Risk and Derisking — What Risk Should Really Mean for Banks in Trade Finance and How to Mitigate Them

Presentation by Geoffrey Wynne, Partner

Sullivan & Worcester UK LLP

on 23 November, 2017

At Pinners Hall, 105-108 Old Broad Street,

London, EC2N 1EX

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Overview Look at Risk – what does it mean and to whom?

“Misuse” of the word Risk in the regulatory context?

Consider risk and risk analysis in transactions

How it used to be done

What has gone wrong?

How to try to reset what the regulator should want and how you do business

Satisfying risk assessment

Mitigation of risk then and now

Regulatory risk mitigation tools

Going forward

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What is Risk? – The definition

Risk is a situation involving exposure to danger › A little over dramatic?

Risk is the possibility that something unpleasant or unwelcome will happen › Perhaps your trip to the Risk Committee or the Regulator

Risk is the possibility of financial loss › As in “ the bank is rigorous when it comes to analysing and evaluating risk” › This is more like it…

How does this translate?

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Why talk of Risk brings you here Risk and trade closely linked Remember – trade finance is inherently risky (who says?!) Did Regulators take this too literally? What is the risk based approach?

› Protect the system at the cost of trade?

How we have attempted to explain the opposite › Trade finance is a good product › Has this been a failure? › Are we too late to be back on track?

One response has been to “derisk relationships” › What does derisk mean? › Close off relationships? › Avoid transactions in emerging markets?

Can we explain our view of risks better? › Can we show how there is a better approach

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Transaction related risks

Back to the beginning in risk terms

Identifying and evaluating risk

Types of transaction related risk

How to deal with transaction related risk › Eliminate, reduce, mitigate, transfer or allocate

So, what risks are we talking about …

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Performance risk

Due diligence the obligor › Expertise/equipment/authorisations › Supply › Cashflows › Onboard that party

Risk to goods › Damage/theft › Price/commercial terms

Potential solutions › Elimination/reduction › Mitigation › Can you accept a risk?

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Country risk

Legal regime

Foreign exchange

Repatriation of proceeds

Consents

Regulatory › Sanctions › AML and financial crime

Potential solutions › Elimination/reduction › Mitigation

What should be sufficient?

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Counterparty Payment Risk

Assess counterparty › Can you onboard that counterparty?

Collection arrangements

Accept risk?

Potential solutions › Take credit support from an acceptable bank/third party › Transfer risk to another › Where do you stand on KYC?

Track proceeds › Avoid risk of breaches of law and regulation

Should this be sufficient to allow bona fide transactions to proceed?

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So where and why did it change? Historic perspectives

› Regulators (FATF, FCA etc.) › Market – you!

Proving the negative › The consequences of inaction

Chance to demonstrate what we know about risk and dealing with them › What risks? › How they are covered

Applicable to all types of transactions

Matrix and checklist ideas

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Can you take out the risk in trade? Trade finance is not risky

› Deal with credit and structural risks

BUT there are risks in trade › What is the position about satisfying the Regulator on how risks can be dealt

with › Satisfy a credit committee/risk committee › Proceed?

Mitigate by good practices and procedures – will that be enough? › More needed to answer this question › Current view is to say no – too risky!

Where are the risk areas? Transaction risks/counterparty risk Breach of sanctions; money laundering; financial crime and bribery What other concerns?

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Risks in doing trade finance business

Different approaches › Trade finance practitioners say trade finance is risk free › Regulators say it is inherently risky!

Basel II – a lost opportunity for better regulatory treatment

Basel III – the fight back but with limited success

“Res ipsa loquitur” – no the facts do not necessarily speak for themselves › Lies, damned lies and statistics › More is needed to explain trade finance structures › More is needed to show how risks are dealt with (in context of risk capital)

Regulators need to accept what is being done › Better regulatory framework should pertain

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The two “risk” streams run in parallel

Historic risk and risk analysis › Transactional

How the regulators view risk › Protect the bank’s capital › Protect against bank failure › These two may be inconsistent with each other

The two can exist together and be resolved together

It means Regulators understanding trade finance

What follows then is to give incentives to trade finance correctly undertaken

Counter arguments remain that Regulators want banks to police laws

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Risk Areas Trade is generally about buying and selling goods

Goods move from seller to buyer › Possibly through a number of buyers › Possibly through a number of countries

Possibly by use of different means of transport

How to deal with all this? › Avoid running unacceptable risks

Can trade still be about documents only? › Unlikely › Need to know the transaction › Need to know the parties

How far should a financer protect the system? › Where should KYC end? › Who must be onboarded?

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Onboarding Who must be onboarded?

› Direct customer › Customer’s customer (KYCC) › All parties in the transaction?

Can you only do business with a party you know very well?

How often must you refresh your KYC?

Can a third party supply the information? › There are good information systems › It could reduct cost

Are the Regulators saying no to this?

Are there more laws and regulations to make onboarding to new customers too risky?

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Possible parties to a trade finance transaction

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Arranger(s) (Mandate to

arrange financing)

Security

Bank

Agent

Security Agent (holds security)

Guarantor Insurer

Borrower

Buyer

Collateral Manager / Stock Monitor

Warehouser

Transporter

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The Parties in the Transaction Know your customer

› Systems in place

What about your customer’s customer › KYCC › Levels of due diligence

How many other parties must you check? › Transporters, storers…

Sales of goods › Risk of dual use › Check unusual transactions › Check unusual documents › Watch out for bribery and corruption

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Derisking the supply chain - production True supply chain

› Production to ultimate “consumer” purchase

How to secure production › Quantity and quality › Who will help? › Who takes what risk?

Are there means to cover non production? › Production guarantees › Crop risk insurance › Purchase guarantees › Quality and quantity enhancements

Structure to get benefit for producer › Cost can be part of financing cost

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Who else is involved with the goods? Forwarders

Transporters

Ships and aircrafts › Bills of lading and airway bills › Documents of title › Electronically produced?

Trucks etc. › FCRs › Value?

Movement of goods and their sale › Release › Trust receipt

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Collateral Management Use of collateral managers

Part of a solution but not THE solution

Their insurance helps but…

Uses of CMA › Help check on goods › Help with taking security

Still need to check parties and goods

Who takes what risk › Theft › Fraud › Others

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Derisking – storage and transportation Better ways to store commodity?

› Less risk in transportation › Less risk in warehouse

What about warehouses? › Key questions where financed goods in warehouse

Is warehouse trustworthy? › Regulated › Insured › Use of warehouse receipts › Fraud risk of double funding

Need to work within current laws and regulations › Analyse local position › Use good documents › Exchange information on warehouse?

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What to look for in Receivables Financing

Supply chain structures

Electronic platforms › Own › Third party platforms

Double funding

Trade receivables or not?

Other methods of making payment

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Other risks issues in Receivable Financings Structure important for risk analysis

Are receivables security or being purchased › True sale questions › Notices to which parties and when

Collection arrangements

Structure where receivable is insured › All or part insured › Waiting periods in the structure

Failure to pay › Remedies and action › Is it true trade debt? › Does it matter?

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Reputation risk Must it trump all structures?

Take a step back and consider trade finance

Assume that costs can be contained

Assume regulators can be persuaded at least to support trade transactions

Use solutions analysis to convince › Internal-committees › External-regulators

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Too many risks to make it worthwhile Perhaps not

Need to understand transaction fully

Consider all parties in the transaction

Take each risk and deal with it

Accept risk and then mitigate

Look at derisking tools

Apply relevant tools to the particular transaction

Not one size fits all

Many ideas around › Often using technology or third parties

But where do regulators sit within this?

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Regulatory risks in transactions How the regulators approach risk

› Sanctions, financial crime, AML etc. › Cost of compliance › Show they are dealt with

Bank risk in light of Article 55 BRRD › Bail in › Trade should be outside this

De-risking of relationships › Knock on effect of reduced banking relationships › Less use of banks for on lending transactions › SWIFT issues on payments › How to return from this?

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Better Risk Treatment Satisfactory risk capital treatment

› Yet more regulation to come › Basel IV and beyond › Where do trade finance banks stand in all this?

Deadline for Basel III is 1 January 2019

Basel Committee developing updated standards

Main proposed changes

› IRB banks to be subject to capital floors on counterparties based on standardised approach

› Risk weighting of bank counterparty risk - increases

› Risk weighting of multilaterals/development banks - increases

› Increased capital requirements for non-hedged currency mismatch financing by borrowers

› CCF changes for uncommitted facilities - cost

Effect on Trade Finance business

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Where do banks and trade finance sit in risk mitigation?

Risk mitigation and beyond › Credit risk mitigation and Article 194

Where do you start?

Where are we now?

Where do we go?

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Credit risk mitigation

What is a Credit Risk Mitigant? Basel II first introduced the concept of credit risk mitigants

› Very limited for trade

Requirements of Basel III Has risk been transferred? Satisfy regulatory requirements Article 194 (onwards) of CRD IV Key issues to satisfy

› Transfer › Circumstances within control

Legal opinions › Per transaction? › Generic?

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Credit risk mitigation – not logical?

Article 194 and its following sections lead to anomalies

Sometimes it takes you to other sections

A quick reprise and suggestions

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Structuring issues in trade and commodity finance Banks may use various techniques which reduce their exposure to

individual customers and transactions. The taking of guarantees and security to support the obligations of the primary borrower pre-dates capital adequacy rules by many centuries

Basel III recognises the value of security and guarantees as a form of credit risk mitigation. But if such techniques are to be effective in a capital adequacy context, then it must be clear that the relevant arrangement is legally robust

Necessary to consider both the qualifying forms of credit risk mitigation and the legal certainty tests which must be met if the desired capital treatment is to be achieved

Basel III offers two broad forms of credit mitigation techniques. The essential distinction lies between “funded” and “unfunded” credit protection

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Funded and unfunded credit protection Funded

› Right to liquidate, appropriate or retain assets, or to replace exposure and claim on the counterparty (and net that exposure) On-balance sheet netting Financial collateral Deposits with third parties Close-out netting Receivables (Advanced IRB approach only) Physical collateral – including commodities (Advanced IRB approach only)

Unfunded › Right to receive payment from third party

Guarantees Subparticipations Credit derivatives Insurance

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Legal requirements for a funded credit protection

Arrangement can only be taken into account as funded credit protection if it meets certain legal requirements

› It must be enforceable in all relevant jurisdictions notwithstanding the insolvency of the counterparty or any custodian

› The lender must be able to satisfy the regulator that it has adequate risk management processes to control any risks arising from the use of risk mitigation techniques

› The bank must have the legal right to take possession of the security and to liquidate it upon the occurrence of a default

› There are further detailed requirements for individual forms of collateral (e.g. netting agreements, security over cash etc.)

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Legal requirements for unfunded credit protection Arrangements must meet certain minimum legal criteria if they are to

qualify as unfunded credit protection

Relevant documentation must provide a sufficient degree of legal certainty as to the level of the credit protection

Where the credit protection consists of a guarantee: › The guarantee must be an explicit, documented, clearly defined and

unconditional obligation of the guarantor › The guarantee can now be provided by corporates (e.g. parent companies) with

credit quality of possibly at least A- S&P › The guarantee must be legally effective in all relevant jurisdictions › The protection provider must not have any rights to vary, cancel or reduce the

scope of the guarantee › The lender must have a right of direct recourse following default, without any

need to take proceedings against the primary borrower › The guarantee should preferably cover all of the obligations of the primary

obligor under the transaction. In the event of a mismatch, then the eligible value of the guarantee must be adjusted to reflect that fact

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Anomalies in CRR Standardised Banks “penalised”

› Why cannot a wide range of guarantors be used? › Why are receivables not a CRM for standardised approach banks?

Why is the potential charge to guarantors setting IRB banks back to standardised approach?

The trading book v banking book issue › Where can you use CRM? › Can it only be used for banking book assets? › Can you argue it can be used for trading book assets? › The argument and the effect of it

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What to consider in transferring risk

How does regulatory regime treat the transfer?

What is the transfer of risk strategy?

Has whole risk been transferred?

Guarantees

Insurance

What if bank wants to stay lender of record › Use of participation agreements

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Use of guarantees

Transfer risk to another party

Use of URDG

Use of SBLCs

Take a corporate guarantee › Restriction on which guarantor

Note other forms of “guarantees”

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Use of insurance Comprehensive Non Payment Insurance

› Context of transferring payment risk

› What is in the policy?

› New Insurance Act changes “fair presentation” requirement

Relevance for credit risk mitigation (CRM)

Problems for Article 194 opinion

Portfolio insurance

Specific risk insurance

Compare with guarantees

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Why grant a participation?

From the outset: for structural reasons › Withholding tax avoidance › Borrower prefers bilateral relationships

After the asset exists: › Free up capital (or obtain a different capital or balance sheet treatment) or lines › Offload distressed assets › Offload assets that are no longer generating optimum yield (all upfront fees now

paid) › Move out of a geographic area or industry sector › Because a full legal transfer is not possible

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Different from a transfer

For the participant › No benefit of any tax gross up and increased cost indemnities › No benefit of illegality provisions (if any) › No right to set-off against the underlying obligor › Double insolvency risk (i.e. obligor and grantor) › No direct rights against the obligor or to any collateral

For the grantor › Participant insolvency risk (risk participations and unutilised commitments only) › Participant not obliged to participate in restructurings unless express provision

made (usually is) › Retains underlying obligor relationship and control but also has

maladministration risk

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The position of trade debt in Restructuring Where do you rank if loan/receivable not paid?

Just unsecured or better? › The argument if trade gets paid

Can you keep security over the goods? › Would you have it?

Can you get better ranking in insolvency of producer and/or buyer (of goods)?

The essence of restructuring in a trade context › Keep company going › Respect financing structures › Do not use liquidation model

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Going Forward

How do you satisfy risk assessment?

How do you show you have done so?

What needs to happen?

How do you achieve the benefit of all this?

Is there enough available to obtain the benefit of a good treatment for well structured trade? › Internally › From regulators

If not, is it too late to see more adjustments?

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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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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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© 2017 Sullivan & Worcester Sullivan & Worcester is the collective trade name for an international legal practice. Sullivan & Worcester UK LLP is a limited liability partnership registered in England and Wales under number OC381549 and is a practice of registered and foreign lawyers and English solicitors. Sullivan & Worcester UK LLP is authorised and regulated by the Solicitors Regulation Authority (“SRA”). The term partner is used to refer to a member of Sullivan & Worcester UK LLP. A list of the names of all the partners is available for inspection at our registered office, Tower 42, 25 Old Broad Street, London, EC2N 1HQ. Please see sandw.com for Legal Notices, including further information on our professional obligations. This presentation is not designed to provide legal or other advice and you should not take, or refrain from taking, action based on its content. We are providing information to you on the basis you agree to keep it confidential. If you give us confidential information but do not instruct or retain us, we may act for another client on any matter to which that confidential information may be relevant.

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