Business Credit Risk Management

A Comparison of Techniques for Mitigating Credit Risks CMA Webinar November 30, 2006 Buddy Baker, Atradius Trade Credit Insurance buddy.baker@ atradius .com

Identifying Export Risks

Identifying Risks in Cross-Border Sales

What might go wrong

Commercial risks

Political risks

Transfer/economic risks

Foreign exchange rate fluctuation risks

Identifying Risks in Cross-Border Sales Slow payment/default Bankruptcy Contract repudiation Commercial risk Contract dispute Abusive bond drawing Financing risk Contract risk

Identifying Risks in Cross-Border Sales Slow payment/default Bankruptcy Contract repudiation Contract dispute Abusive bond drawing Financing risk Contract risk Commercial risk Foreign exchange control legislation Discharge of debt legislation Government repudiation of debt Payment moratorium Insurrection/overthrow/domestic turmoil Non-payment due to war Non-payment due to natural disasters Country risk Political risk Currency inconvertibility Transfer/economic risk

Identifying Risks in Cross-Border Sales Slow payment/default Bankruptcy Contract repudiation Contract dispute Abusive bond drawing Financing risk Contract risk Commercial risk Foreign exchange control legislation Discharge of debt legislation Government repudiation of debt Payment moratorium Insurrection/overthrow/domestic turmoil Non-payment due to war Non-payment due to natural disasters Country risk Political risk Currency fluctuation/devaluation FX risk Currency inconvertibility Transfer/economic risk

Identifying Risks in Cross-Border Sales

What might go wrong

Commercial risks

Political risks

Transfer/economic risks

Foreign exchange rate fluctuation risks

Depending on the goods, it may make a big difference whether things go wrong before or after shipment

Choosing Credit/Payment Terms

The spectrum of credit/payment terms

Extended terms, installment notes

Open account, clean drafts

Time draft (D/A)

Consignment/retention of title

Sight draft (D/P, C.A.D.)

Cash against goods, C.O.D.

Advised letter of credit: sight & time

Confirmed letter of credit

Cash in advance

Choosing Credit/Payment Terms

The spectrum of credit/payment terms

Extended terms, installment notes

Open account, clean drafts

Time draft (D/A)

Consignment/retention of title

Sight draft (D/P, C.A.D.)

Cash against goods, C.O.D.

Advised letter of credit: sight & time

Confirmed letter of credit

Cash in advance

Risk Mitigation Techniques

Letter-of-Credit-related techniques

Unconfirmed L/C

Confirmed L/C

‘ Silent L/C confirmation’

Standby L/C

Independent/demand guarantee

Accessory/contract guarantee, surety bond

Sight draft, ‘documents against payment’

Avalized draft & forfaiting

Factoring

Non-recourse sale of receivables

Credit insurance

Credit derivatives

Forwards & futures

Options

Guarantees Documentary-Draft-Collection-related techniques Open-Account-related techniques FX contracts

Unconfirmed L/C

How Letters of Credit Work: Theory Buyer Seller Contract Buyer’s Bank Letter of Credit Application

How Letters of Credit Work: Theory Buyer Seller Contract Buyer’s Bank Letter of Credit Application Letter of Credit

How Letters of Credit Work: Theory Buyer Buyer’s Bank Seller Contract Letter of Credit Application Letter of Credit 3 parties 3 independent contracts

How Letters of Credit Work: Theory Buyer Buyer’s Bank Seller Contract Letter of Credit Application Letter of Credit Principles of Letters of Credit: Independent and Documentary Goods Documents

How Letters of Credit Work: Theory Buyer Buyer’s Bank Seller Contract Letter of Credit Application Documents Letter of Credit Goods Payment

How Letters of Credit Work: Theory Buyer Buyer’s Bank Seller Contract Letter of Credit Application Documents Letter of Credit Goods Documents Payment Debit

How Letters of Credit Work: Theory Buyer Buyer’s Bank Seller Contract Letter of Credit Application Documents Documents Payment Debit Letter of Credit Goods

How Letters of Credit Work: Reality Foreign Buyer Buyer’s Bank Advising Bank Seller’s Bank Seller Negotiating Bank Freight Forwarder Reimbursing Bank Contract L/C Appli-cation Docu-ments L/C L/C L/C L/C & Documents Documents Payment Payment Reimbursement Authorization Reimbursement Goods Goods Reimbursement Claim Debit

Risk Mitigation Techniques 7. A receivable in a foreign currency made be sold, including the remaining currency fluctuation risk. 8. FX exposure depends on the currency of the credit.

Risk Mitigation Techniques 1. It may be possible for the applicant to obtain a court injunction to stop payment of a non-negotiable L/C.

Unconfirmed L/C

Unconfirmed L/C

Confirmed L/C

How Letters of Credit Work: Theory Buyer Buyer’s Bank Seller Contract Letter of Credit Application Documents Documents Debit Letter of Credit Goods Payment

How Confirmed Letters of Credit Work Buyer Seller Docu-ments Pay- ment Goods Contract Confirming Bank L/C L/C Debit Documents Payment Buyer’s Bank L/C Appli-cation Docu-ments

Problems with Confirming Banks

The Confirming Bank is chosen by the Issuing Bank

The Confirming Bank has a monopoly position

The Confirming Bank may be an affiliate of the Issuing Bank

The Confirming Bank can be enjoined from making payment #

Unconfirmed L/C

Confirmed L/C

Unconfirmed L/C

Confirmed L/C

‘Silent L/C confirmation’

How Commercial Letters of Credit Work Seller Buyer Negotiating Bank Docu-ments Goods Contract Debit Documents Payment Pay- ment Buyer’s Bank L/C Appli-cation L/C Advising Bank L/C Docu-ments

Unconfirmed L/C

Confirmed L/C

Unconfirmed L/C

Confirmed L/C

Standby L/C

Unconfirmed L/C

Confirmed L/C

Assignment of proceeds

Assignments of Proceeds

Security interest in a contingent asset

Not top of the priority list (U.S. law):

1. transferred L/Cs

2. holders-in-due-course (cut off by endorsing the L/C)

3. third-party payees(?)

4. set-off rights of Negotiating Bank/Issuing Bank

5. prior perfected assignees of proceeds with “control”

6. holder of a perfected assignment of proceeds with “control”

7. holders of general, perfected security interests

8. general creditors

Unconfirmed L/C

Confirmed L/C

Unconfirmed L/C

Confirmed L/C

Transferable L/C

Unconfirmed L/C

Confirmed L/C

Transferable L/C

Standby L/C

How Letters of Credit Work: Theory Buyer Buyer’s Bank Seller Contract Letter of Credit Application Documents Documents Payment Debit Letter of Credit Goods

How Standby Letters of Credit Work Applicant Applicant’s Bank Beneficiary Contract Letter of Credit Application Letter of Credit Payment

How Standby Letters of Credit Work Applicant Applicant’s Bank Beneficiary Contract Letter of Credit Application Letter of Credit Documents Documents Payment Debit

Risk Mitigation Techniques 2. Preferential payment risk exists unless the standby is properly worded. 3. Country risks are covered if the L/C is confirmed by a “developed-world” bank. [7. A receivable in a foreign currency made be sold, including the remaining currency fluctuation risk.]

Guarantees

Independent/demand guarantee

Accessory/contract guarantee, surety bond

Standby L/Cs vs. Guarantees & Bonds Standby L/C Demand Guarantee Accessory/Contract Guarantee, Surety Bond Independent & payable against documents Independent & payable against documents Specified amount Specified amount Payable upon occurrence of specified event Amount of damages (usually with a maximum) Specified expiry Usually has a specified expiry Expiry event Rules: UCP or ISP (and UCC5 in the U.S.) Rules: URDG, ISP, or local law Rules: Local law

Risk Mitigation Techniques 4. Country risks are covered if the guarantee is a ‘local guarantee’. 5. If the principal repudiates the contract, the guarantor may do the same. Be sure you know which kind of guarantee you’re dealing with

Documentary-Draft-Collection-related techniques

How Documentary Collections Work: Sight Drafts Buyer Seller Contract

How Documentary Collections Work: Sight Drafts Buyer Seller Contract Goods

How Documentary Collections Work: Sight Drafts Buyer Seller Contract Buyer’s Bank Documents Goods

How Documentary Collections Work: Sight Drafts Buyer Buyer’s Bank Seller Contract Documents Payment Goods

How Documentary Collections Work: Sight Drafts Buyer Buyer’s Bank Seller Contract Documents Payment Documents Goods

How Documentary Collections Work: Sight Drafts Buyer Buyer’s Bank Seller Contract Documents Documents Payment Goods

How Documentary Collections Work: Sight Drafts Buyer Buyer’s Bank Seller Contract Goods Documents Documents Payment Payment

How Documentary Collections Work: Sight Drafts Buyer Buyer’s Bank Seller Contract Goods Payment Documents Documents Payment

Avalized draft & forfaiting

How Documentary Collections Work: Sight Drafts Buyer Buyer’s Bank Seller Contract Goods Payment Documents Documents Payment

How Documentary Collections Work: Sight Drafts Buyer Buyer’s Bank Seller Contract Documents Payment Goods

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Documents Accepted Draft Goods

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Documents Goods Accepted Draft Documents

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Goods Documents Accepted Draft Documents

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Documents Goods Accepted Draft Documents Payment

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Documents Payment Goods Accepted Draft Documents Accepted Draft

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Documents Payment Accepted Draft Goods Payment Accepted Draft Documents

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Payment Documents Payment Accepted Draft Goods Accepted Draft Documents

How Documentary Collections Work: Time Drafts Buyer Buyer’s Bank Seller Contract Documents Accepted Draft Goods

How Documentary Collections Work: Avalized Drafts Buyer Buyer’s Bank Seller Contract Goods Documents adds aval Accepted Draft

How Documentary Collections Work: Avalized Drafts Buyer Seller Contract Documents Avalized Draft Documents Buyer’s Bank Goods Accepted Draft

How Documentary Collections Work: Avalized Drafts Buyer Buyer’s Bank Seller Contract Avalized Draft Documents Goods Accepted Draft Documents Payment

How Documentary Collections Work: Avalized Drafts Buyer Buyer’s Bank Seller Contract Avalized Draft Documents Payment Goods Accepted Draft Documents Payment Avalized Draft

Open-Account-related techniques

Factoring

Factoring

Factoring

Factoring

Factoring

Credit insurance

Risk Mitigation Techniques 6. Contract repudiation insurance is available as separate coverage.

Factoring

Credit insurance

Factoring

Credit insurance

Credit derivatives

Factoring

Credit insurance

Credit derivatives

FX contracts

Forwards & futures

Options

Commercial Letters of Credit

Standby Letters of Credit & Demand Guarantees

Forfaiting

Sale of Receivables

Credit Insurance

Credit Derivatives

Foreign Exchange Contracts

Credit Policy Matrix

Unconfirmed LC

Cash in advance

Demand guarantee or standby LC

1 Low 2 Moderate 3 High 4 Very High Country Risk 4 Very High 3 High 2 Moderate 1 Low Customer Risk

Unconfirmed or confirmed LC

Cash in advance

Local guarantee or confirmed standby LC

Demand guarantee or standbyLC

Confirmed LC

Cash in advance

Cash in advance

Confirmed LC

Unconfirmed LC

Demand guarantee or standby LC

Factoring

Credit insurance (commercial risks)

Confirmed Authority to Pay

Demand guarantee or standbyLC

Credit insurance (commercial risks or comprehensive)

Confirmed LC

Credit insurance (comprehensive)

Confirmed LC

Cash in advance

Factoring

D/P collections

D/A collections w/ forfaiting

Credit insurance (commercial risks)

Unconfirmed LC

Authority to Pay

Confirmed LC

D/P collections

Confirmed LC

Cash in advance

Open account

D/A collections

Factoring

Open account

D/P collections

Credit insurance (political & economic risks)

D/P collections

Countertrade

Credit insurance (political & economic risks)

Cash in advance

Countertrade

Denotes ‘High to Very High Risk’ areas which may require significant risk neutralization NB: This document is for illustrative purposes only, and is not intended to delineate the recommendations of Atradius regarding risks associated with international trade