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  • Risk in relation to credit - some basics


    Risk is often assumed to concern only sellers and buyers but there are other parties to a transaction. Usually finance for the deal is directly or indirectly provided by banks or other financial institutions whose risk is that after they have advanced funds to enable a transaction things somehow fall apart and part or all of the funds cannot be recovered. So there are three principals to almost all transactions: sellers, buyers and financiers, each of whom have different but interlinked risk concerns.Therefore credit and risk mitigation are irrevocably linked. (Of course insurers or underwriters are also party to risk but as service providers, not as principals).

    Few producers, traders, processors, exporters, importers, trade houses or roasters are able to finance turnover from 'own funds'. If they were able to do so then the financiers' preoccupations with risk would not concern them, except to say that in a well run business many of those concerns are taken into account as a matter of course. But if one aspires to borrow working capital then all the lender's preoccupations have to be addressed satisfactorily: otherwise there is little chance of obtaining any finance.

    Simply put, there are two perspectives to risk and risk management:

    • The commercial perspective or trade perspective is mainly preoccupied with managing physical and price risks, although performance risk also plays a role.
    • The financial perspective or lending perspective on the other hand is mainly concerned with performance risk.

    All the other risks associated with commerce also feature, but a lender can insist on many types of risk 'insurance' against these, ranging from insurance against loss or theft to the hedging of unsold stocks or open positions. But what of the risk that a borrower does not perform - that is, someone becomes unable to refund a loan, misrepresents the company's financial or trading position, misstates the quality of goods financed, or engages in pure speculation without the knowledge of their financial backers?

    What if the suppliers or buyers a borrower depends on default against that borrower? For example, unfavourable price movements cause a supplier to renege on sales contracts, thereby rendering the borrower unable to fulfil their own obligations, through no fault of their own.

    Each type of trade has its peculiarities and coffee is no exception. An added factor is that a coffee's value depends not only on supply and demand but also on quality. No-one without at least some ability to assess and value quality would be expected to make a success of the physical or green coffee business as a trader, processor, exporter, importer or roaster. But assessing that quality, and therefore a coffee's commercial value, is not an exact science. Market analysis is not exact either, with many price movements difficult to anticipate or explain. These uncertainties complicate the business of raising loan finance because banks dislike uncertainty in any shape or form.

    The risks that attach to monies lent for investment in visible physical assets (i.e. land and buildings) are very different from the risks on monies lent to finance trade in coffee. Commodity trade finance is a highly specialized activity, usually undertaken not by the average retail bank but rather by corporate lending or commodity trade finance banks.

    The term 'trade finance' is self-explanatory: these banks finance trade, not speculation. Prospective borrowers should understand this from the very beginning. Therefore, before any credit limit or credit line can be agreed, the types of transactions that are to be financed have to be agreed, to avoid each and every deal having to be individually approved. Usually, but not always, the borrower can then trade freely within the limits that have been agreed and needs to apply for additional approval only if, for example, they wish to increase their credit line.

    Different risks attach to financing the trade in coffee. Some of these could be termed trend risks, in that changing trends in the coffee world can have negative effects on those who borrow trade finance. Other, more transaction specific risks attach to the type of coffee trade engaged in.

    This discussion is limited to the financing of coffee that has been harvested, i.e. 'off the tree'. 'On tree' financing criteria would be based on many of the considerations described below but also on many others that go beyond the scope of this website.