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The Dimensions of Risk Management - July

By Michael Vincent

28 December, 2006

Risk is defined by function rather than impact.  We have seen over the last few months that identification and control procedures within corporations are implemented on a discipline basis and risk is usually segmented and control fragmented.  The corporation that adopts an holistic approach to the identification and control of risk will be the entity that prospers within the corporate risk environment of today.

 

This month we examine the risks incurred by a financial institution in the wholesaling of foreign currency to the holiday/tourist industry segment of our economy.   This project was undertaken by Mr. Charles Isbester who is a practitioner within the industry.  His major concern was to identify the actual risks incurred by a financial institution that used agents to get their product to market.

 

The report focused on wholesaling of foreign currencies to various types of businesses involved in the travel and tourist industry.   Examples of the types of entities are, automobile associations, airlines, government, travel agents  and other financial institutions.

 

The various types of risk identified are, security risk, foreign exchange risk, liquidity risk,  interest rate risk, credit and settlement risk.    All are forms of financial risk and have to potential to drastically affect the profitability of the wholesaler, on the other hand there is the potential for significant opportunity gains based on external movements of the factors rather than internal effective management systems.

 

The report concentrated on two of the major risks identified, i.e. Credit risk and settlement risk.  The writer concluded that these risks had the potential for most damage and paradoxically had the best potential for correct control systems.

 

Credit risk, can be defined as the inability of the debtor to settle the debt at a future date.   Sourcing information regarding a potential debtor will initially require data containing all relevant information required for an effective financial decision to be made, in addition it must be recognised that the process of assessment must be constant and ongoing.

 

Under normal business conditions it is practice for a credit supplier to require the completion of an application for credit before allowing goods and services to be supplied on agreed terms.   The credit application is a useful tool in assessing the risk of potential default in the future.

 

The most important aspect of a credit application is the verification of the quality of the data given, thus enabling an informed decision to be made as to the credit worthiness of the potential client.   Financial ratios and strengths can also be assessed.

In addition it can be a legal document that supplies information about the structure and ownership of the entity.  It forms the basis for further enquiries about the applicant and the worthiness of the applicant to become a line client.    Verification of the information contained in the application can be sought from trade references, banks, or agencies specialising in the supply of credit information.   

 

 

Settlement risk, can be defined as the inability of the debtor to settle the debt at a future date under the agreed terms.    Profit margins in the industry are relatively thin and profitability revolves around time and volume.  The inability of the debtor to settle within the agreed time frame can drastically affect the level of profit;  basically because the transaction profit is based on a margin over the cost of funds.   Effective management of this segment of risk ensures a continuance of an effective and sufficient cash flow.  

 

Different payment methods lead to different settlement times and accordingly different levels and exposure to this risk, i.e. bank cheque, company cheque, settlement by mail or direct and electronic funds transfer.

 

Conclusion:

  

Financial institutions depend of high volumes and low margins for their ongoing cashflows and profitability.   When a business operates under tight margins the maximising of revenue and the minimisation of costs is essential for ongoing survival.

 

Under such conditions all costs can have major repercussions on the profitability of the business.

 

The identification of credit risk and the effective implementation of control procedures will be an effective tool in minimising the impact of adverse results on the entity and industry.

 

There is a cost to any business in the granting of credit, within the financial services community the timing of collection is the key to effective profits.  The inability to have effective control mechanisms in place means the corporation will cease to be an effective player within the highly competitive financial arena.

About the Authors

Senior Lecturer, Department of Accounting and Finance

Faculty of Business and Economics

Monash University

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