The purpose of Basel II, the second of the Basel Accords (which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision), was to create an international standard that banking regulators can use when creating regulations about how much capital needs to be reserved to guard against financial and operational risks. In essence, the goal was to reduce risk and insure trade even in the event that a series of major banks collapsed.
But did it, in fact, accomplish the exact opposite? In two recent articles in the financial times which addressed the current trade credit shortages that are threatening to throttle the global flow of goods, we see that Basel II has become (an) obstacle to trade flows. It seems that the Basel II charter imposes a significant increase in the risk weighting for this activity, relative to its predecessor. (This is scary. Physical goods HAVE a value and invoices to solvent companies result in receivables and trade credit loans make a lot more sense than business development loans to risky start-ups or bail-outs to big corporations that ARE NOT too big to fail in this economy).
More specifically, the focus of Basel II on the “probability of default” of banks’ counterparts — which naturally increases during downturns — substantially exacerbates the negative effect of recessions on banks’ lending. In this context, Basel II has inadvertently become an obstruction to the very lifeblood of international trade. As a result, even though the World Bank (is) urged to lift trade credit finance by the primary global players in trade finance, until a review of the impact of Basel II implementation on lending activities is carried out and new recommendations are made, those companies that don’t take a different path to trade finance and start trading against accounts receivable on The Receivables Exchange (in the US) or Venture Finance (in the UK) are going to have a very rough road ahead.
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Accenture’s recent white paper on taking control in the new era or price volatility listed the following as the four most important success factors for managing commodity risk. At a high level, they’re spot on.
- Procurement & Finance Alignment
A risk policy needs to underlie all activities in both departments to insure the risk appetite of the buyer matches the risk appetite of the corporation. The mitigation strategies have to be implemented appropriately. These means that some risks cannot be ignored while others have to be carried.
- Expertise in Managing Commodity Supply & Price Developments
When do you buy, how long do you contract for, and how much inventory do you carry?
- Visibility into Demand Throughout the Supply Chain
This is the only way to truly measure the impact of raw material fluctuations on the business.
- Effective Performance Measures
Specifically, measures which link the actual purchase price of a commodity to its market price which allow true savings to be calculated as a percentage savings against expected price and the impact of raw material price fluctuations to be assessed.
Unfortunately, the paper was sparse on implementation details, but here are some tips to get you started:
- Aligning Procurement & Finance
The key here is for procurement to lean the language of finance. You can start with Bob’s books on Straight to the Bottom Line and Beat the Odds and Dick’s book on Global Supply Management.
- Managing Commodity Supply & Price Developments
The key here is to stay on top of trends and understand what they mean. Your supply management blogs like Sourcing Innovation, Supply Excellence, and @ Risk will help you out here on a regular basis.
- Demand Visibility
Technology will really help out here. Get a good supply chain visibility platform with good forecasting capabilities and you’ll get a handle on how much you need and how long you should be buying for.
- Performance Measurement
As the white paper noted, year-over-year savings is not a good measurement. What if raw material prices dropped 20% and you only saved 10% — then you left 10% on the table. That’s not good at all. Similarly, if raw material prices went up 20% above the board and you kept cost increases to 10%, that’s a big, big win. Year-over-Year doesn’t capture that. You should be measuring year-over-year savings as the % change in cost over indexed raw material prices. The calculation is a bit more involved than a simple year-over-year differential, but a much more accurate view into how your supply management organization is truly performing. An example calculation is below given the following raw material costs:
||Index Price per Unit
||Units per Commodity
||Cost per Commodity
If you paid $19.64 per unit, then you paid 128% of indexed raw material cost per unit. If, when you did the calculation last year, you paid 135% of raw material cost, then your year-over-year savings is 7% over indexed raw material cost, which is a 25% improvement (7/28).
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