PRA consultation paper on the eligibility of guarantees as unfunded credit protection

Under the Basel III reforms, can trade credit insurers offset their credit risk using a trade credit policy?

The Basel III reforms, set by the Basel Committee on Banking Supervision, are designed to reduce the probability and severity of future financial crises by introducing new and improved prudential requirements as to, for example, the quality and quantity of capital and risk coverage and capital buffers, the leverage ratio and liquidity requirements for banks.

Trade credit insurers need to consider what the position is where their insured is a bank under the Basel III reforms, a bank’s trade credit policy may be used to offset their credit risk, and decrease the bank’s required level of capital. The PRA which issued a consultation paper on the eligibility of guarantees as unfunded credit protection in February 2018, is seeking input on these proposed changes, including guidance on the eligibility criteria for the recognition of guarantees. The consultation closes on Wednesday 16 May 2018.

Strict eligibility criteria must be met to be treated as a guarantee for credit risk mitigation under the CRR (Capital Requirements Regulation (575/2013).

The PRA is looking at what “guarantees” qualify to reduce banks’ (i) credit risk, and (ii) capital requirements, having realised that it is not always clear which obligations or contracts might qualify in order to obtain capital relief. The PRA describes a “guarantee”, broadly, as “the obligation of a third party to pay out in the event of non-payment or default of a credit obligor [i.e. including a bank’s debtor]”. The proposed changes seek to clarify that guarantees are only eligible where the risk has been “effectively transferred do the guarantor”, and the wording of the guarantee should be “clear and unambiguous, and leave no practical scope for the guarantor to dispute, contest, and challenge or otherwise seek to be released from, or reduce, their liability.”

Although the PRA did not refer to trade credit policies specifically, such policies clearly come within this broad description of a ‘guarantee’. This issue and those set out below, are currently what trade credit insurers are addressing where banks are their policyholders: 

  1. The PRA does expect independent legal opinions for all relevant jurisdictions.
  2. Conditionality – this is a big issue for banks as the conditions under the policy may not be within their control.
  3. Credit ratings and changes to credit risk mitigation vary from bank to bank, and technology is going to play a part in reviewing data and eligibility.
  4. A Basel III compliant insurance policy may mean that banks have to hold less capital. Technology can be used to ensure that the relevant conditions are met before the policy is entered into, which makes it easier to pay on a claim. Basel III, however, does not specifically address the use of insurance, although it would appear that if the insurance fulfils the tests applicable to guarantees then it can be taken into account for capital purposes. In other words, the question is whether a policy is designed to meet the requirements for use of unfunded credit protection as a risk mitigation technique under Basel III.
  5. A concern for trade credit insurers is the PRA’s suggestion that to be eligible for credit mitigation / capital reduction, “guarantees” (including trade credit policies) must provide for payment “within a timely manner”, which the PRA says is “within days”. Unfortunately, and as any trade credit insurer will know, this simply does not reflect how trade credit policies work. This may exercise some insurers, bringing in issues such as liquidity. Many trade credit insurance policies have a 180 day payment period (albeit that many insurers have circumvented this and that this is very often reduced by the banks if on the other side).

At the moment, all we have are proposals within the consultation, but in view of this and the other concerns expressed above, we will be watching this space.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.