A bank’s capitalization and risk and commercial approaches will generally be the biggest determinants of its risk appetite. This is not to forget that, over the years, compliance organizations have also become major components of the risk apparatus, writes Mihai Andreoiu, senior director at Redbridge Switzerland.
Before we can answer this question we have to look at the relevant building blocks of a particular bank. One such building block could be called “capital and risk”. Simply put, what sort of capital adequacy does the lender have to pursue its activities and how is its risk management function organized in terms of overseeing and quantifying the risks taken?
Lenders have to set aside capital that, among other critical variables (such as leverage and funding ratio), will be a function of their risk-weighted assets (RWAs). And these RWAs will be driven by various factors, two of which are external / client-related and can be directly influenced. These are the client’s probability of default (the PD rating) and the Loss Given Default (the LGD rating) of a particular transaction. The better these ratings, the less capital that has to be set aside and the lower the pricing of the transaction. And typically, the better the ratings, the more credit appetite a bank should have.
Sector-specific rating models
When it comes to the organization of the risk management function, several aspects come into play. These can include the sector-specificity of the risk models the bank deploys and client tiering policies coupled with concentration limits and portfolio management considerations.
Under the Advanced Internal Ratings Based approach, many banks did not miss the chance to develop sector-specific rating models for both PD and LGD. With commodity traders appearing to a generalist as highly leveraged, tailoring dedicated risk models that account for industry specificity was in the end a technique to obtain a competitive advantage. Including leverage adjustments for balance sheets consisting of large, readily marketable inventory has become mainstream, with the banks leading the sector and even the large rating agencies publishing guidance on such topics.
Further qualitative aspects mainly aimed at gauging the soundness of client risk management practices were included in such models. Similarly, taking advantage of the Specialized Lending slotting, many banks looked further and developed dedicated LGD models to account for specific risk mitigation in the sector, basically “monetizing” aspects like the self-liquidating nature of transactions financed and collateral quality as the main risk mitigants.
Most institutions also typically have a “concentration grid”, as a portfolio management tool, defining the maximum exposure for a certain risk rating and also for each specific sector. Typically, the lower the rating, the lower the maximum exposure to that rating will be. Whether this is reasonable, and how to best tailor portfolio management, is a matter for debate as most lenders seem to be chasing the limited number of large investment grade corporates, while firms that are below investment grade, despite being willing to fairly compensate lenders for the higher risk they involve, receive less appetite.
As risk managers represent the critical link between the banks’ origination side and what ultimately gets decided by credit committees, they are of great importance. Most established sector banks have put in place expert dedicated teams to ensure the proper understanding of the sector (similarly to other sectors, such as leverage finance, project finance, etc), while other smaller or simply corporate banks have by default opted for head-office-centralized and non-specialized risk management in an attempt to keep an “independent” assessment.
Stepping aside from the capital and risk realm, the next relevant building block is the business side’s commercial strategy and targeted risk-reward profile.
Bank business models can differ considerably from a risk perspective. Among large financial institutions, there is a difference between pure commercial banking practices and those with a more investment banking style. For the former, a commercial lending approach is typically coupled with a long sector-specific track record for both institution and management, driving credit appetite upwards across the board in terms of amounts and ratings. For the latter the aim is to maximize the relationship’s returns in an “originate to distribute” and multi-product context – in other words, de-risk as much as possible and provide the capital selectively. Certain large traditional players will therefore take larger amounts on their balance sheet and potentially reduce pricing, whilst for others the secondary / insurance market will dictate the potential for risk appetite and drive pricing upwards.
Geographical and cultural aspects
Furthermore, some players will have a specific angle that is dictated by either geographical and cultural aspects, or simply by the cost of funding limiting the business they can pursue. Some banks will have built up specific expertise by type of commodity (such as energy, metals or agri commodities), while others will adopt a more corporate approach with no commodity type differentiation. Some banks will have a natural bias for certain geographical regions as specific circumstances (such as sanctions) might give them an edge, or they may simply be driven by cultural and geopolitical aspects (such as in the Middle East). Furthermore, the choice of products will not be obvious.
Trade and Commodity Finance can represent a very large universe, ranging from large syndicated facilities (funded or unfunded, secured or unsecured) to small bilateral transactional facilities financing various materials around the world in different stages, or simply covering the counterparty risk of the buyer or its bank.
This means that a bank’s capitalization and risk and commercial approaches will generally be the biggest determinants of its risk appetite. This is not to forget that, over the years, compliance organizations have also become major components of the risk apparatus. For some institutions, compliance can completely block some business, even if they make sense from a risk perspective on paper.
The human factor
And last but not least, behind the scenes are managers with different backgrounds, perspectives and appetites for risk. Is the emergence of the generalist banker relative to the old-school specialist favorable or a potential hurdle? Do you know who is supervising the sector and supposedly ultimately supporting your case within the bank?
When was the last time you met them? So how can the risk appetite for credit-hungry trading businesses with high working capital requirements be improved? Ideally, each bank should be analyzed just as any other counterparty would be, meaning that there should be at least a reasonable understanding of their commodity sector business strategy approach, processes, risk management practices and management comfort. This kind of mapping is crucial in managing “bank counterparty risk”.
What is the process for approving your credit application? Does the bank have multi-level credit committees with several members, or is the approval process on individual signatory basis? Has anyone from the approval chain visited you or do they sit in an “ivory tower” not allowed to meet clients and perform risk due diligence in person? Risk managers visiting clients might seem controversial from an academic perspective, but the practice suggests that first-hand information in fact leads to a higher-quality risk assessment and eliminates potential agency risk, whereby the relationship managers have to be the sole representatives of the bank. Do the respective approvers come from the sector or are they general risk managers without a specific sector track record? One might be surprised how little understanding some risk managers have of relatively basic concepts linked to commodity trading and the related risks.
Understanding your banks, improving the visibility of the approval process and hopefully meeting risk managers will make a big difference to the quality of the risk assessment process. And to anyone who is skeptical about this, I would be more than happy to share a number of anecdotes on this topic.
Continuously engaging on risk topics and seeking the banks’ feedback on how they assess borrower and transaction risk is fascinating. The more one understands what drives the banker’s perception of risk, the better the chances of increasing their credit appetite and reducing the price they charge. As one of my former managers used to say, “perception is reality”. The perception of your relationship manager and that of the risk chain will be the reality when it comes to your liquidity and cost of borrowing. Are you spending enough time improving that perception, or do you think that it’s simply the relationship manager’s job to write all those memos, perform risk analysis and get you an optimal deal?
Mapping the lenders’ universe
Do you understand the key metrics driving your risk rating? Are there some quick wins that could result in your bank upgrading your PD rating, which has a huge impact on both credit appetite and pricing? Quantitative factors (like the treatment of short term debt financing inventories) and qualitative factors (such as the existence of a risk policy, separation of duties and the management team’s track record) alike will affect the risk rating your bank assigns you. Similarly, when it comes to the transaction risk assessment one needs to understand what type of risk mitigation will affect the lender’s perception of risk. It could be the perfection of collateral, the way the insurance policy is assigned, or simply the various risk mitigation elements you are giving to your banks, such as title, control or simply transaction evidence.
A continued rigorous approach mapping the lenders’ universe will result not only in a better perception of the stakeholder from the other side of the fence, but in tangible results such as improved liquidity, a lower cost of borrowing, and more disciplined (reporting) practices improving the business quality.
Commodity trading firms face a large number of risks that could jeopardize a patiently fostered business
Given the multitude of industry specific challenges at present for commodity trading firms, Redbridge’s consulting team believes in sharing its thoughts on a wide range of topics of interest through a publication designed especially for this select audience.
In this publication
- Trading firms and banks: who’s afraid of whom?
- What’s driving the risk appetite of your (potential) financing banks?
- Why borrowing bases are valuable opportunities to consider
- The alternative represented by trade finance funds
- How to achieve a consolidated vision of all the trades processed at each moment in time
And also, a conversation with
- Louis Dreyfus Commodities