Risk Transfer Options: Guarantees and LCʼs

Presented to the PCFAC November 26, 2006

Risk Transfer Options: Guarantees and LCs

Presentation outline

• Credit Granting principles

• Why do we need to consider risk transfer

• Letters of Credit

• Guarantees

• Comparison of each

• Practical issues in their use

• Conclusion

Risk Transfer Options: Guarantees and LCs

Credit granting

The basic premise of credit granting is to determine if the risk of the buyer is

acceptable within the decision parameters of the return on the sale. In other

words the margin generated on the sale must be sufficient to provide a risk

premium to cover the probability of the buyer not paying.

This decision is akin to an insurance pool concept wherein the overall

exposure on all buyers is covered by the reserve created by the margin on

sales.

Risk Transfer Options: Guarantees and LCs

Risk tolerance

Credit granters are constantly balancing the seemingly contradictory

objectives of maximizing credit acceptance while minimizing risk to the

company from the exposures taken. As such, when the direct party risk is

too high, we look to alternative structures to transfer and improve the risk

profile.

Two such mechanisms are a guarantee from a stronger company (usually the

parent) and a Letter of Credit. Both transfer the risk from the direct company

to something (or someone) else, presumably so that it meets the established

criteria for risk and return.

Risk Transfer Options: Guarantees and LCs

Letters of credit

Defined: a written instrument issued by a bank at the request of its

customer (the Applicant) whereby the bank promises to pay the seller (the

Beneficiary) for the goods or services provided that the seller presents all

documents and meets all conditions set out in the L/C.

It is important to note that L/Cs deal in documents not goods and services.

This is why they are commonly referred to as Documentary Credits.

Risk Transfer Options: Guarantees and LCs

Parties to a L/C

Risk Transfer Options: Guarantees and LCs

Types of L/C

Commercial L/C:• When issued, this becomes the primary payment mechanism in the transaction.

• The most common form of L/C issued:

• Negotiable

• Revocability

• Transfer and assignment

• Sight and time drafts

Risk Transfer Options: Guarantees and LCs

Types of L/C

Standby L/C: • Secondary form of payment in a transaction.

• Issued by a bank on behalf of a buyer to provide assurance to the seller of their ability

under the contract.

• The seller can draw on the Standby L/C only upon presenting documents to the issuing

bank showing the buyer has failed to perform.

• Typical uses:

• Ensure payment obligations are met.

• Support of bid and performance obligations.

• Insure refund of advance payment.

Risk Transfer Options: Guarantees and LCs

Guarantees

Defined: In common law, a pledge given by one legal entity to answer for all

or part of the debt of another legal entity.

A legal agreement between two parties to address the specifics of a

particular situation - as such, there is no standard form. The document will

be crafted to meet the needs of the situation.

Types: Blanket

Time Specific

Dollar Value Specific

Risk Transfer Options: Guarantees and LCs

Guarantees

In order to determine the value of the guarantee, one must perform a

complete review of the Guarantor – ability and willingness to pay. The review

should consider all the standard credit factors as well as:

•Reputation risk – historical performance on guarantees.

•Brand image – how does the company view failure to perform.

•Covenants of Guarantor – guarantees are a contingent liability for the firm.

•Supply chain – importance of subsidiary to overall operations.

•Financial condition of related companies.

Risk Transfer Options: Guarantees and LCs

Comparison – when to use

The two are not interchangeable.

L/C:

• A L/C should be used when the credit professional is unable to make an accurate

determination of risk or when said determination renders a negative decision on credit

acceptance. They should not be used in lieu of appropriate credit adjudication.

• Commercial L/C vs. Standby.

Guarantee:

• Used when the subsidiary risk is uncertain and looking to a stronger affiliate (usually a

parent) significantly improves the credit risk.

• Most common in situations where the subsidiary does not provide financial statements.

Risk Transfer Options: Guarantees and LCs

Comparison – practical issues

1. Costs involved:

• L/Cs are not without cost to the seller – large opportunity cost imbedded in transaction related

to the basis point spread charged to the buyer.

• Guarantee cost largely related to documentation review. Complexity of the transaction will

dictate the complexity of the document and corresponding cost. Cost not only in execution of

document but also enforcement.

2. Administrative Ease:

• Relatively speaking, the L/C requires less admin as they are more standardized.

Risk Transfer Options: Guarantees and LCs

Comparison – practical issues

3. Risk Transfer:

•Common view that a L/C has no risk – not

true.

•During the period 1995 to 1999,

approximately 31% of all banks in East Asia

and Latin America failed.*

•The figures for the US have been alarming

as well at times (from FDIC):

* Source: Bank of Canada Working Paper 2005 – 19: Bank Failures and Bank Fundamentals

Risk Transfer Options: Guarantees and LCs

Comparison – practical issues

3. Risk Transfer (cont’d):

•The risk in a guarantee is two-fold; the credit risk of the guarantor as well as the documentation risk.

•Anecdotal evidence would suggest exercising your rights under a guarantee is difficult at best. The

reason being the time when you need to call on the guarantee is the time when the guarantor is least

able to fulfill its obligation.

•In practice, the request for a guarantee has largely symbolic value. The document itself should never

be the reason for granting credit.

Risk Transfer Options: Guarantees and LCs

Conclusion

• Risk transfer options are important but not a replacement

for credit adjudication.

• Documentation is critical.

• Do not assume a L/C is a risk free and costless instrument.

• Guarantees are more effective in theory than practice.

Questions?