The building blocks that shape a bank’s risk profile
A bank’s capitalization and risk, along with its commercial approaches, will generally be the biggest determinants of its risk appetite. But other factors also play a role. Understanding the risk universe and gaining insights into your lenders’ approval process can help you improve the quality of your dialogue with your bank, the outcome of your risk assessment and potentially lower the cost of borrowing.
Let’s take a look at the basic building blocks that shape a bank’s risk profile.
Capital and risk
First, there’s capital and risk.
What sort of capital adequacy does the lender have to pursue its activities? 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). In turn, various factors will drive these RWAs.
Lenders can directly influence two of these factors: 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 a lender has to 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
Several aspects come into play when it comes to the organization of the risk management function. These can include the sector-specificity of the risk models the bank deploys and client-tiering policies that are coupled with concentration limits and portfolio management considerations.
Under the advanced internal ratings-based approach, many banks developed 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 a common practice, with the banks leading the sector and even the large rating agencies publishing guidance on such topics.
These models also include additional qualitative aspects, mainly aimed at gauging the soundness of client risk management practices. Similarly, taking advantage of specialized lending slotting, many banks have developed dedicated LGD models to account for specific risk mitigation in the sector, basically monetizing such aspects as the self-liquidating nature of transactions financed and collateral quality as the main risk mitigants.
Most institutions also typically use a concentration grid as a portfolio management tool. This grid defines 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 debatable because most lenders appear 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, have less appetite.
Risk managers represent the critical link between the banks’ origination side and what ultimately gets decided by credit committees, so do not overlook them. Most established sector banks have expert dedicated teams to ensure the proper understanding of the sector, while other smaller or simply corporate banks use centralized, nonspecialized risk management to maintain an independent assessment.
Bank’s commercial strategy
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, difference distinction between pure commercial banking practices and those with more of an investment banking style has emerged. 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 multiproduct context – in other words, de-risk as much as possible and provide the capital selectively. As a result, certain large traditional players will take larger amounts on their balance sheet and potentially reduce pricing. For others, the secondary or insurance market will dictate the potential for risk appetite and drive pricing upwards.
Geographical and cultural aspects
Some players have a specific angle dictated either by geographical and cultural aspects or simply by the cost of funding limiting the business that they can pursue. Some banks will have built up specific expertise by type of commodity (energy, metals or agri commodities), and others have adopted a more corporate approach with no commodity-type differentiation. Some banks will have a natural bias for certain geographical regions because sanctions and other circumstances might provide an edge, or they may simply be driven by cultural and geopolitical aspects. 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 its commercial approaches will generally be the biggest determinants of its risk appetite. For some institutions, compliance can completely block some business, even if they make economic sense from a risk perspective. “Over the years, compliance organizations have also become major components of the risk apparatus,” observes Mihai Andreoiu, senior director at Redbridge Switzerland.
Understanding your bankers
Managers have different backgrounds, perspectives and appetites for risk, which means that a human factor is inevitably part of the mix.
Is the emergence of the generalist banker relative to the old-school specialist favorable or a potential hurdle for you? 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?
The risk appetite for credit-hungry trading businesses with high working-capital requirements can be improved. Ideally, you should analyze each bank like you would any other counterparty. That means you should have 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.
Evaluate the approval process for your credit application. Does the bank have multilevel credit committees with several members, or is the approval process on individual signatory basis? Has anyone from the approval chain visited you, or are they not allowed to meet clients and perform risk due diligence in person?
Risk managers visiting clients might seem controversial from an academic perspective, but in practice, first-hand information can lead 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? You might be surprised how little understanding some risk managers have of relatively basic concepts linked to commodity trading and the related risks.
Understanding your potential lenders, improving the visibility of their approval process and meeting their risk managers will boost the quality of the risk assessment process. Continuously engaging on risk topics and seeking the banks’ feedback on how they assess borrower and transaction risk is fascinating. The more you understand what drives the banker’s perception of risk, the better the chances of increasing their credit appetite and reducing the price they charge. Perception is reality, and 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 is 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, including 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 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 also in tangible results, including 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