Head Off Concentration Risk at the Pass
August 28, 2018
Every commercial borrower faces financial risks. It’s important to identify these risks so that you can find ways to minimize the negative effects they might have on business performance. Concentration risk is a financial risk that comes into play when a borrower relies too heavily on one, or one set of, suppliers or customers — making the business vulnerable if those “key” suppliers or customers fail.
A rule of thumb for spotting concentration risk is if you notice that a borrower is buying 10% or more of materials from just one supplier, or selling 10% or more of its goods to one customer. Due diligence can help you stay on top of the financial health of borrowers and their supply chains.
Product and geographic risk
Borrowers may experience two main types of concentration risks: product and geographic. The most obvious type is product concentration risks. If a borrower’s most profitable product line depends on a few key customers, the borrower is at their mercy. Key customers that unexpectedly cut budgets or switch to a competitor could significantly lower revenues.
Similarly, suppliers that provide 10% or more of a borrower’s materials could suddenly increase prices or become lax in quality control, causing the borrower’s profits to plummet. This is especially problematic if the number of alternative suppliers is limited.
When gauging geographic risks, assess whether a large number of the borrower’s customers or suppliers are located in one geographic region. Operating near supply chain partners offers such advantages as lower transportation costs and faster delivery. Conversely, overseas locales may offer cheaper labor and raw materials prices. But there are also potential risks associated with geographic centricity, which increase substantially when dealing with global partners.
Local weather conditions, regulations, geopolitical uncertainty and exchange rate volatility are some of the risks that accompany geographic concentration.
If lenders identify particular customers or suppliers that have concentrations of power over a particular borrower, they should examine the credit and other potential risks for each party, including legal, political and transportation risks. For instance, ask whether any customers or suppliers are involved in legal conflicts that could adversely affect the company’s ability to compete or earn revenue.
Also, you need to investigate whether any customers or suppliers are located in a politically unstable region or whether the supply chain could be adversely affected by the outcome of a municipal, state or federal election. In addition, if a customer or supplier depends on a particular type of transportation, it could cause serious snafus. For example, if winter weather shuts down air routes for a few days, does the borrower have a backup plan?
Lenders should discuss significant product or geographic concentration risks with their borrowers. Management can use several strategies to lower concentration levels. For example, a borrower might divide purchases equally among three suppliers — instead of just one — to diversify its supplier base. Or the company might initiate an aggressive sales campaign to expand its customer base.
Borrowers can also strengthen protections against unforeseen events by adding to inventory buffers to hedge against short-term shortages in their supply chain. Or they might negotiate long-term contracts with major customers to include upfront payment terms, exclusivity clauses and access to computerized just-in-time inventory systems to more accurately forecast demand and more closely tie themselves to supply-chain partners.
Knowledge is power
Be aware of all facets of your borrower’s financial status, including its potential concentration risks. If you see issues, you may need to adjust interest rates or take other measures to offset the risk, or even deny the loan until remedial measures are taken. What you don’t see may hurt you. Open your eyes to your borrowers’ supply chains and stay vigilant — or your borrowers’ risk will become yours as well.
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