Tuesday, November 28, 2017

Bank Commitments in the structured trade finance space – Why we (don’t) need them and what this means for regulators

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.