Conducting cross-border business is riskier than operating domestically. There are numerous additional risks related to foreign laws and regulations, the availability and conversion of foreign currency, as well as logistics involved in export and import.
Trade finance plays a crucial role in supporting international trade and mitigating some of these risks for both buyers and sellers. According to estimates from the World Trade Organization (WTO), 80–90 percent of global trade depends on some form of trade finance.
However, it’s not only importers and exporters who bear risks in international trade. Banks and other financial service providers (hereinafter “providers”) offer financing in various ways and, in doing so, face their own risks.
This guide is dedicated to the main risks faced by financial service providers. Its purpose is to give you a broad overview of the risks you may encounter so that you are better prepared and can better manage the solutions you offer your clients.
The following risks are considered:
- Counterparty risks
- Political risks
- Foreign exchange risks
- Dilution risks
- Insolvency risks
- Fraud risks
- Regulatory risks (Compliance)
Counterparty Risks
Counterparty risk is the risk that one or more parties to a transaction will fail to fulfill their obligations. A default may relate to the payment of funds or the performance of contractual obligations, leading to potential losses for the provider.
Each counterparty in a trade finance transaction represents a certain level of risk, and the provider must assess this risk to decide whether to accept it and under what conditions.
The provider needs to know or determine what constitutes risks when working with these counterparties. Generally, the risks are the source of repayment, reimbursement, or payment for a transaction or financing provided by the provider.
For example:
- When a provider extends financing to an importer based on their invoices, it assumes the counterparty risk of the importer regarding the repayment of that debt on time.
- When the advising bank processes or negotiates a letter of credit (LC), it assumes the issuer bank’s risk of timely reimbursement.
- When a bank (guarantor) issues a guarantee countered by a counter-guarantee from a correspondent bank, the guarantor assumes the risk of the correspondent bank counterparty for the reimbursement of any payment on demand.
- When a provider purchases receivables, it assumes the risk of the debtor counterparty (usually the buyer of goods) paying the receivables on time, as well as the risk of the seller counterparty regarding any performance issues that reduce the amount payable by the debtor.
The counterparty’s ability and willingness to pay or perform their obligations is paramount. Whether the provider and their instrument are paid, reimbursed, or settled on time depends on whether the counterparty is risky:
- Wants and can;
- Wants but cannot;
- Can but does not want;
- Neither wants nor can.
Counterparty risk often overlaps with many other risks mentioned in this guide, and various risks often do not exist in isolation from one another.
Methods to mitigate counterparty risk include enhancing creditworthiness and security. Examples of enhancing creditworthiness are:
- Corporate guarantees (e.g., from the parent company of the client) when the guarantor is a counterparty with a higher level of trust/credit leverage/credit history;
- Trade credit insurance on the acquired or financed receivables;
- Development bank guarantees for confirmation and/or financing under a letter of credit;
- Equity participation (consolidation) to distribute risk in transactions or trade finance programs among participants (usually financial institutions).
COVID-19 has negatively impacted revenues, cash flow, debt levels, and access to financing for many businesses, leading to increased counterparty risks in some trade finance transactions.
Political Risks
Political risk is the risk arising from actions by governments, authorities, or regulators that lead to adverse consequences for trade with counterparties within their jurisdiction. The causes of risk are diverse and include geopolitical tensions, economic crises, and political instability.
Examples of risks in importing countries include the imposition of import restrictions, increased import duties, and restrictions on the outflow of foreign currency from the country.
Examples of risks in exporting countries include changes in export licensing requirements, imposition of restrictions on exporting certain goods, and embargoes on sales to certain counterparties or countries. Political risk also includes situations where a country is unable to service its sovereign debt or faces a currency crisis.
Some examples of how this risk can affect trade finance:
- The issuing bank’s inability to reimburse the advising or negotiating bank, which has been demanded or properly presented, due to the imposition of currency controls in the importing country.
- The exporter’s inability to fulfill export orders for which pre-shipment financing was provided, due to the imposition of export restrictions or embargoes, cutting off their source of financing repayment.
Some ways to reduce this risk include:
- Credit insurance covering political risk, where possible or advisable.
- A multilaterally backed development bank guarantee (e.g., from the Asian Development Bank, Afreximbank, International Finance Corporation) under the relevant trade finance program offered by the MDB.
- For documentary trade finance — confirmation or irrevocable undertaking of reimbursement from a bank in a lower-risk location (country).
- Distribution of risks among other financial institutions.
COVID-19 has exacerbated the causes of political risk and thereby increased it. The tension caused by the global spread of the virus has led to the adoption of protectionist policies, trade embargoes, and trade sanctions by nation-states. It has also increased the risk of sovereign defaults.
Foreign Exchange Risks
Foreign exchange risk is the risk arising from fluctuations in currency conversion rates. Exchange rate fluctuations occur for various reasons, including monetary policy, economic conditions, government actions, currency traders’ speculation, and the supply and demand for the currencies being bought and sold.
Although foreign exchange risk is primarily a risk for the importer and exporter, the provider needs to know how it can affect its clients and be aware of how exposure to foreign exchange risk can worsen a client’s solvency.
An importer may pay their bank in local currency for conversion into the foreign currency in which their purchases are denominated. If the purchase is secured by a letter of credit denominated in a foreign currency, the issuing bank faces the applicant’s currency risk, as any devaluation or depreciation of the local currency will increase the amount in local currency that must be reimbursed or repaid to the issuing bank by the applicant.
An exporter selling goods in foreign currency may convert it into local currency to settle with the provider that offered export financing. If financing is provided in local currency, a significant increase in the local currency’s value may result in insufficient funds converted from the foreign currency to repay the financing.
A common way to mitigate foreign exchange risk is to use hedging methods, such as forward contracts with banks (to fix the exchange rate for a certain period) and currency options. The counterparty may also conduct exports and imports in the same currency, which can provide a natural hedge for their foreign currency needs.
COVID-19 has caused sharp fluctuations in currency markets, especially in the currencies of some emerging economies, as a result of a flight to “safe” currencies.
Dilution/Dilution Risk
Dilution/dilution risk refers to the risk that the amount a debtor can pay on trade receivables will be less than the invoiced amount. Dilution can occur for a variety of reasons, including returns of goods, underdelivery, damaged goods, warranty claims, invoicing errors, discounts, and commercial disputes.
The impact of this risk on trade finance is primarily in the financing of exporters’ receivables on open account terms using supply chain finance methods such as receivables discounting, factoring, and loan or advance against receivables. This is because the buyer has time until the receivables are due to adjust the amount they will pay on the exporter’s invoices.
Dilution risk may reflect the exporter’s performance risk, as some events leading to dilution occur due to the exporter’s fault; examples include defective goods, insufficient shipment, invoicing error.
Methods to mitigate this risk include:
- Proper due diligence on receivables should be conducted before financing begins to assess the dilution percentage and set an appropriate advance rate for financing. The level of dilution can be monitored on a continuous basis, and advance rates may be periodically adjusted accordingly.
- Use of unconditional payment instruments such as promissory notes/bills of exchange and debt instruments to create a payment obligation separate from the underlying commercial transaction.
- Dilution should be included as a recourse event in the financing agreement with the exporter; i.e., the exporter must reimburse the provider for any shortfall caused by dilution in the receivables collection.
Insolvency Risk
Insolvency risk refers to the risk that a counterparty may become unable to pay its debts and financial obligations. Insolvency might result from losses and cash flow problems due to uncollectible debts, inability to sell inventory, and/or loss of credit facilities.
When a commercial organization becomes insolvent and goes under the management of a bankruptcy trustee (also known as an insolvency practitioner, liquidator, administrator, etc., depending on the jurisdiction), the insolvent company’s debts are ranked by priority as secured or unsecured to determine the order of creditors’ payments.
A provider may face competing claims from other creditors over the insolvent entity’s assets; these other creditors may include the government (e.g., for taxes), banking creditors, and trade creditors such as suppliers.
A provider faces insolvency risk from counterparties that have bilateral repayment obligations to it (e.g., for trade financing extended), counterparties with which it may not have direct financial relationships (e.g., debtors in receivables purchases), and other counterparties on whose risk the financial provider has extended financing (e.g., the issuing bank of a letter of credit).
Mitigating insolvency risks includes:
- Assessing and continuously monitoring the creditworthiness of relevant counterparties
- Non-recourse financing agreements
- Collateral availability
- Enhancing collateral mechanisms
- Trade credit insurance, where possible
Fraud Risk
Fraud risk refers to the risk arising from deliberate deception. Fraud may be committed against one or more buyers, the seller, and the provider. Fraud can be perpetrated by a single party or two or more parties acting in collusion.
Common types of fraud in trade finance include:
- Duplicate financing of invoices, where the same invoices are used to obtain financing from two or more providers.
- Use of fake or forged documents to obtain financing.
- Collateral fraud related to inventory, such as false valuation and pledging the same inventory multiple times to different providers.
Since fraud is intentional, its forms can be highly varied and are limited only by the creativity of criminals.
There is no guaranteed protection against fraud, but the provider should implement certain risk management methods, such as ensuring strict internal controls (e.g., segregation of duties, use of the “four-eyes principle”), proper client due diligence, and independent fact-checking of transactions (e.g., vessel verification, price verification).
Technology can help in detecting fraud, for example, using data in information systems to identify anomalies and “red flags,” such as the repeated use of the same data for different financial operations within one financial provider or across different financial providers.
COVID-19 has led to increased fraud risks, and business disruptions caused by the pandemic (commodity prices, availability of financing, etc.) have also contributed to the disclosure of some types of fraud that were previously undetected in the trade and commodity finance sector.
Regulatory Risks
Regulatory compliance risk refers to the risk of legal or regulatory sanctions, financial losses, and reputational damage that a provider may incur as a result of failing to comply with applicable laws and regulations.
The Financial Action Task Force (FATF) refers to “trade-based money laundering” as the process of disguising proceeds of crime and moving values using trade transactions, which may be carried out by misrepresenting the price, quantity, or quality of imports/exports, as well as through fictitious trade activities.
In addition to money laundering, compliance with financial crime requirements includes countering terrorism financing, combating bribery and corruption, non-proliferation of weapons of mass destruction, and adhering to economic, financial, and trade sanctions imposed by states and the United Nations.
A provider may also face the risk of being unable to recover or be reimbursed, for example, if it has provided financing to an exporter under a documentary letter of credit, but the issuing bank withholds payment due to detection of a breach of applicable sanctions.
Methods to mitigate this risk include:
- Training and educating provider staff on compliance issues and instilling a compliance culture based on guidelines or directives from regulators
- Effective Know-Your-Customer (“KYC”) practices for verifying the client and their owners prior to onboarding (and periodic post-onboarding reviews) and Customer Due Diligence (“CDD”) to assess AML/CTF risk levels
- Reviewing, analyzing, and monitoring transactions to ensure that the underlying trade operations are genuine and do not violate applicable laws
Effective regulatory compliance management should yield benefits in the form of reduced complexities for clients and help governments achieve their goal of financial transparency.
FATF reports that criminals are exploiting the COVID-19 pandemic to conduct financial fraud and scams, and that terrorists may also use similar opportunities to raise funds, recommending that financial institutions and other enterprises remain vigilant regarding emerging risks of money laundering and terrorism financing in mitigation, detection, and reporting.
COVID-19 Considerations
The COVID-19 pandemic has increased all the types of risk discussed. For many businesses, this event has been a “black swan.”
An increase in counterparty risk entails an increase in insolvency, dilution, fraud, and compliance risks. An increase in political risk entails an increase in counterparty, foreign exchange, and insolvency risks. There is an interconnection between different risks, and one can feed another.
Trade finance is vulnerable to heightened risks, and some financial service providers (providers) have responded by restricting or reducing trade finance.
In September 2020, the ICC established the “Advisory Task Force on Trade Finance” (ATF) aimed at informing governments and multilateral institutions about policy reforms and interventions designed to create a trade finance ecosystem for a rapid economic recovery after COVID-19. Trade finance is seen as a crucial tool for international trade and as key to reviving the global economy and creating jobs after COVID-19.
Effective management of various risks associated with trade finance will benefit providers and the clients they serve, the national economy, international trade, and the global economy. The first step toward effective risk management is understanding the nature of different risks.
Modern challenges in managing trade finance risks may become a catalyst for the implementation of new risk management tools, which should include the digitization of processes to make them more efficient, secure, verifiable, and cost-effective.