Beware credit risk exposures

December 2004 Security Services & Risk Management

Companies today are often too easily lured by seemingly attractive potential business prospects in their quest to deliver positive financial results and enhance business sustainability, particularly in tough, competitive and precarious market environments.

Paul Skivington, a director of enterprise-wide risk at Alexander Forbes Risk Services says the first step in any business strategy should be to identify potential credit risk. Credit risk is defined as the possibility that a counter-party will fail to meet its obligation in accordance with the agreed terms.

"Minimising the risk of a creditor defaulting on a payment by maintaining credit risk exposure within acceptable parameters is the central goal of credit risk management," he says.

"Credit risk exposures are an imperative aspect of a company's risk management strategy and one that also needs to be aligned with the company's overall corporate growth strategy.

"This is particularly the case in view of the guidelines in the code of corporate governance, commonly known as the King II Report, which highlights that the onerous responsibility for managing the company's risk lies with the board of directors. These guidelines and codes generally promote practices designed to enhance accountability to shareholders," says Skivington.

Growth strategies such as offshore opportunities, expansion plans, mergers and acquisitions and product developments may initially appear to increase profitability. However, the often-unseen associated credit risks therein may be detrimental to the success of the strategy.

Skivington cites some examples of potential credit risks that businesses need to be cognisant of:

* US dollars are commonly used in many countries for foreign trade transactions and currency fluctuations and recent dollar weakness can create currency risk.

* Greater access to international financial markets has benefited many businesses, however, it has also exposed them to the potential dangers of the volatile flows of these markets, sizable foreign currency debts of many countries, such as Argentina, and to speculative currency attacks.

* Some countries such as Zimbabwe and Argentina offer disincentives to release foreign currency within their country by charging a fee of up 20% to do so.

* Fiscal policies such as foreign exchange regulations, tax legislation, import and export taxes and legislation and interest rate fluctuations are among the various credit risk exposures that need to be thoroughly investigated.

"An error often made by South African businesses operating in foreign markets is that of assuming the dynamics of foreign countries is similar to those of the local market and that foreign companies conduct their business in a comparable manner," says Skivington.

The financial risk of conducting business transactions before the identification of potential credit risks and a full due diligence often far outweigh any potential business benefit.

"Subsequent to the identification of potential credit risks is the establishment of credit risk reduction measures," says Skivington. "Mergers and acquisitions can expose a company to the potential credit risk of being overweight in a particular market or sector and literally having 'too many eggs in one basket'. To avoid huge potential losses that could be incurred should the one company suffer financially, a company should consider ways to change the situation - for example, through diversification of its business risks."

Other factors that have a bearing on credit risk include: the timing of exchange of value, payment/settlement finality, the role of intermediaries and clearing houses; market movements and trends, competing product developments, changes in economic conditions, legislation and industry specific changes.

Skivington says a credit risk assessment process will enhance long-term shareholder value, protecting a company's people, assets and its operating environment.

Alexander Forbes Risk Services, Paul Skivington, 011 669 3000, [email protected]

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