANCES

WISELY INVEST RECEIVABLE BALANCES

3





RISK AVOIDANCEREDUCE DSO(DAYS SALES OUTSTANDING)

RISK MANAGEMENTAPPROPRIATE DSO

4





REDUCE COSTSMINIMISE LOSSES

ELIMINATE REVENUE CONSTRAINTSADD VALUE

5





6

COMPANIES





PEOPLE

7





MANAGING THE FUTURE

8





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.

9





UNKNOWN UNKNOWNS

10





11





12

Credit Risk consists of two main elements;

namely Performance Risk

and Payment Risk.





13

Performance Risk





14

Payment Risk





15

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.





16

REPUTATION RISK

PRICE OR MARKET

RISK

CREDIT RISK

OPERATIONAL RISK

COLLATERAL RISK

RISK

TRA

NSFER

RIS

K T

RA

NSF

ER





17

REPUTATION RISK

PRICE OR MARKET

RISK

CREDIT RISK

OPERATIONAL RISK

COLLATERAL RISK

RISK

TRA

NSFER

RIS

K T

RA

NSF

ER





18

Why do companies fail?





19

Incompetentor

Dishonest MANAGEMENT





20

• 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





21

• 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





SCENARIO PLANNING

22





23

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.





24

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.





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...

25

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





26

THE AGE OF PROGRESS IS OVER

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

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.





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.

27





AGENDA

28






29

Physical Performance RiskPerformance Risk is the risk that a counterparty will not deliver or will not accept delivery of a physical product or service, at the agreed price, on the agreed future date or series of dates.

Payment Risk is the risk that a buyer will not pay an invoice in full, on the due date;it is post-delivery risk. This is sometimes referred to as Delivery Risk or Deferred Settlement Risk.





30

AssertionIt is evident that the risk that a buyer will not pay an

invoice on due date, a date after physical delivery of a commodity, is fundamentally not equivalent to the risk that

the same counterparty will refuse to receive the same commodity at a previously agreed fixed price.

Likewise the risk that a supplier of a physical commodity will fail to deliver the commodity, at a previously agreed

fixed price in the future, is fundamentally not the same as the risk that that supplier would fail to repay a loan at

some future date.





31

Basel II Credit Risk

PD

EAD

LGD

X

X

Probability of Default (PD)

Exposure at Default (PFE)

Loss Given Default (LGD)

= EL

Expected Loss

THE ONLY DEFINITION





32

This Credit Risk related formula has been adopted by

Banks to quantify Performance Risk related to Financial

Derivatives.

The contention is that it is also inappropriately applied to the

measurement of Physical Performance Risk





33

Expedient Not SensibleThe risk that a buyer will not pay an invoice on due date after physical delivery, is not the same

as the risk that the same counterparty will repudiate a fixed price contract.

The risk that a supplier will fail to deliver at a previously agreed fixed price is not the same as the risk that a supplier will fail to repay a loan.





34

Physical Performance Risk Today• The ‘Probability of Default’ (PD) or the

‘likelihood of failure to take or deliver’ a Physical Commodity per contract in future is erroneously based on a Credit Risk assessment

THIS IS OFTEN IMPUTED BASED ON S&P TABLESUSING AN EQUIVALENCE MAPPING OF INTERNAL CREDIT

RATINGS TO S&P RATINGS





35

Physical Performance Risk Today• Potential Future Exposure (PFE) is based

on Value at Risk (VaR) calculations, a methodology that has repeatedly proven to be seriously flawed

THIS IS THE AMOUNT USED TO CALCULATE REQUIRED INITIAL MARGIN (COLLATERAL) AND/OR THE AMOUNT NECESSARY TO

PROVIDE ADEQUATE ASSURANCE, IF INVOKED, AND TO ESTIMATE THE ‘EXPOSURE AT DEFAULT’





36

The Impact of the Highly ImprobableNassim 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….Read the article at: http://www.barrettwells.co.uk/blackswan.html





37

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 Taleb 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.





38

http

://w

ww

.bar

rettw

ells

.co.

uk/b

ooks

hop.

htm

l





39

Physical Performance Risk Today• ‘Loss Given Default’ (LGD) or ‘loss given failure’

is assessed on the basis of Credit Collection experience, not actual cases of performance default

LGD IS USUALLY ASSIGNED BASED ON COLLECTION DATA GATHERED IN RELATION TO DEFAULTED ASSETS IN THE

SAME ASSET CLASS AND JURISDICTION





40

Who are the majority of ‘risky’ Suppliers and Buyers for physical commodities?• Growing Country Based Producers• Marginal Producers (Peak or Eco-friendly)• Small & Medium Size Industrial and

Commercial Consumers• Energy Retailers• New Businesses





41

THE DILEMMAThe result of using these inappropriate tools is often the exaggeration of the physical performance risk and failure to complete otherwise profitable business transactions. When a counterparty risk management function repeatedly declines potentially profitable business it fails in its primary objective, which is to actively manage performance and payment risk, not to avoid or eliminate such risk.





AGENDA

42






43

Possible Alternative Method:• Scenario Planning as a basis to estimate the

Potential Future Exposure and the probable impact on the CP’s business (Opportunity)

• A Performance Risk ScoreCard to produce a Probability of Performance Default (Motive)

• A Recovery Rate Model to estimate the Loss Given Default (Means)





44

Opportunity Motive & Means• Is the Counterparty (CP) sufficiently

hedged to tolerate any foreseeable Potential Future Exposure? Opportunity

• Is the CP motivated to meet its commitments? Motive

• Will the CP have the financial means to pay? Means





45

Opportunity to PerformCreate an Appropriate Scenario

• Decide how far in the future the risk extends; for example 3 months, 6 months, one year, two, five, seven, ten or twenty years. Then consider the CP’s business model and what relevant factors may change during that period.

• Devise a method to determine the maximum Potential Future Price (PFP) factor for the related product-market combination category, in each future time period.

• Apply these factors to the current values of the relevant volumes daily. Revise the factors periodically.





46

Motive to PerformCreate a Performance Risk ScoreCard

• Consider what are the imperatives of the senior Executives of the Counterparty (CP), what is in their interest given those imperatives, and on what basis they will likely decide whether to perform or not when the time for performance arrives.

• Include country risk related issues when imports or exports are involved.





47

Means to PerformCreate a Recovery Rate Model

• Design a Recovery Rate Model that includes scoring a number of significant factors, such as:– The existence in ‘helpful’ jurisdictions of assets of

value belonging to the Counterparty.– The existence or otherwise of a liquid market for the

product in question at the place of failure to perform

• Is Right-way Risk a factor?





48

SummaryMethods that were invented for credit risk assessment, and are suitable for cash settled derivatives trading (futures) have been migrated into the physical (forward) world, where they produce unhelpful results.

In the micro sense, when examining physical performance risk counterparty by counterparty, more appropriate and useful tools need to be invented.

That is our challenge……





49

The Art of Assessing, Quantifying and Managing Buyer or Supplier Future Physical Performance Risk

Read more on this subject in English at:www.barrettwells.com/PerformanceRiskNewToolsNeededJune2010.pdf

Or in Chinese (Mandarin - Simplified Characters) at:www.barrettwells.com/PerformanceRiskNewToolsNeededJune2010cnSM.pdf

FALKIRK WHEEL





AGENDA

50






FUTURE COMMODITY PRICE RISK

未来的商品价格风险





52

Many businesses incur costs that are related to commodities. These costs may relate to power or metals or agricultural products. The prices of many commodities are determined by the perception of the global supply and demand balance, and are agreed on international exchanges.





HEDGING

套期保值





54

The term ‘Hedge’ has been adopted in finance because it describes the act of sheltering from danger or risk; as if by hiding in or behind a hedge.

Powis Castle Garden

There are two types of hedging generally available to commercial businesses.





DIRECT PHYSICAL HEDGE

‘直接的’现货套期保值





DIRECT PHYSICAL HEDGEYou may agree to buy a certain amount of electricity, natural gas, coal, liquefied petroleum gas, aluminium, nickel, zinc, tin, copper, rice, corn, cocoa or sugar to be received in December 2011 at a price fixed today.

Your supplier could be a producer or a trader of physical products.





RISKS FOR BUYER 风险 – 针对买家来说

• Supplier fails to deliver (Performance Risk)• Supplier demands cash or other security,

when the future price falls below the contract price; to cover the risk Buyer will not honour the contract (Liquidity Risk)

• Competitors are able to sell goods more cheaply (Market Share Risk)





LIQUIDITY RISK 流动性风险

The risk that not enough cash and/or bank credit will be available to pay an obligation when it is due. Such obligation may for example be an invoice, interest due on a loan, or a margin call.





MARGIN CALLS 追加保证金

A supplier that agrees to deliver in the future at a fixed price will request protection against possible loss, in case the buyer fails to accept the commodity at a time when the market price of the commodity is less than the fixed price. Often protection is obtained through a ‘margining agreement’, which requires the buyer to pay the supplier cash equal to the supplier’s potential loss or additional potential loss, each day when the market price is lower than the contract price.





= M

AR

KE

T IN

DE

X P

RIC

E /

市场

价格指

数

FIXED PRICE AGREED / 议定的价格

TIME DAYS / 时间日期

PR

ICE

OF

CO

PP

ER

/ 铜

的价格

0 90 days

NO

MA

RG

IN C

ALL

不需要追加保证金

SUPP

LIER

PAY

S BU

YER

$1

0/TO

NN

E 供

应商需要

向买家支付的保证金

–每吨

10美元

BUYE

R P

AYS

SUPP

LIER

$2

0/TO

NN

E 买

家需要向

供应商支付的保证金

–每吨

20美元

BUYE

R P

AYS

SUPP

LIER

$1

0/TO

NN

E 买

家需要向

供应商支付的保险金

–每

吨10

美元

AG

RE

ED

DE

LIV

ER

Y D

AY

议定

的交

割日

期

按议定的支付方式进行铜

的交割, 保证金被退还或

用于抵销应付的货款

COPPER IS DELIVERED ON AGREED PAYMENT TERMS, MARGIN IS REPAID OR SETOFF AGAINST INVOICE

+ $10

- $10

- $20





BUYER’S TRAP 买家可能落入的圈套When a Buyer, that is not a back-to-back trader, signs a physical hedge agreement it will be confident that it will take delivery. Confident that, if the market index price is lower than the contract price, it will not have to drop its sales prices to compete, so will remain profitable. Therefore the buyer will be confident that it will be able to pay the supplier’s invoice on due date.

However the cash from sales will only be received after the commodity is received, so cash to meet margin calls will have to be found from other sources. It is this ‘timing difference’ that creates Liquidity Risk.





AVOIDING THE BUYER’S TRAPMANAGING LIQUIDITY RISK

避免买家可能陷入的圈套管理流动性风险





TWO TOOLS 两种工具• Negotiate a margin free portion; called a

‘variation margin threshold’. That is only pay (post) margin if the supplier’s risk exceeds a threshold amount. Beware; a threshold may change if your credit rating changes.

• Negotiate to provide Standby Letters of Credit (SBLCs) or bank guarantees to cover margin calls, instead of cash. May not be permitted in some jurisdictions.





ANOTHER TACTIC 另一种策略Model or project the amount of cash that will have to be paid to cover margin calls in various extreme situations. For example; consider how much cash will have to be paid if the price of the commodity decreases by 70%.

Then approach a bank that understands the business and request ‘committed’ loan facilities sufficient to provide enough cash in such extreme circumstances.





INDIRECT FINANCIAL HEDGE

‘间接的’金融性套期保值





INDIRECT FINANCIAL HEDGEYou have bought a certain amount of electricity, natural gas, coal, liquefied petroleum gas, aluminium, nickel, zinc, tin, copper, rice, corn, cocoa or sugar to be received in December 2011 at a price related to the global index pricepublished at the time of receipt.

To fix the cost today, a swap contract can be concluded with a Broker or Bank.





SWAP CONTRACTS 掉期合同

POWER BUYER

电力买家 BANK OR BROKER 银行或经纪人

PRODUCER 生产商

BUYER PAYS BANK FIXED PRICE FOR NOTIONAL QUANTITY RECEIVES INDEX *

NOTIONAL

买家以固定的价格向银行支付议定的（商品）数量

并收取议定的指数

BUYER RECEIVES POWER 买家接收电力

BUYER PAYS PRODUCER INDEX RELATED PRICE FOR ACTUAL

QUANTITY RECEIVED

买家以与指数相关的价格向生产商支付

实际收到的（商品）数量

PAYS FIXED $$ 支付固定的 $$

INDEX $$ 指数 $$

INDEX $$ 指数 $$





IFH RISKS FOR BUYER买家的非间接金融风险

• Bank or Broker demands cash or other security, when the future price falls below the contract price, to protect against risk Buyer will not honour the swap contract. An initial margin may also be demanded. (Liquidity Risk)

• Competitors are able to sell goods more cheaply (Market Share Risk)





INITIAL MARGIN 初始保证金An initial margin (IM) is a cash deposit given to the Bank or Broker (also demanded by any Exchange) before swap trading begins, and held as a permanent security as long as trading continues.

The amount can be changed on demand by the Bank or Broker.

This initial margin cash provides the Bank or Broker with a reserve amount to use to cover (pay) any losses that may be incurred if its client’s position is closed. A position may be closed, for example, if a client fails to pay a margin call. However prices may move during the three to ten days that it takes to close the positions, so the variation margin (VM) already held by the Bank may be insufficient. In such a case the initial margin will be used to clear the balance due to the Bank or Broker.

A Bank, Broker or Exchange will only rarely accept a Standby Letter of Credit or Bank Guarantee instead of cash, as an initial margin deposit.





70

Hedging Future Commodity Price Risk Can Damage Your Company’s Liquidity

Read more on this subject in English at:www.barrettwells.co.uk/liquidity.html

Or in Chinese (Mandarin - Simplified Characters) at:www.barrettwells.co.uk/HedgingLiquidityRiskMar2010cn.pdf

FALKIRK WHEEL





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





唤醒平衡表上的睡狮国际信用管理实用指南

Huan Xin Ping Heng Biao Shang De Shui Shi Guo Ji Xin Yong Guan Li Shi Yong Zhi Nan

ISBN 978-988-99586-1-9

Awaken the Sleeping Lion on the Balance Sheet an Executive Summary for Global Credit Management





73

Ron Wells wrote Global Credit Management, an Executive Summary published by John Wiley & Sons. This concise work describes effective credit risk 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. 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 marketing.

ITI @SMU Guest Lecture Series Strategic B2B Credit Risk ...ITI @SMU Guest Lecture Series Strategic B2B Credit Risk Management 30 Assertion It is evident that the risk that a buyer

Documents