Whenever
we discuss transactions with clients, at one point in time, we
encounter the topic of bank commitments. What are we precisely
talking about? Who needs a bank commitment and why? What does it
imply for the instructing corporate and the bank? In this post, I
look at all these questions and conclude that there is no one unique
form of commitment. The practice is indeed more complex and nuanced
than theoretical legal definitions can ever be.
What
is a bank commitment?
Let
us first have a look into a general dictionary:
The
Cambridge Dictionary defines a commitment as “a willingness to
give your time and energy to something that you believe in, or a
promise of firm decision to do something”. Merriam Webster
writes about an “agreement or pledge to do something in the
future”.
If
we move a bit closer to the business world, terms such as
“willingness” and “promise” are a bit less
useful, even though they keep some importance. I will return to this
point later. In contractual negotiations, showing a commitment is
still part of the pre-contractual phase. However, being committed to
your business partner is more than just figuring out whether you have
common interests. You are actually entering a phase where your
behavior must respect certain good business practices. In other
words, when you show commitment, your negotiating partner has the
right to expect a negotiation practice that corresponds to common
international standards.
Moving
into the finance space, the term commitment becomes even stronger:
Most companies (some more others less – depending on their
financial stance and direct access to financial markets) need banking
support for their business. Indeed, any contract in the business
world requires some form of financial product and if a corporate
cannot rely on its financial partner (be it a bank, a bond investor,
an insurance company, and the like), it will usually not be able to
close the transaction. This is, by the way, the precise reason why
all financial institutions run ad campaigns worshiping their culture
for long-term and trustworthy relationships with clients.
Negotiating
big contracts for huge projects, for example in the oil & gas
business, is a particularly good example for the above described
aspect of commitments. Let’s look at the example of an EPC
(Engineering, Procurement, & Construction) Contract: Naturally,
the EPC Contractor will be chosen, first and foremost, for his
competence to carry out the project, i.e. his engineering,
procurement, and construction works. But sometimes, this is not
enough: Buyers of turnkey projects want to ensure that their partner
has also the financial capacity to carry out the project until the
end. Beyond financing the project itself, this is where trade finance
instruments come into play. And this is also the point where the
commitment of the EPC Contractor’s financial partner is raised to a
higher level. Depending on the stakeholders involved, it might not
only be the bank’s client who relies on a financial institution but
the client’s client as well.
This
is where the story becomes relevant for financial regulators as well:
To put it bluntly, if a financial institution promises too much but
several stakeholders still rely on it, it’s not only the bank’s
client who will have a problem but all the stakeholders involved. And
if we take this still a step further where it’s not only one
financial institution but all financial institutions who promise too
much, we enter into a space where the problem becomes systemic for
the whole financial system.
This
is why regulators today have a precise idea of what constitutes a
bank commitment. However, surprisingly, the European Union’s Basel
III regulation (more precisely called Capital Requirements Regulation
(CRR) initially issued on June 26, 2013) does not include a
definition of what is a commitment, although it is still 580 pages
long. Yet, indirectly, we can understand that regulators distinguish
between firm and non-binding undertakings of a bank: As a matter of
fact, credit lines that are unconditionally cancellable at any time
without prior notice and those which cancel automatically upon
deterioration of the client’s creditworthiness do not require any
minimum capital.
Why
do bank commitments matter in trade finance?
The
importance of bank commitments is basically a function of four
parameters:
-
the credit stance of the Exporter (The better the exporter’s credit rating is, the higher is the competition among banks, and the lower is the need for a commitment.);
-
the size of the transaction (The bigger the transaction is, the more important it becomes for the parties secure its financing, and the more likely it is that the parties will ask for a bank commitment.);
-
the tenor of the transaction (The longer the tenor is, the more one must put emphasis on the bankability of the project and the likelier it becomes that a bank commitment will be necessary.);
-
the competition among banks and insurance companies for a given transaction (The more financiers are available, the less important it becomes to formally secure their commitment for a transaction.).
The
importance of committed trade finance instruments – A 360°
Perspective
From
the exporter’s
perspective, there
is a trade-off to be made between a hard commitment and a soft
commitment. The hard commitment is easy to qualify: The bank writes
to his client: “I will accompany you on this export deal, whatever
may happen in the future.” The soft commitment (We sometimes also
talk about pure commercial commitments) is more subtle: The financial
institution engages commercially with his client while, at the same
time, reserving the right to retract if its appreciation of the
client or the project changes.
The
importer’s perspective
is different: As a matter of fact, the importer will only indirectly
be interested in any banking commitment. His interest is only
indirect in a sense that, without financial support, the exporter
will not be able to carry out the export transaction as such.
Oftentimes, it is the size and quality of his business relationship
with the seller and the countries involved which can trigger the need
for a hard commitment.
The
bank’s perspective
is usually dominated by a risk / return trade-off. The question
of a bank commitment is no different: The more I commit the more it
becomes risky the more I should earn. Let me be more precise:
-
If a bank issues a hard commitment, it increases the risk profile of the transaction and its regulator will ask for mobilizing regulatory capital. This costs money and then triggers the need for a commitment fee.
-
If, however, the commitment is only of a commercial nature and leaves room for the bank to walk away, it incurs less risk on the transaction which, in turn, does not require additional capital.
We
have already touched upon the regulator’s
perspective:
Bearing
in mind the possibly systemic importance of commitments issued by the
financial industry as a whole, the
regulator might want to transform
firm commitments into risk weighted assets which then require the
backing through regulatory capital.
(Un)committed bank guarantee lines in practice
At
first glance, one would expect the practice being pretty simple: The
corporate should want a commitment only if it is absolutely necessary
because it costs him finance charges. The financier should always
want a commitment because this generates revenue.
The
practice is more nuanced though:
-
The bank might actually not want to commit, for example because the option to walk away simplifies risk approvals or because a commitment would unnecessarily block available country risk limits.
-
The client might actually want a commitment even though his contractual counter party does not require any: In a large transaction, the corporate might want to secure the banking consortium involved in order to avoid a higher workload due to changes in the constitution of the financing pool.
-
There is no one single concept of a banking commitment. It’s a contractual instrument and, therefore, will always depend on what you specifically agree on with your bank. Indeed, a bank might commit subject to this and that, meaning that a commitment is sometimes worth paying for and sometimes not.
-
To complicate things further, a commitment evolves over time as well: For example, a commitment today is worth nothing if an embargo tomorrow runs against it.
Conclusion
The
topic of bank commitments is difficult to grasp because it is very
much dependent on the business practice in the sector at hand and
because every stakeholder looks at it from its own and unique
perspective. Whether it’s worth issuing (and paying) for them, will
probably remain a case-by-case question.