Regulatory and Compliance Headwinds (and Crosswinds) for 2018

Presentations by Geoffrey Wynne and Mark Norris, Partners

Sullivan & Worcester UK LLP

On 29 March 2018

At New Broad Street House, 35 New Broad Street,

London, EC2M 1NH

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Prudential Regulation Authority’s proposed changes to their Supervisory Statement (SS) 17/13 “Credit risk mitigation” On 16 February 2018, the Prudential Regulation Authority published its consultation paper (CP 6/18) setting out proposed updates to its Supervisory Statement on Credit Risk Mitigation

CP 6/18 seeks to clarify the PRA’s expectations regarding the eligibility of guarantees as unfunded credit protection under the Capital Requirements Regulation (575/2013)

The proposals raise a number of serious concerns and, in many cases, may not reflect how banks, insurers, export credit agencies and legal counsel have either applied, or understood, the relevant rules up until now

There is widespread concern amongst financial institutions, insurers and UK exporters that the proposed clarification will render ineligible CRMs which are widely used to support trade and export finance

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Trade finance concerns

Widespread concern that the proposed changes will:

● (A) increase costs to exporters – particularly SME exporters

● (B) reduce access to finance for exporters – particularly SME exporters

A key issue faced by SMEs in accessing trade and export finance is their ability (or inability) to provide adequate security or collateral - hence the critical importance of CRMs from ECAs and the private insurance market

If financial institutions are unable to use ECA guarantees or private insurance policies on their current, market standard terms, as eligible CRMs there is a concern that that this will have a direct and adverse impact on UK exporters

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CRR Eligibility Criteria – A Refresher

To qualify as eligible unfunded credit protection the following conditions must be met:

● (a) the credit protection is direct;

● (b) the extent of the credit protection is clearly defined and incontrovertible;

● (c) the credit protection does not contain any clause, the fulfilment of which is outside the direct control of the lender, that: › (i) would allow the protection provider to cancel the protection unilaterally;

› (ii) would increase the effective cost of protection as a result of a deterioration in the credit quality of the protected exposure;

› (iii) could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make any payments due …;

› (iv) could allow the maturity of the credit protection to be reduced by the protection provider;

● (d) the credit protection contract is legally effective and enforceable ….

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The PRA’s expectations – “… legally effective and enforceable …”

The guarantee must be legally effective and enforceable in all relevant jurisdictions

The PRA expects, at a minimum, that the firm satisfies itself that the guarantee is enforceable:

● under its governing law

● in the jurisdiction where the guarantor is incorporated

● other jurisdictions where enforcement action may be taken

The practical ease of enforcement should also be considered

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Expanding the scope of the legal opinion – Article 194(1) Article 194(1) Principles governing the eligibility of credit risk mitigation techniques

The technique used to provide the credit protection together with the actions and steps taken and procedures and policies implemented by the lending institution shall be such as to result in credit protection arrangements which are legally effective and enforceable in all relevant jurisdictions.

The lending institution shall provide, upon request of the competent authority, the most recent version of the independent, written and reasoned legal opinion or opinions that it used to establish whether its credit protection arrangement or arrangements meet the condition laid down in the first subparagraph.

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The PRA’s Proposal

“… As part of considering its effectiveness, the PRA would expect an independent legal opinion to consider the eligibility criteria …”

No clarification as to which criteria – everyone single one?

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Costs to exporters – legal opinions As long as a legal opinion is “independent, written and reasoned” it may be provided by an internal legal counsel

Particularly on structured transactions the Article 194(1) legal opinions are provided by external counsel

To the extent that the legal opinion required by Article 194(1) will now need to “… consider the eligibility criteria ...” there is a concern that financial institutions will use external legal opinions as a matter of course and will be reluctant to rely on generic legal opinions

The cost of external opinions is usually borne by the exporter

This has always been an issue for exporters (particularly, SME exporters) - by requiring more extensive legal opinions industry groups are concerned that this will be a further (potentially irrecoverable) cost for UK exporters

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“… Clearly defined and incontrovertible …”

The PRA considers that incontrovertibility is important because a guarantee which can be disputed, and which is not robust, does not effectively transfer credit risk

The PRA interprets ‘incontrovertible’ to mean that 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

When satisfying themselves that a guarantee is ‘incontrovertible’, the PRA would expect firms to:

● consider the terms of the guarantee itself

● the remedies available under the law that applies to that guarantee

● whether there are scenarios in which the guarantor could in practice successfully seek to reduce or be released from liability under the guarantee

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“… Without any clauses that will render the guarantee ineligible for CRM …”

Some types of clauses will render a guarantee ineligible

These are set out in CRR Article 213(1)(c)

Types of Clauses - clauses, the fulfilment of which is outside the direct control of the lender, that:

● (i) would allow the protection provider to cancel the protection unilaterally

● (ii) would increase the effective cost of protection as a result of a deterioration in the credit quality of the protected exposure

● (iii) could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make any payments due …

● (iv) could allow the maturity of the credit protection to be reduced by the protection provider

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“… Timeliness …” Article 213 (c) (iii) provides that:

● “… the credit protection contract does not contain any clause, the fulfilment of which is outside the direct control of the lender, that: …

● could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make any payments due …”

“… The PRA considers that the requirement for the guarantor to be obliged, contractually, to pay out ‘in a timely manner’ means that the pay out should be made without delay and within days, but not weeks or months, of the date on which the obligor fails to make payment due under the claim in respect of which the protection is provided. …”

The PRA said that it:

● “… considered other uses of this phrase in CRR …, the phrase used in other official language versions of the CRR, the timeliness of settlement of credit derivative contracts once an event of default has been declared, and market practice for guarantees and other forms of eligible funded credit protection. …”

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“… Timeliness …”

Export Credit Agency guarantees typically have significantly longer claim waiting periods – from 45 to 180 days

PRI insurance policies have significantly longer claim waiting periods than “… days …”

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Timeliness - Exceptions The only exceptions to the timeliness requirement described in the Appendix (that pay out should occur without delay, ie within days) are as follows:

● for guarantees covering residential mortgage loans, where the CRR specifically provides that the protection may pay out within 24 months (CRR Article 215(1)(a))

● where provisional payments are made under guarantees provided by mutual guarantee schemes or by public sector bodies (CRR Article 215(2))

● where CRR Part Three, Title II, Chapter 4 is applied in respect of a securitisation position in the different context of CRR Part Three, Title II, Chapter 5 (Securitisation)

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Timeliness - Concerns The importance of credit risk mitigants

Most recent figures from the Berne Union - the international trade association representing the global export credit and investment insurance industry

New business underwritten globally by members of the Berne Union in 2017 totalled US$2,330 billion

● Cross border trade (short term) US$2,088 billion

● Export credits (Medium / long-term) US$179 billion

● Investment insurance US$64 billion › Berne Union members’ share of world trade to over 14%

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Timeliness - Concerns Whose “… market practice …”?

Industry groups are concerned that reducing existing claim waiting periods of 90, 120 or 180 days to “…. within days …” will disproportionately increase the cost of cover

Anything which increases costs for trade and export finance will reduce the competitiveness of UK exporters

Increases in financing costs are of particular concern to SMEs who may have little or no “ancillary business” to provide to financiers

Most UK SME exporters are limited in their choice of financiers and tend to be reliant on UK financial institutions

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Timeliness - Concerns Would the market be ready? - If the PRA were to require that claim waiting times were shortened for both ECA and private insurance CRMs are ECAs (so that payments had to be made “… within days …”) are ECAs and the private insurance market actually set-up to be able to this?

Who should be excluded? Just ECAs?

In the absence of equal treatment, ECAs will have a competitive advantage over the private insurance market. Without a “level playing field” between ECAs and the private insurance market UK exporters (and their financiers) will face limited choice

From a UK government perspective, without “a level playing field” UKEF will need to be ready to take up the support which would otherwise have been provided by the private insurance market

Improving processing times at UKEF has been a focus for UKEF

Without the addition of significantly greater resources at UKEF, trade associations are concerned that a difference in regulatory treatment between ECA CRMs and private insurance market CRMs will mean that processing times will slow down

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The benefit of a longer (rather than shorter) claim waiting periods

For trade and export finance transactions the existence of a longer claim waiting period can have a positive benefit for all parties involved – the exporter, the buyer, the financier and the provider of the CRM

This is of particular importance for large export and project financings as it gives the parties the opportunity to seek to resolve the underlying default without being forced to collapse the financing and risk the cancellation or early termination of the underlying export contract

Even with a claim waiting period of 90, 120 or 180 days the beneficiary of the CRM is likely to receive payment sooner than if it had to enforce against the underlying obligor directly through the courts or arbitration

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Exclusion of certain types of payments and limited coverage

The PRA has considered what ‘certain types of payment’ and ‘limited coverage’ mean in the context of CRR Article 215(1)(c).1

The Article sets out two scenarios:

● (i) the underlying contract and the guarantee mirror each other in terms of liability so if the underlying obligor is not obliged to pay the firm, there is no non-payment of the guarantee; and

● (ii) ‘certain types of payment’ can be excluded from the guarantee, but the value of the guarantee is then adjusted by the firm to reflect the ‘limited coverage’

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Exclusion of certain types of payments and limited coverage

The PRA considers that, in the context of CRR Article 215(1)(c), “limited coverage” refers to a quantifiable portion of the exposure

The “certain types of payment” refer to different sums the obligor may be required to pay to the firm under the contract, such as the principal, interest, margin payments, fees and charges

For example, it contemplates a guarantor guaranteeing non-payment of principal, but not interest payments due by the obligor, or both principal and interest payments, but not fees or other charges

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HM Treasury recommendations Whilst the PRA acknowledges that:

● “… HM Treasury has made recommendations to the PRC about aspects of the Government’s economic policy to which the PRC should have regard when considering how to advance the PRA’s objectives and apply the regulatory principles …”

and states that

● “… [t]he PRA has considered these in relation to these proposals …”

It is not clear what weight the PRA applied when considering the government’s economic policy, the government’s industrial strategy and the government’s “aim” to encourage trade and inward investment

Likewise it is unclear if the PRA took into account “… the costs and burdens …” that their proposed approach would have on the UK Government’s aim of encouraging trade

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UK Trade Policy Through the work of BExA, UKEF and UK Finance, exporters have become more aware of how CRMs can help them access finance and win exports

Industry groups such as BExA are concerned that the proposed “clarification” of its “… expectations regarding the eligibility of guarantees as unfunded credit protection …” will cut across the work that BExA, UKEF and UK Finance has done to date

UK trade policy has been to encourage UK exporters to access markets outside of EU.

To do this access to capital effective CRMs from ECAs and the private insurance market will be critical to financing these transactions

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Cyber resilience – Russia, China, North Korea

Regulators are continuing to review Emerging risks

Banks, insurers, ECAs and their clients are increasingly reliant on information technology which exposes them to a growing and evolving set of operational and credit risks

It is expected that regulators will require additional measures to enhance banks' operational resilience

The magnitude, frequency and impact of network and information system security incidents is increasing

Cyber attacks and force majeure

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Cyber resilience – “moving beyond compliance”

Cyber risk remains one of the FCA’s top priorities

“…. The financial crises of the past have been responded to with many global initiatives to shore up institutions’ financial resilience. But now, it is generally recognised that cyber resilience is a key area of focus – for us in the UK, and with our colleagues internationally. Global bodies such as the International Organization of Securities Commissions (IOSCO), Group of Seven (G7), Financial Stability Board (FSB) and many others have this at the top of their agenda, and we are actively engaged in the work of those bodies …”

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Cyber resilience

We expect that regulators will become more interested in how banks and insurers manage cyber risks “beneath the surface”

The “risks of harm” posed from counterparties, suppliers and partners

The need to ask “What is their cyber risk profile”

The cyber risk profile of your counterparties, suppliers and partners can end up being yours

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Cyber Security Directive - To Be Implemented Into UK Law

In 2018 the UK will be implementing the EU directive on the security of Networks and Information Systems (the “NIS Directive”)

The EU recognised that any cyber security incident could affect a number of Member States and in 2013 put forward a proposal to improve the EU's preparedness for a cyber attack

This proposal became a directive in August 2016 - Member States had 21 months to embed the Directive into their respective national laws

The focus is on infrastructure systems and essential services and the damage a cyber attack can have on the EU’s infrastructure and economy

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Cyber risk has trade got off lightly?

● Ships are vulnerable

● The international shipping industry is responsible for the carriage of around 90% of world trade

● A massive consolidation is underway in the global shipping industry – the top 5 shipping lines control more than 50% of the global shipping market - Ships are getting bigger

● In June 2017 Maersk and TNT (amongst others) were subject to the “Petya” ransomware attack which resulted in significant disruption, reputational impact and cost to their customers

● The cost to each company has been estimated to be $300m per company.

● Maersk’s container ships stood still at sea - its 76 port terminals around the world ground to a halt

● TNT’s parcels were “backed up to ceiling”

● As well as companies vessels are vulnerable - a 2017 study by Futurenautics has shown that 44% of ship operators believe their company’s current IT defences are not effective at repelling cyber attacks, and that 39% experienced a cyber attack in the last 12 months

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Anti-money laundering and counter terrorist financing – 5MLD More provisions to further strengthen rules on anti-money laundering and counter terrorist financing to be introduced

Objective to enhance transparency, to improve the prevention of money laundering, to cut off terrorist financing and prevent tax avoidance.

5th Anti-Money Laundering Directive, aims at:

● increasing transparency on who owns companies and trusts by establishing beneficial ownership registers

● preventing risks associated with the use of virtual currencies for terrorist financing and limiting the use of pre-paid cards

● improving the safeguards for financial transactions to and from high-risk third countries

● enhancing the access of Financial Intelligence Units to information, including centralised bank account registers

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Business Contract Terms (Assignment Of Receivables) Regulations - What Next?

September 2017 final form regulations to ban provisions prohibiting the assignment of receivables in certain business-to-business contracts were laid before Parliament Regulations were expected to come into force before the end of 2017 In November 2017 the Regulations were withdrawn The aim of the Regulations was to increase access to invoice financing for small and medium sized businesses but were regarded as being uncertain with unintended consequences The Government still intends to introduce Regulations ban provisions prohibiting the assignment of receivables in certain business-to-business contracts and is carrying out a full review

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What else on the regulatory front?

Changes to Basel III › Basel IV?

EBA report

More on the PRA proposals

Other areas

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How is trade finance doing? Some optimism

› ITFA announcement

“Interest in trade finance asset class is on the march”

That interest is coming from investors

Ironic if limitation on credit risk mitigation tools hamper this

Growth of Fintech › How will the regulators react?

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Regulatory Framework under Basel Basel Committee on Banking Supervision (BCBS) : Basel III –

published December 2010 and subsequent revisions

Basel III developed by the BCBS following financial crisis of 2007/8 to improve resilience and stability of banking sector

Sets out number of minimum capital requirements for banks determined by assessment of individual bank’s risk

Basel III has no direct effect and must be implemented through legislation

EU implemented Basel III by enacting the Capital Requirements Regulation (Regulation EU) No. 575/2013 (the CRR) and the Capital Requirements Directive (Directive 2013/36/EU)

CRR directly applicable to financial institutions in the EU

Prudential rules for credit institutions and investment firms

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Basel “IV” – Recent Changes “In December (2017), the committee (BCBS) published the last and most

contentious version of the Basel III accord, or Basel IV. The rules set out statistical models for banks to use to measure investment risks and how much they can lose, which has a bearing on their capital holdings.” ~ Law 360, “Basel Committee Toughens Up on Credit Risk Model for Banks”, by Mariko Iwasaki

The aim of the revisions is to restore credibility in the calculation of risk-weighted assets (RWA) and improve the comparability of banks’ capital ratios

Under the revised credit risk framework, the two main approaches for calculating RWAs are those found under Basel II › Standardised approach (SA): This involves banks using a prescribed risk weight schedule for

calculating RWAs. Similarly to Basel II, the risk weights depend on asset class and are generally linked to external ratings, but enhancements have been introduced

› Internal ratings-based (IRB) approach: This approach allows banks to use their internal rating systems for credit risk, subject to the explicit approval of their respective supervisors. Similarly to Basel II, banks can use either: i) the advanced IRB approach (i.e. use their internal estimates of risk parameters such as probability of default (PD), loss-given-default (LGD) and exposure-at-default (EAD)); or ii) the foundation IRB approach (i.e. use only their internal estimates of PD)

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Details on change Standardised approach (SA)

The following are the main changes to the credit risk SA: › Requirement for banks using credit ratings to conduct sufficient due diligence; › Adoption of a sufficiently granular non-ratings based approach for jurisdictions

that cannot or do not wish to rely on external credit ratings

The aim in both of the above cases is to reduce mechanistic reliance on external credit ratings

Adoption of a more granular risk weighting approach, particularly for the following credit risk exposures in which a flat risk weight currently applies: - residential real estate (e.g. mortgage risk weights would now depend on loan-to-value (LTV) ratio of the mortgage); - commercial real estate; - subordinated debt and equity

The aim here is to improve granularity and risk sensitivity. Note in particular that the revised SA includes a standalone treatment for exposures to project finance, object finance and commodities finance

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More details Internal ratings-based (IRB) approach

The following are the main changes to the credit risk IRB approach:

Removal of the option to use the advanced IRB approach for asset classes that cannot be modelled in a robust and prudent manner. [This does not include large and mid-sized corporates, banks and other financial institutions, or specialised lending]

Removal of all IRB approaches for exposures to equities

Adoption of “input” floors (i.e. internal estimates of PD and LGD) to ensure a minimum level of conservatism in model parameters for asset classes where the advanced IRB approach remains available;

Provide greater specification of parameter estimation practices

The aim of these changes is to address the lack of robustness in modelling certain asset classes and to enhance comparability in banks’ IRB capital requirements

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CVA risk framework The initial phase of Basel III reforms introduced a capital charge for

potential mark-to-market losses of derivative instruments as a result of the deterioration in the creditworthiness of a counterparty (the CVA risk). This was a major source of losses for banks during the global financial crisis

BCBS has agreed to revise the CVA framework to: › Enhance its risk sensitivity, since the current CVA framework does not cover an

important driver of CVA risk, namely the exposure component of CVA › Strengthen its robustness: the Committee is of the view that such a risk cannot

be modelled by banks in a robust and prudent matter. The revised framework removes the use of an internally modelled approach

› Improve its consistency: CVA risk is a form of market risk. Thus the standardized and basic approaches of the revised CVA framework have been designed and calibrated to be consistent with the approaches used in the revised market risk framework

These changes will be implemented on 1 January 2022

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Where do these take trade finance? Supervisors are moving financial institutions to a level playing field

in some areas › Levelling down?

Supervisors driven by worries of financial stability of banks and the banking system not increasing trade finance

Trade finance never seems to be mentioned

There is a need for huge amounts of trade finance

How can we reconcile this?

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European Banking Authority (EBA) Report on the Credit Risk Mitigation (CRM) Framework – 19 March 2018 Overview of the CRM

Article 4(57) CRR defines CRM as “a technique used by an institution to reduce the credit risk associated with an exposure or exposes which that institution continues to hold”

The CRR outlines various techniques of both funded and unfunded credit protection, as well as methods through which those techniques can be used to obtain capital relief. Before using a particular CRM technique, relevant eligibility criteria must be met

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European Banking Authority (EBA) Report (Cont) Under the Standardised Approach

Once the criteria is met, financial collateral can be considered using either the Financial Collateral Simple Method (FCSM) or the Financial Collateral Comprehensive Method (FCCM): › Under the FCSM, the collateralised part of the exposure is assigned the risk

weight that the institution would assign if it had a direct exposure to the collateral instrument, subject to a 20% floor, except in specific cases, while the risk weight assigned to the unsecured part of the exposure is the same as that assigned to the original exposure;

› Under the FCCM, the exposure value is reduced by the collateral amount after relevant volatility adjustments (or ‘haircuts’) are applied, and the resulting reduced exposure value is multiplied by the risk weight assigned to the original exposure as if it were not collateralised. Under the FCCM, the institution may use either supervisory haircuts or own estimated haircuts, subject to supervisory approval (see Articles 224 and 225 of the CRR), and shall adjust the haircuts depending on the relevant revaluation and liquidation period of the collateral

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European Banking Authority (EBA) Report (Cont)

Eligibility of credit insurance

Whether credit insurance can be used as a guarantee revolves around the economic substance of the financial agreement, which would determine the extent to which the credit insurance meets the definition of a “guarantee” used in the CRR. Credit insurance can qualify as a guarantee depending on the circumstances of the individual case and on the intrinsic characteristics of the context and its economic substance. Therefore, the term “guarantee” in the context of CRM under the CRR should be interpreted from a substantive/functional viewpoint rather than a legal one, as this may differ across Member States depending of their legal systems

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European Banking Authority (EBA) Report (Cont)

CRM under Internal Ratings Based Approach (IRBA) without using own estimates of Loss given default (LGD) and conversion factors (Foundation Internal Ratings-Based Approach (R-IRB)

The available techniques of CRM and their eligibility are generally the same as the standardised approach

Credit insurance: Similar to the above approach, credit insurance with the economic substance equivalent to a guarantee may qualify as a guarantee (and so can be used for the purpose of CRM) subject to the fulfilment of all the relevant eligibility requirements set out in the CRR for the use of guarantees

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European Banking Authority (EBA) Report (Cont) CRM under the supervisory slotting approach

Any guarantees that are part of the security package contribute to the factors that enable the slotting. Any additional guarantees, such as those against default by a sovereign bank or another bank, should be treated under the CRM framework, provided they meet the eligibility criteria. In assessing eligibility, banks will make sure there is no double counting of the effect of the guarantee (i.e. once taken into account in the security package, the guarantee should also fit the CRM criteria but it will not be further considered, since it was already considered when applying the slotting approach). However, it may not be straightforward to distinguish between the different types of guarantees (i.e. those belonging to the security package and those against the default of an obligor); therefore, it is possible that further thought will be given to the sequence of allocation of guarantees in the scope of the forthcoming Guidelines on CRM

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European Banking Authority (EBA) Report (Cont) CRM under IRBA with use of own estimates of LGD and conversion factors

(A-IRB)

In the case of A-IRB, some clarifications on the use of CRM have already been provided in the Guidelines on the PD estimation, LGD estimation and the treatment of defaulted assets published in November 201716 as part of the guidance for the LGD estimation. However, there are still certain outstanding issues that have not been addressed by the aforementioned Guidelines and where different interpretations and practices are observed. The following issues are highlighted: › the eligibility criteria for collateral, in particular an understanding of the interaction with the

requirements set out in Article 181(1)(f) of the CRR;

› the recognition of UFCP, including the application of the double default treatment; and

› the treatment of bilateral master netting agreements and OBSN, taking into account the effect on the exposure value

These aspects and methods need to be considered from a legal perspective as well as their impact on the institutions. The EBA take the view that more detailed guidance is necessary and will initiate this in 2018, with a view to conclude in 2019

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European Banking Authority (EBA) Report (Cont) CRM under IRBA for equity exposures

In the case of equity exposures under the IRBA, institutions may apply three different approaches (as specified under Article 155 of the CRR): (i) the Simple risk weight approach, (ii) the PD/LGD approach, and (iii) the internal models approach. In all three cases, institutions may employ forms of UFCP (e.g. guarantees and credit derivatives) as a technique of CRM, but not as collateral in the form of FCP

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European Banking Authority (EBA) Report (Cont) Policy issues on CRM framework

The following policy issues are discussed: › Treatment of On-balance sheet netting with regard to currency mismatch; › Cash assimilated instruments used as a technique of CRM; › CAIs used as a form of other funded credit protection; › Forms of gold eligible under Article 197(1)(g) of the CRR; › Eligibility of financial collateral based on credit assessments for non-nominated

external credit assessment institution; › Loan commitments contingent on collateral; › Requirement in Articles 199(6)(d) of the CRR regarding eligibility of physical

collateral; › Insurance against the risk of damage; › Requirements for the value of immovable property collateral; › Alignment of the terminology for exposures secured by immovable property; › Exposures guaranteed by central governments and central banks; and › Deletion of mandate under Article 194(10) of the CRR

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Thoughts on EBA Report and Trade Finance

Good news that Credit Risk Mitigation tools continue to be recognised

Does it fit with PRA proposals? › Not really

It indicates that Regulators are taking a closer look at these areas › Benefit from clarity (perhaps?)

A chance to influence Regulators on what CRM tools can be used › Physical collateral? › Receivables?

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More background on credit risk mitigation

Prudential Regulation Authority (PRA) Consultation Paper (CP6/18) published on 16 February 2018 likely to change the position on many credit risk mitigation tools radically

Issues › CRR and credit risk mitigation › PRA consultation paper – key points › Next steps

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CRR and capital requirements Different methodologies for calculating capital requirements for

credit risk

Standardised approach (CRR Part Three, Title II, Chapter 2) › Measures credit risk in a standardised manner, supported by external credit

assessments › Risk weighting of the protection provider is substituted for the risk weighting of

the original obligor, using prescribed values

Internal ratings based approach (CRR Part Three, Title II, Chapter 3) › Approval of local regulator › FIRB – own estimates of PD, prescribed LGD and other parameters › AIRB – own estimates of parameters required for calculating risk weighted

exposures – PD and LGD must take account of both the ability and the willingness of the guarantor to perform

CRR Part Three, Title II, Chapter 4 – Credit risk mitigation › Eligibility criteria for eligible credit risk mitigation

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CRR and credit risk mitigation Eligible credit risk mitigation is used to reduce risk weighted

exposure amounts for the purpose of calculating capital requirements – can be funded or unfunded

Guarantees are one form of unfunded credit protection (Article 203 CRR) › No guidance on meaning of “guarantee” › Possible to interpret in a broad way to refer to a range of direct unfunded credit

risk substitutes including insurance policies, which operate as contracts of indemnity

› In December 2002 FAQ publication, BCBS confirmed insurance could be used as CRM provided operational requirements applicable to guarantees were fulfilled

› Prior to the implementation of Basel III, the Financial Services Authority (FSA) (as the predecessor to the PRA) produced guidance which confirmed that insurance was eligible credit risk mitigation

› Market practice

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CRR – key requirements The credit protection contract is legally effective and enforceable in all

relevant jurisdictions (Articles 194(1), 213(1)(d) and 213(3) CRR)

The credit protection is direct (Article 213(1)(a) CRR)

The extent of the credit protection is clearly defined and incontrovertible (Article 213(1)(b) CRR)

The credit protection contract does not contain any clause, the fulfillment of which is outside the direct control of the lender, that (Article 213(1)(c) CRR): › would allow the protection provider to cancel the protection unilaterally; › would increase the effective cost of protection as a result of a deterioration in

the credit quality of the protected exposure; › could prevent the protection provider from being obliged to pay out in a timely

manner in the event that the original obligor fails to make any payments due; or › could allow the maturity of the credit protection to be reduced by the protection

provider

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CRR – key requirements (continued) The institution has the right to pursue, in a timely manner, the guarantor

for payment without having first to pursue the obligor (Article 215(1)(a) CRR)

The guarantee is an explicitly documented obligation assumed by the guarantor (Article 215(1)(b) CRR)

The guarantee covers all types of payments the obligor is expected to make in respect of the claim; or where certain types of payment are excluded from the guarantee, the lending institution has adjusted the value of the guarantee to reflect the limited coverage (Article 215(1)(c) CRR)

An institution has the right and expectation to receive payment from the protection provider without having to take legal action in order to pursue the counterparty for payment. To the extent possible, the institution shall take steps to satisfy itself that the protection provider is willing to pay promptly should a credit event occur (Article 217(1)(f) CRR)

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PRA Consultation Paper – Credit risk mitigation: Eligibility of guarantees as unfunded credit protection On 16 February 2018, PRA published consultation paper on the use of

guarantees as CRM under CRR (CP 6/18)

Sets out PRA’s proposed changes to its Supervisory Statement (17/13) on credit risk mitigation

Stated purpose: to clarify expectations regarding eligibility of guarantees as unfunded credit protection under Part 3 Title II Chapter 4 (Credit risk mitigation) of the CRR › Guarantees that do not meet PRA’s expectations should not be recognised in

Pillar I of a firm’s capital requirements

The proposals extend to any contract or other documented obligation that purports to be a guarantee for the purpose of achieving unfunded credit protection under CRR Part Three, Title II, Chapter 4 › Relevant for Standardised Approach and FIRB › Relevant for other parts of the CRR that cross-refer to Chapter 4 – for example,

the double default framework for IRB in Article 153(3) CRR

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PRA Consultation Paper (continued) Consultation paper focuses on four key CRR criteria

The guarantee must be: › legally effective and enforceable in all relevant jurisdictions; › clearly defined and incontrovertible; › without any clauses, the fulfilment of which is outside the direct control of the

lender, that could render the contract ineligible for CRM; and › covering all types of payments the obligor is expected to make, or the lending

institution has adjusted the value of the guarantee to reflect the limited coverage

“Guarantee” is not defined in the CRR › Proposed Supervisory Statement appears to confirm the approach widely taken

in the market that this is not intended to be limited to guarantees in the strict sense as a matter of English law, but includes various different forms of instruments, so long as they meet all the strict eligibility criteria in the CRR

› “Guarantees can take many forms and be governed by different laws”

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Legally effective and enforceable Article 194(1) CRR provides that the guarantee must be “legally effective

and enforceable in all relevant jurisdictions”

PRA’s proposed position: › At a minimum, this will require the firm to satisfy itself that the guarantee is

enforceable: under its governing law; and in the jurisdiction where the guarantor is incorporated

› Could also include other jurisdictions where enforcement action may be taken › The practical ease of enforcement should be considered

Requirement for a independent, written and reasoned legal opinion › As part of considering the guarantee’s effectiveness, the PRA expects the

independent legal opinion to consider the CRR eligibility criteria › Could result in a significant financial and administrative burden for institutions

relying on credit protection and for the providers of credit protection who would need to be able to provide appropriate corporate authorisation documentation

› No view on expressed on generic opinions

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Clearly defined and incontrovertible The extent of the guarantee must be clearly defined and incontrovertible

(Article 213(1)(a) CRR) › No earlier guidance on “incontrovertible”

PRA’s proposed position: › “Incontrovertible” means the wording of the guarantee should be clear and

unambiguous, and leave no practical scope for the guarantor to dispute, contest, challenge or otherwise seek to be released from, or reduce, its liability

› Firms should consider the terms of the guarantee itself, the remedies available under the law that applies to that guarantee

› Firms should consider whether there are scenarios in which the guarantor could in practice successfully seek to reduce or be released from liability under the guarantee

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Clauses that render a guarantee ineligible for CRM Some types of clauses will render a guarantee ineligible (Article 213(1)(c)

CRR)

Consultation paper does not address all of the prohibited clauses in the CRR › For example, a guarantor must not have unilateral cancellation rights

The guarantee must not contain any clause that prevents the guarantor from being obliged to pay out in a timely manner (Article 213(1)(c)(iii) CRR)

Must be read together with the following requirements (Article 215(1)(a) CRR): › The firm must have the right to pursue, in a timely manner, the guarantor for any

monies due under the guarantee – for example, no delay in the right to be able to serve a claim form or demand

› Payment by the guarantor shall not be subject to the firm first having to pursue the defaulting obligor for recovery – for example, loss minimisation obligations such as requirement to start any proceedings against the obligor should not be a pre-condition to claims payment

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Pay out in a timely manner Guarantor must be obliged, contractually, to pay out “in a timely manner”

No guidance on the meaning of “timely” and CRR does not specify

Previously argued that reasonable to assess “timely” in light of established market practice for widely used guarantee-type instruments

Credit insurance policies which typically include a waiting period of 180 days

Prior to the implementation of Basel III, the Financial Services Authority (FSA) (as the predecessor to the PRA) did produce guidance which confirmed that insurance was eligible credit risk mitigation

PRA must have been aware that the practice of using insurance policies that contain market standard waiting periods as unfunded credit risk mitigation has continued

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Pay out in a timely manner (continued)

PRA considers “timely” to mean “without delay and within days, but not weeks or months” › PRA has considered other uses of this phrase in CRR Part Three, Title II, Chapter

4 and the phrases used in other official language versions of the CRR › PRA has considered the timeliness of settlement of credit derivative contracts

and market practice for guarantees and other forms of eligible funded credit protection – the PRA suggest that rights to liquidate assets or terminate and close out transactions are typically exercisable immediately on an event of default

The consultation paper suggests the PRA would not view typical waiting periods in insurance polices as being “timely”

These proposals risk rendering a number of well established credit risk mitigation techniques as ineligible under for the CRR, in markets where suitable alternatives may not be available

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Exclusion of certain types of payment and limited coverage The guarantee must cover “all types of payments” the obligor is expected

to make in respect of the claim or, where certain types of payment are excluded from the guarantee, the lending institution must adjust the value of the guarantee to reflect the “limited coverage” (Article 215(1)(c) CRR)

PRA’s view: › “Certain types of payment” refers to different sums the obligor may be required

to pay to the bank, e.g. principal, interest, margin payments, fees and charges › “Limited coverage” refers to a quantifiable portion of the exposure

It does not seem open to an institution to use this Article as a basis to adjust the value of a guarantee to reflect its assessment of the impact of any documented limitations on coverage in the relevant instrument › In insurance any policy containing exclusion clauses the operation of which is

outside the bank’s control (e.g. nuclear exclusions) would be considered ineligible by the PRA

› The regulator has given no apparent weight to the fact that the non-payment insurance market has a stellar claims payment record, as confirmed by market data

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Conclusions The proposed Supervisory Statement raises real concerns, impacting a

number of different types of CRM

Consultation closes on Wednesday 16 May › No evidence that PRA consulted widely before producing this paper › Initial market reaction suggests there will be a significant response

This is a consultation by the UK regulator on Regulation that has direct effect in all EU member states › Supervisory Statement is directly relevant to UK-regulated banks › EU regulators tend to try to maintain a consistent approach

Impact for a particular bank will depend on the methodology used › Note Basel IV will change use of AIRB models for certain exposures from 2022

Get thinking about effect and how to respond

Will we have to find alternatives?

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What else is going on?

MIFID II

General Data Protection Regulation (GDPR)

Sanctions

New BAFT MRPA to facilitate it all?

BUT main focus is on CRM

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An Action Plan? Put as much pressure as possible on PRA and its proposals

At least get time before implementation

Brace yourselves for changes

Get thinking on alternatives

Get structuring………!

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Geoffrey L Wynne Partner Geoffrey Wynne is head of Sullivan & Worcester’s London office and also head of its Trade & Export Finance Group. He has extensive experience in banking and finance, specifically trade and structured trade and commodity finance. He also advises on corporate and international finance, asset and project finance, syndicated lending, equipment leasing and workouts and financing restructuring.

Geoff is one of the leading trade finance lawyers and has advised extensively many of the major trade finance banks, multilateral financers and companies around the world on trade and commodity transactions in virtually every emerging market including CIS, Far East, India, Africa and Latin America. He has worked on many structured trade transactions covering such diverse commodities as oil, nickel, steel, tobacco, cocoa and coffee. He has worked on warehouse financings in many jurisdictions and advised on how to structure involving warehouse operators and collateral managers. He has also advised on ownership structures and repos for commodities and receivables financings.

Geoff sits on the editorial boards of a number of publications and is a regular contributor and speaker at conferences. He is also the editor of and contributor to The Practitioner’s Guide to Trade and Commodity Finance published by Sweet & Maxwell and A Guide to Receivables Finance, a special report from TFR published by Ark.

Sullivan & Worcester UK LLP Tower 42 25 Old Broad Street London EC2N 1HQ

T +44 (0)20 7448 1001 F +44 (0)20 7900 3472 gwynne@sandw.com

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Mark Norris Partner Mark Norris is a partner in the Finance and the Trade & Export Finance groups in our London office. His practice covers cross border syndicated lending, structured export credit finance, structured trade and commodity finance, debt restructurings, acquisition finance and asset finance. Mark is recognized in The Legal 500 UK as "excelling" in structured export credit transactions (2016) and is praised for his "commercial and user-friendly approach" (2017). Mark also advises on regulatory, modern slavery, bribery and corruption issues in connection with trade and export finance. Mark led Sullivan & Worcester’s response to the UK Government's consultation on UK Export Finance (UKEF)'s anti-bribery and corruption policy. Many of Mark’s recommendations were specifically accepted by the UK Government.

He has advised financial institutions, funds, corporate borrowers, agents and trustees, and national and supranational sovereign/quasi-sovereign organisations on award-winning finance transactions throughout Africa, Western, Central and Eastern Europe, Russia and the CIS and the Middle East.

Mark has lived and practised in the Czech Republic (Prague), England (London), Germany (Düsseldorf and Frankfurt) and Russia (Moscow).

Mark holds graduate and post-graduate degrees with honors from the London School of Economics.

Sullivan & Worcester UK LLP Tower 42 25 Old Broad Street London EC2N 1HQ

T +44 (0)20 7448 1003 F +44 (0)20 7900 3472 mnorris@sandw.com

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Awards & Recognition TFR “Best Law Firm in Trade Finance”

Trade & Forfaiting Review (TFR) named Sullivan & Worcester "Best Law Firm in Trade Finance" in its 2014, 2015 and 2016 TFR Excellence Awards GTR “Best Law Firm”

Sullivan & Worcester UK LLP was top ranked firm in the Global Trade Review (GTR) Best Law Firm 2015 and 2016 polls The Legal 500 UK 2016

Geoffrey Wynne and Simon Cook are listed as Leading Lawyers and Sullivan & Worcester UK LLP was ranked in the following category in The Legal 500 UK:

› Trade Finance (Tier 1) Chambers UK 2017

Chambers UK ranked Sullivan & Worcester UK LLP, along with Geoffrey Wynne and Simon Cook, in the following area:

› Commodities: Trade Finance (UK-wide)

TFR Fellowship Award 2017

Trade & Forfaiting Review (TFR) honoured Geoffrey Wynne with the TFR Fellowship Award in its 2017 TFR Excellence Awards

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Future breakfast seminars Thursday 26 April

Thursday 24 May

Thursday 21 June

Thursday 19 July

No event in August

Thursday 20 September

Thursday 18 October

Thursday 22 November

Thursday 13 December

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