PRA deadline fuels post-Brexit fears for London trade insurance market

A deadline has a marvellous way of concentrating minds. And few are more pressing than 16 May when consultation closes on the UK Prudential Regulatory Authority (PRA) proposals on unfunded credit protection. Why is this important? Because one (most likely unintended) consequence will be on limiting how banks can insure non-payment of trade finance assets.  

“It’s crazy, it could really hit the whole UK insurance market,” says one banker. “I’m sure they didn’t mean to do it, I’m sure good sense will prevail.”

The PRA’s expectations on the eligibility of guarantees as unfunded credit risk mitigation (CRM) under the Capital Requirements Regulation (CRR) are what’s causing consternation. On 16 February the PRA published its consultation paper (CP 6/18) with proposed updates to its supervisory statement on credit risk mitigation to clarify the PRA’s expectations regarding the eligibility of guarantees as unfunded credit protection under CRR (575/2013). 

“This is exercising quite a few brains in the City of London,” says a senior insurer at one large brokerage house. “We think that the PRA has intended interpreting the EU in relation to credit defaults, but all trade finance (short and medium term) is affected.”

When ‘timely’ is too soon for insurers

Some of the consternation is being caused by Article 215(1)(a) CRR, in particular the use of the wording ‘timely’ payments after a default. The guidance says the PRA considers timely to mean ‘without delay and within days, but not weeks and months (subject to some limited specified exceptions).’ The consequences of this could be wide.

According to an update paper by Geoff Wynne, partner at Sullivan & Worcester: “This is likely to be of serious concern for certain institutions in respect of various different types of unfunded credit risk mitigation instruments that typically have longer settlement periods. For example, credit insurance policies, ECA guarantees and some risk participation agreements which, as a matter of well-established market practice, have longer waiting periods before the guarantor’s payment is due. In respect of ECAs, we note that Article 215(2) permits some flexibility in terms of the settlement period, but this is subject to meeting one of two alternative additional criteria, which may not be met by the terms of all such instruments.”

Trade finance cover could be hit

A large proportion of insurance cover in the London market is for banks who use cover (for instance with 90-180 day claim waiting period) to make trade finance more attractive through optimising their capital allocation. In the wake of Basel III capital adequacy weightings, this is very important for banks. “The PRA’s suggestion that unfunded credit protection should be paid in days not weeks or months is entirely impractical,” says the broker.

“If a payment is late, the first consideration is to establish if there is a documentary reason or a performance reason, or even a simple banking delay,” says the broker. Sometimes that’s as simple as a key player being on an airplane. “Having to pay out in days, rather than weeks or months, could also mean that the insurer would be paying a claim unnecessarily early and therefore adding another credit risk – that of the risk of non-repayment by the policyholder of a claim that had to be repaid because the cash has come in from the obligor.”

Amelia Slocombe, director and head of legal at Loan Market Association (LMA) in London spells out why the assertion that unfunded credit protection should be paid in days not weeks or months is impractical for insurers: “Firstly, firms benefitting from these types of product may not seek to make a claim for reimbursement under an insurance policy straight away, despite the occurrence of a default giving rise to a claim. Indeed, this may not be considered advantageous if the firm intends to undertake some kind of debt restructuring, which would result in the default being remedied. Nor may final pay-out occur until the event in question has been adequately assessed by the insurer (which incidentally, is no different in practice to pay-out claims in respect of a credit default swap (CDS)).”

She offers a solution. “We would therefore advocate a more flexible approach in the guidance, particularly because under an insurance policy, the likelihood of recovery is really determined by the financial robustness of the relevant insurer, rather than the period of time between non-payment of the underlying obligation and an associated claim arising.”

How could the suggested changes affect trade finance banks?

Slocombe at LMA notes: “While the proposals are expressed to be limited to the substitution approach (ie they will affect those CRR regulated banks which use either the Standardised Approach or the Foundation Internal Ratings Based Approach). In addition, those which use the Advanced Internal Ratings Based Approach are also likely to be impacted.” This is on the basis that such institutions often look to satisfy the same requirements for a variety of different reasons. “Consequently, any guidance published as a result of the consultation will be of relevance to any CRR regulated bank, which is in turn regulated by the PRA and which uses unfunded CRM.”

In terms of actual impact on banks, if the use of widely used CRM techniques is unexpectedly restricted, banks will no longer be able to use such products for the purposes of credit risk mitigation going forward.  This is particularly concerning given the lack of grandfathering/transition provisions [currently] in the proposals, which could create a potential risk to instability within the financial system (since products which banks were previously using for CRM to offset their exposures will no longer be eligible, resulting in increased capital requirements or the need to reduce the amount outstanding  in respect of those exposures).  “The risk of financial instability is more likely in view of the very wide usage of insurance products across the market, and the reliance of firms on them for the purposes of satisfying their CRR obligations.  This could in turn impact the availability of liquidity for trade finance borrowers, at least until the market is given time to adapt to the new environment,” says Slocombe.

There are also other concerns raised about the consultation paper. First, according to Sullivan & Worcester, the CRR requirement that the guarantee is legally effective and enforcement in all jurisdictions raises questions. “It is certainly a reasonable interpretation of the guidance that the PRA would require local law independent legal opinions in the jurisdiction of the guarantor and, if applicable, in other jurisdictions where enforcement action might be taken against the guarantor. If the PRA takes this approach, this could result in a significant financial and administrative burden for both institutions relying on credit protection, and for the providers of credit protection (who would need to be able to provide appropriate corporate authorisation documentation required for law firms to be able to prepare such opinions).”

A post Brexit hindrance?

If implemented, the PRA regulations would only affect PRA-regulated entities, and that means there will be a clear distinction post Brexit in the treatment of banks not regulated by the PRA. “French and German banks would not be so affected,” says the broker, “unless they wanted to use the secondary banking market to make space in their capacities.” Nonetheless, Italian and Spanish banks could also be added to this latter (as they could also want to use some primary and secondary capacities). In different, and more limited ways, the same goes for all EU banks by geography and sector.

Brexit itself may not have any bearing on these proposals.  All they will do is prevent UK regulated banks from using insurance policies for the purposes of credit risk mitigation, which will happen regardless of Brexit. Nonetheless, the insurance market itself is very UK-based, and in a post Brexit trade world, every little will help.  

What else and what to do

There are other, perhaps more technical, points which the PRA has sought to address which are likely to cause problems including limits on how to value the unfunded credit risk instrument and consequently making the instrument suddenly non-compliant. 

Participants recommend reading the paper itself to reveal all. Indeed, there is still time to make your thoughts known. Talk to any trade body of which you are a member like ITFA and the LMA or, better still, make your objections and concerns known to the PRA within the consultation period. The more the PRA hears, the more likely changes will be made, insiders say.