Effective Transactional Risk Management

How Transactional Risk Differs from Country Risk

Transactional risk is distinct from "political," "sovereign," and "country" risk. Although the term "country risk" is widely and generically used to refer to the risks assumed by operating in another country, country risk is really a misnomer in this context. Even the term "political" risk does not fully encompass the scope of risks a company encounters when operating in a foreign arena.

Political risk may be differentiated from a number of other forms of risk that are often used in tandem. Political risk refers to arbitrary or discriminatory actions taken by governments, political groups, or individuals that have an adverse impact on trade or investment transactions.

Political risk may be differentiated from country risk, which is the risk that a country will be unable to honor its financial commitments, and sovereign risk, which is the risk that a foreign central bank will alter its foreign-exchange regulations and significantly reduce the value of foreign-exchange contracts.

In spite of these clear differences, it is common for business practitioners to use the three terms interchangeably. Transactional risk, by contrast, is the country, sovereign, political, economic, financial, technical, environmental, developmental, and socio-cultural risk that an organization assumes in every international action it engages in.

How Banks Approach Transactional Risk Management

Much can be learned from the experience of international banks in managing transactional risk. Nearly all banks have developed formal programs to manage transactional risk, and most of these are centralized so as to establish and maintain control over an entire network of operations. More often than not, a board of directors will approve the risk management policy, but the nature of a risk management reporting system will vary by organization. Transactional risk management is usually integrated with the credit risk management function, but larger banks tend to integrate transactional risk management into their overall risk management process.

Responsibility for transactional risk management generally resides with a high-level risk management committee at headquarters or the senior country officer (in the case of foreign operations). Although there is general inconsistency about who within an organization actually takes responsibility for determining transactional risk, common approaches include a formal "country" risk committee, a credit department, or country managers.

No bank relies entirely on external sources of information, but smaller banks are more inclined to rely more heavily on such sources due to lack of resources. A number of regional and multinational banks have established procedures to deal with risk tolerances and deteriorating conditions in a country. The most common approach simply relies on informal lines of communication among experienced managers in times of crisis.

Almost all banks assign formal country ratings, most of which cover a broad definition of risk. Ratings are typically assigned to all types of credit and investment risk, including local currency lending. Transactional risk ratings establish a ceiling that also applies to credit risk ratings. Most banks do not generally have formal regional limits, but some banks monitor exposures for a given region informally, and most have specific country limits.

Most banks take a comprehensive view of risk, but tend to differ in terms of how specific risks affect their risk rating system. Many banks apply a single country rating to all types of exposure, while distinguishing between foreign and local currency funding. Formal exposure limits tend to be set annually and managed through the use of aggregate country exposures. Risk tolerances are recommended primarily by line management and approved by a high level committee. The maximum level of exposure for a given country is generally determined by the assigned risk rating.

The Lessons of the Asia Crisis

Although most banks indicate that existing macroeconomic data needed to assess country risk is generally adequate, there are gaps in the data necessary to evaluate country vulnerability to payment shocks. Most banks use a system of country risk ratings that rely on monitoring of real and financial macroeconomic indicators. This has, at times, failed to give them adequate warning to arrange to exit a market in a timely fashion. Better information on foreign currency reserves and short-term debt would have been useful in that regard. ¹

One of the lessons learned from the Asia Crisis was the relevance of measuring available official foreign exchange resources and short-term public sector obligations denominated in foreign currencies that constitute a drain on resources. There is a need for timely and transparent reporting of official foreign exchange reserves and other information needed to assess the short-term liquidity positions of the official sector. Another area of generally insufficient data is the outstanding short-term foreign currency exposures of nonfinancial corporations in emerging markets. Means must be found to address these shortfalls, which serve to highlight the importance of obtaining a variety of types of data to measure the same variable.

The Asia Crisis taught banks some important lessons about transactional risk management. Among them, the need to more effectively incorporate several additional sources of information in risk analyses to include the credit risk associated with private sector counterparties, the potential loss of liquidity, and contagion effects. An over-reliance on historical volatility to measure risk contributed to an underestimation of risk.

Elements of an Effective Risk Management Process

A sound transactional risk management process will include certain basic elements that result in the creation of an environment conducive to effectively managing risk. ²

• Effective oversight by a board of directors
• Adequate risk management policies and procedures
• An accurate system for reporting country exposures
• An effective process for analyzing country risk
• A country risk rating system
• Established country exposure limits
• Regular monitoring of country conditions
• Periodic stress testing of foreign exposures
• Adequate internal controls and an audit function

Within this context, it is important to establish clear tolerance limits, delineate clear lines of responsibility and accountability for decisions made, and identify in advance desirable and undesirable types of business. Policies, standards, and practices should be clearly communicated, and enforced, with affected staff and offices. Quarterly reporting should be imposed—more frequently if foreign exchange exposure impacts a given investment.

It is naturally also important that analyses be adequately documented and conclusions communicated in a way that gives decision makers an accurate basis on which to gauge exposure levels, and that sufficient resources be devoted to the task of assessing risk. Since the Crisis, some banks have centralized the analytical process and engage in periodic assessments of risk on a more regionalized basis (as opposed to strictly on a country-specific basis).

Best practices dictate that a number of actions should be taken to create a transactional risk management program. Among them:

• The transactional risk management function should be centralized.
• Transactional risk guidelines should be established and widely disseminated.
• Country/sector limits should be established.
• A system to better delineate the severity of perceived risks should be established.
• Quarterly transactional risk reporting should be implemented.
• A company should make maximal use of internal information capabilities while incorporating a wide array of external information sources into analyses.

Much can be learned at a corporate level by the approach and experience of international banks in addressing transactional risk. Nearly all banks have developed formal programs to manage transactional risk, and most of these are centralized so as to establish and maintain control over an entire network of operations. Almost all banks assign formal country ratings, most of which cover a broad definition of risk. Ratings are typically assigned to all types of credit and investment risk, including local currency lending.

Transactional risk ratings establish a ceiling that also applies to credit risk ratings. Most banks do not generally have formal regional limits to lending, but some banks monitor exposures for a given region informally, and most have specific country limits. Many banks apply a single country rating to all types of exposure, while distinguishing between foreign and local currency funding. Formal exposure limits tend to be set annually and managed through the use of aggregate country exposures.

It is important to establish clear tolerance limits, delineate clear lines of responsibility and accountability for decisions made, and identify in advance desirable and undesirable types of business. Policies, standards, and practices should be clearly communicated, and enforced, with affected staff and offices. Quarterly reporting should be imposed—more frequently if foreign exchange exposure impacts a given investment.

The ability to obtain primary knowledge through inputs from local offices, as well as by regular visits on the part of country risk officers, cannot be overemphasized. Best practice should encourage in-house assessments before relying on external sources of information in order to build internal rating applications.

In most organizations, the country risk function operates autonomously, as there tends to be diverging interests between the operating side of the business and risk management. It is therefore important for senior management to effectively oversee interaction between the two sides. The risk assessment decision chain should be transparent and independent of compromise by business unit practices.

Even if there is a rating guide at one's disposal, it is best to utilize information from a variety of sources, identify the central themes that keep reappearing, and make a judgment about the nature of the risk. This should not be done in a vacuum, however. The underwriting and pricing process should be viewed as collaborative, seeking the affirmation of others in the decision-making chain.

The addition of an effective transactional risk management program will enhance existing risk management guidelines and provide valuable insights to better understanding the international business arena.