SMEs Face Significant Financing Gap

Speaking at the World Trade Organization’s annual “aid-for-trade” review earlier this month, a representative of the International Chamber of Commerce (ICC) made a plea for added financing for cross-border trade.

ICC Senior Policy Manager Thierry Senechal said that trade finance intermediation is crucial today as it provides real-time risk mitigation, while improving liquidity and cash flow of the trading parties. It also gives localized small- and medium-sized enterprises much-needed access to credit and working capital to finance exports and imports.

Between 80 and 90 percent of global trade depends on some sort of trade finance, yet structural access issues, related to factors such as poorly-developed banking sectors or perceived country credit risk, continue to act as bottlenecks.

In remarks at the event, WTO Director General Pascal Lamy said: “Overcoming existing skills gaps in developing countries can help them draw enhanced benefits from their participation in the multilateral trading system. These discussions have brought some key areas into focus, including access to finance — and trade finance in particular.”

Click here to read more on ICC’s website.

Staff contact: Eva Hampl

More on USCIB’s Banking Committee

ICC names Donald Smith New Banking Commission Technical Advisor

ICC announced earlier this month the appointment of three new technical advisors for its Commission on Banking – a leading global policy and rule-making body for the banking industry known worldwide for its trade finance products and services including Uniform Customs and Practice for Documentary Credits, the most successful privately drafted rules for trade ever developed.

These  include Donald Smith, president of Global Trade Advisory Ltd.

Smith has over 40 years’ experience in international banking operations and trade product management. He has been responsible for international operations for 4 banks. He served as senior project manager for the ICC’s 2011 Basel III Default Registry project which documented the level of risk in trade transactions; chaired the US Delegation to the ICC Banking Commission from 1998 to 2009 and co-chaired the drafting group which produced the ICC’s first International Standard Banking Practices (ISBP) publication. He presently serves on several ICC Task Forces. Read more on ICC’s website.

The Future of Trade Finance: Outlook 2011

By Michael F. Quinn, Managing Director, JP Morgan Global Trade and Chair of USCIB’s Banking Committee

As 2009 ended, we viewed the global economy – and its lifeblood, trade – through the prism of cautious optimism. The limited trade finance available from strong providers had been supplemented by central banks and international finance organizations. To keep the wheels of commerce turning, central banks had also injected liquidity into local economies and assisted in deleveraging bloated balance sheets. In markets where local action was weak or nonexistent, massive trade finance initiatives by various regional and global development banks had delivered much-needed liquidity. For all these reasons, we saw 2010 as the year in which the global economy would  receive a strong push along its road to recovery.

Trade rebounds

Throughout 2010,this proved to be the case. Economies in Asia and Latin America stayed strong as intra-Asia and South-South trade continued to show growth and vitality, although the rebound in Western Europe and the United States was slower, and some regions — Africa, Central Asia and Central America  — continued to lag behind.  Throughout 2010, demand for manufactured and finished goods increased. The voracious appetite of China and India for raw materials to support their internal infrastructure and increased production capacity continued unabated, keeping commodity flows strong as well . In the US, consumers who saw low inflation and a marked improvement in returns on investment came back from the sidelines, showing their famous American optimism even as housing values continued to erode and the job market failed to improve. Europe’s economic engine, Germany, resumed its traditionally strong performance, providing stability and funding to the Eurozone economies.  Global supply chains were restored — and in some cases, streamlined.  The shipping industry, which had over-invested in capacity in boom times, adjusted capacity to meet demand while taking less efficient equipment out of inventory.  Countries not previously engaged in global trade entered the market as the new low cost providers.  The evidence of these global improvements was faster growth in Trade than the WTO had originally envisioned. Its original growth forecast for 2010 was 9%; the actual figure is a considerably higher 14.5%.

In 2010, Letters of Credit usage continued to remain flat to the ’09 exit rate, with volume concentrated in support of Small and Medium sized Enterprises (SMEs) and smaller economies.  Dollar values tended to increase, tracking the rising costs of commodities as well as consumer goods and electronics orders that were the largest seen since early 2008. J.P. Morgan’s correspondent bank customers increased their demand for dollar-based financing to support the needs of their local customers, but from all appearances the transactions financed were open account.  Supply chain finance demand continued its growth trajectory as major buyers continued to strengthen their supply chains while negotiating more favorable terms.  As sellers showed more appetite for their counterparty’s paper, previously constrained liquidity sources began freeing  up capacity. Highly structured trade finance transactions re-emerged, but with greater transparency and fortified documentation.  The credit insurance market also saw improvement as overall trade flows grew and underwriting became more viable.

In 2011, with mostly good news on a macroeconomic front, Trade Finance pricing continues to fall. In many markets, prices are now at or near pre-crisis levels.  Secondary markets have been restored, with investor appetite continuing to increase and ramping to near pre-crisis capacity through a combination of direct participation in deals and continued utilization of development bank  support programs.  Market participation has also expanded to pre-crisis levels as banks that withdrew during the crisis returned.  Unfortunately, some are now demonstrating the bad behavior that was in evidence before the crisis and taking risk without reasonable and rational return.

Trade trend: Up, with some possible turbulence

A repercussion of the economic crisis for the banking community has been intensified scrutiny by the local and global regulators working to prevent a reoccurrence of the ’08 debacle. Basel III emerged in 2010, sending shock waves through the banking industry. The proposed requirements for trade transactions — increased capital, higher risk premiums –are causing banks to seriously reconsider their involvement in the trade finance arena.  Especially troubling are proposals to dramatically increase the capital required to support off-balance sheet documentary credits. The Asset Value Correlation factor, which impacts credit exposure to other financial institutions, and the Liquidity Ratio, which implies that Export Credit Agency lending will be considered illiquid, promise to raise the cost of trade loans significantly.  Uncertainty about Basel III is also challenging trade bankers, since much of the implementation timing and actual capital impact of Basel III will be determined by local regulators. On another regulatory front, global sanctions imposed on Iran by the United Nations have also had a major impact on most banks, requiring greater scrutiny of transportation information associated with trade transactions.  As local “know your customer” requirements diverge, global banking could become increasingly fragmented, impeding the flow of information and documentation among buyers, sellers and bankers.

Despite these challenges and complexities, our global trade outlook for 2011 and beyond is bullish.  Major trading partners are expected to continue their rebound or growth trajectories.  Trade finance will remain in demand, but capacity in most markets will continue to improve, reducing prices even further.  Initial forecasts indicate that by early 2012, global trade will have recouped its losses and will resume its traditional growth rates. Other than in credit constrained markets, the expectation is that the multilateral financing vehicles will diminish in importance in the primary and secondary markets, but will remain as a safety net in the event of a double dip recession. Letter of Credit utilization will continue to be concentrated in SME markets and the smaller economies, since their growth prospects are not as favorable as the major markets. Priming the pump in these markets continues to be challenging. For any financial institution other than donor organizations, the ability to do effective KYC is both problematic and not cost effective, given the relative size of the parties. This lack of access to traditional bank funding  will further impede economic development efforts in this sector.

Though increasingly less likely, the threat of a double dip in 2011 remains as deleveraging and the purging of “bad” assets continue unabated. The dreaded risk of inflation will also lurk as the cheap liquidity used to stoke economies after the crisis is reduced or eliminated. China’s strong internal inflation is now threatening low cost exporters. Brazil’s commodity boom is showing signs of contributing to inflationary pressure; Argentina seems to be suffering from the same complaint. In the Eurozone, any future disruptions threatening the fundamentals of its currency will force the European Union’s strong countries to take collective action. Increased volatility in sovereign risk and foreign exchange rates may create another dimension of risk in this year’s trade environment.  A “wild card” to the trajectory of global trade growth is the seismic shift in governments in North Africa and the Middle East.  Immediate and obvious impact will be on the price of oil which has implications for the almost every country but could be particularly harmful to economies which are still struggling to regain momentum.  Austerity measures taken in the United Kingdom and contemplated in other markets could adversely impact global economic growth and have a knock-on effect among trading partners. But whatever bumps we encounter on the road to recovery, we remain optimistic about this year’s prospects for global trade and  trade finance.

More on USCIB’s Banking Committee

CAN U.S. BANKS ISSUE GUARANTEES?

This article appeared in ICC Documentary Credits Insight

Volume 8, No. 2 April-June 2002

by Vin Maulella, banking advisor to USCIB

CAN U.S. BANKS ISSUE GUARANTEES?

In answer to the often-asked question, “Can U.S. banks issue guarantees?”, most readers have probably heard the response: “No, except for Morgan Guaranty because they are grand-fathered.”   For decades, bankers around the world simply repeated that response as if it were a mantra without much thought about what it meant. Even though the statement was not 100% correct, it sounded authoritative and everyone accepted it.

In fact, the creation and growth of the standby market in the United States and globally has been attributed in some circles to a perceived U.S. regulatory prohibition against the issuance of guarantees or anything with the word “guarantee” in it.  Today the response needs to be revisited. Over the years, the market has become more sophisticated, participants more articulate, and, to the delight of all, regulators and rule-makers have largely acted in concert with the market.

WHAT’S IN A NAME?

To U.S. bankers, the word “guarantee” suggests something foreign banks do; surety is something insurance companies do.  “U.S. banks do not and cannot guarantee someone else’s performance!” … “The bank is not a party to the underlying transaction and therefore cannot determine if there has been contractual compliance!” … “Banks are not empowered or permitted by their charter to do this!”  How many times have you heard these arguments? Historically, U.S. courts have restrictively interpreted statutory provisions empowering banks to engage in banking activities: if a power was not expressly granted, it was not given. As the result of a series of 19th Century cases, suretyship activities of banks were determined to be ultra vires.  Compound that with the conservative bias of bank counsel and these interpretations went unchallenged; they simply became accepted as a limitation on bank powers.  However with the growth of standbys in the 1970s, it became imperative for regulators to determine whether a bank was authorized to engage in any activity that resembled a traditional suretyship undertaking.  Standbys were seen as functionally similar to suretyship undertakings with which they competed for market share.

Suretyship v. Standbys

So, what was the regulators’ rationale for their decision? To start with, the issue had long been settled for commercial letters of credit. Perhaps that made the process easier. Do standbys more closely resemble commercial LCs or suretyship undertakings and guarantees? Given that DCI’s readership understands commercial letters of credit, let’s consider how suretyship undertakings and accessory guarantees differ from standby letters of credit.

In a suretyship undertaking or accessory guarantee, the issuer is obligated to pay or fulfill another’s obligation; defenses available to the principal are generally available to the guarantor.  As a general rule, the guarantor’s obligation is linked to the underlying transaction and only arises if and to the extent that obligation is due, often necessitating intense factual inquiry. Henry Harfield  observed that one of the primary elements distinguishing a surety from a banker issuing a standby letter of credit is the question of what types of risk are being evaluated.  The banker examines the credit-worthiness of its customer, while the surety focuses on the statistical probability of certain events occurring which would prevent his principal from performing the contract.  Granted these risks may overlap. Harfield concedes that a surety may disregard his principal’s ability to perform a commitment if he is satisfied that the principal’s financial condition is such that the principal can reimburse the surety for money demanded or for funds needed to complete the project if that is the undertaking of the guarantee.  Accordingly, it is not unusual to see standby letters of credit issued in favor of surety companies, although one must wonder if the costs for both undertakings are economical.

In a letter of credit, the bank is guaranteeing its own performance, i.e., the bank will pay (honor) upon presentation of a complying document and that document may state that there has been a default. So, the bank does not determine that a default occurred but merely determines whether it received a required document stating that a default occurred.   That reasoning leads to the logical use of the letter of credit as a substitute.

TEXT v TITLE

The 1962 Revision of the Uniform Customs and Practice for Documentary Credits (the UCP), ICC Brochure No. 222, first introduced the expression “any arrangement, however named or described” to encompass all undertakings which might be covered under the generic “documentary credit(s)” and “credit(s)”.  That same expression has continued through the 1974, 1983, and 1993 Revisions of the UCP.  The 1983 and 1993 revisions expanded the stated litany to include “standby letters of credit”.

The ICC uses the same “however named or described” expression in the Uniform Rules for Demand Guarantees (ICC Publication No. 458) to identify undertakings such as guarantees, bonds, and the like which may be included under those rules.

On the U.S. domestic scene, the revision of the U.S. Uniform Commercial Code (UCC) Article 5, simply defines letter of credit as “a definite undertaking”.   Importantly, Comment 6 to Section, 5-102(10), reinforces that “The label on a document is not conclusive; certain documents labeled “guarantee” in accordance with European (and occasionally, American) practices are ‘letters of credit.'”  To further make the point that labels are no longer the critical determinant, the 1996 Interpretive Ruling of the US Office of the Comptroller of the Currency dropped its 25-year old safety and soundness guideline that “Each letter of credit should conspicuously state that it is a letter of credit or be conspicuously entitled as such.”   The ruling itself uses the expression “letters of credit and other independent undertakings” and the OCC discussion accompanying the Federal Register notice explains that this change updates the former regulation “to reflect modern market standards and industry usage … and to cover a broader array of transactions in this area.”

In the international arena, UNCITRAL has drawn up a convention entitled the UN Convention on Independent Guarantees and Standbys Letters of Credit. The title alone strongly suggests that these two types of instruments may perform the same functions. Article 2 defines “undertaking” as an independent commitment to pay upon simple demand or upon demand accompanied by other documents, in conformity with the terms and documentary conditions of the undertaking.

Finally, the most comprehensive effort to date articulating rules of practice for this class of undertakings, the International Standby Practices 1998 (ISP98), ICC Publication No. 590, states that it simply applies to “A standby letter of credit or other similar undertaking, however named or described….” The Preface to ISP98 suggests other standby names, reflecting the market characterization of standbys according to their use in the underlying transactions.  Therefore, undertakings titled “Bid Bond”, “Tender Bond”, “Advance Payment Guarantee”, “Counter Guarantee”, “Insurance Standby”, and “Performance Guarantee” may well fall under the rubric of standby letters of credit, provided the undertaking is independent and documentary.

INDEPENDENT AND DOCUMENTARY?

How do we determine whether an undertaking is independent and documentary?

Clearly, the independent character of the undertaking should be apparent from its terms.  That reference may be explicit or alternatively, the undertaking itself should “subject it to laws or rules providing for its independent character.”  Accepting this “safety and soundness” guideline from the Office of the Comptroller of the Currency, undertakings issued subject to the UN Convention, UCP, Uniform Rules on Demand Guarantees (URDG), Revised UCC, or the ISP are independent.

The various models

Let’s look at each of these models.

The UN Convention frames this independence as separate from the precedent (underlying) transaction or the subsequent (counter-guarantee) transaction.  It also enhances our appreciation of independent as something that may be within the control or sphere of operations of the issuer.

Using UCP terminology, “independent” means that the undertaking is separate from the underlying “sales or other contract(s) on which they may be based.”  UCP 500 Article 3 further refines the independent nature of the undertaking, reinforcing that separateness, “even if any reference whatsoever to such contract(s) is included in the Credit.” UCP 500 Article 3 clearly expresses that the issuer cannot avail itself of defenses otherwise available to the applicant “resulting from his relationships with the Issuing Bank or Beneficiary.” Conversely, the beneficiary cannot avail itself of “the contractual relationships existing between the Applicant and the Issuing Bank.”

These explicit references to defined relationships underscore the separateness of the

undertakings: (i) the underlying sales or other contract; (ii) the application and security agreement; and (iii) the letter of credit.  The first, the underlying sales contract which specifies that payment is to be made via letter of credit, is between the buyer (applicant) and seller (beneficiary). The bank (issuer) is not a party to that contract.  The second, the application and security agreement, between the buyer and the bank, requests the bank to issue the letter of credit but the seller (beneficiary) is not a party to that arrangement.  Finally, the actual letter of credit in which the bank obligates itself to pay the seller (beneficiary) [against the presentation of documents] is a unilateral bank obligation to the beneficiary.  The applicant is not a party to the credit.

This clearly distinguishes the letter of credit, however named or described, from a contract guarantee, accessory guarantee or other bilateral contract which would effectively make the bank a party to the underlying transaction and make the bank’s obligation dependent on the underlying arrangement to which it is not a party.

URDG Article 2(b) parallels UCP Article 3: “Guarantees by their nature are separate transactions from the contract or tender conditions on which they may be based and Guarantors are in no way concerned with or bound by such contract(s), or tender conditions, despite the inclusion of a reference to them in the Guarantee.”

This principle is restated with greater specificity in the U.S. Uniform Commercial Code, the UN Convention, U.S. regulatory guidelines, and in expressions of market practice.  In each of these articulations, “independence” is expressed in terms consistent with the focus of that particular set of rules.  For example, in UCC, the focus is on the legal implications of the independence principle, that is, the rights and obligations of the parties–notably the issuer and beneficiary–and impact of that relationship on injunctive relief.  The Commentary to UCC Section 5-109, Fraud and Forgery, gives additional insight.  It justifies the setting of a high standard for injunctive relief, in part due to the independence principle.  Only where “the contract and circumstances reveal that the beneficiary’s demand for payment has ‘absolutely no basis in fact, ‘[and] where the beneficiary’s conduct has so vitiated the entire transaction that the legitimate purposes of the independence of the issuer’s obligation would no longer be served,'” may a court enjoin payment.

The ISP98 Rule 1.06(c) restates the independence principle and offers insight into its practical application: “Because a standby is independent, the enforceability of an issuer’s obligations under a standby does not depend on:

      i. the issuer’s right or ability to obtain reimbursement from the applicant;

      ii. the beneficiary’s right to obtain payment from the applicant;

      iii. a reference in the standby to any reimbursement agreement or underlying transaction; or

      iv. the issuer’s knowledge of performance or breach of any reimbursement agreement or underlying transaction.”

Additionally, ISP98 Rule 1.07 provides:

“An issuer’s obligations toward the beneficiary are not affected by the issuer’s rights and obligations toward the applicant under any applicable agreement, practice, or law.”

THE DEVIL IS IN THE DETAILS!

“Documentary” means that the bank’s decision to honor is based on a determination as to whether the required document was presented, not whether the event actually occurred.  UCP 500 Article 4 states that in “credit operations, banks deal in documents, not in goods, services or other performances to which they may relate.”  UCP further states that banks are not responsible for the “form, genuineness, sufficiency, of the documents….” In addition, entwined throughout UCP is the requirement for presentation of “specified documents”.  Finally, non-documentary conditions and documents not called for in the credit are to be disregarded.

Consistent with UCP, Revised UCC Article 5 bases the validity, operation, and enforceability of the undertaking on the presentation of documents.  So central is the presentation of required documents to the letter of credit that, in addition to the admonitions in 5-102 commentary, the 5-108 commentary states explicitly that:

“Where the non-documentary conditions are central and fundamental to the issuer’s obligation (as for example a condition that would require the issuer to determine in fact whether the beneficiary had performed the underlying contract or whether the applicant had defaulted) their inclusion may remove the undertaking from the scope of Article 5 entirely.”

In the OCC’s safety and soundness guidelines, the bank is not to determine “a matter of fact or law at issue between the applicant and beneficiary.”  Under such letters of credit or other independent undertakings, the bank’s obligation to honor depends upon the presentation of specified documents and not upon non-documentary conditions or resolution of questions of fact or law at issue between the account party and the beneficiary.

The ISP simply states that the documentary nature of the standby “depends on the presentation of documents and an examination of required documents on their face.”

These two defining principles of this idiosyncratic form of engagement are clearly enunciated and repeated in UCP, UCC, UN Convention, the OCC Regulations and now the ISP.

The easiest way to insure that the subject undertaking meets these requirements is to make the bank’s undertaking subject to a set of rules which incorporate these principles.

CAUTIONS

There are other nuances of these new rules and regulations that recognize and give validity to practice.  Based on the rule-maker, there are obvious biases.  For example the U.S. Commercial Code legislates formalities, rights, responsibilities, and remedies.  The Comptroller’s promulgation focuses on the management of risk, while ISP98 reflects the better practice of the better practitioners.  Collectively, they allow issuers to intelligently and selectively respond to market demands for flexible undertakings within certain parameters.   While the standby has exemplified one of the more creative and innovative sides of banking, there have been certain grounds upon which even the most courageous standby practitioners have treaded lightly.  Obligations without stated expiry dates, amounts payable based on fluctuations in public indices and undertakings conditioned on actions involving the bank itself have always presented unique challenges for the banker trying to accommodate a customer and satisfy a market need while not violating any regulation or law.

Those bankers willing to research the rules and do the homework can find support and direction to issue standbys or guarantees (however named or described) without expiry dates, whether payable in dollars, dinars (or other currency), documents or other items of value.  For those willing to push the envelope further, the amount available may even fluctuate based on market changes, such as LIBOR, PLATTS, or other.  The availability of the obligation itself, may be conditioned on determination of events such as receipt or sending of funds or similar operations which can be determined within the bank’s “sphere of control.”

CONCLUSION

Ask that same question today: “Can U.S. banks issue guarantees?” and you will get a different answer. “What is a guarantee?” “Can you define guarantee?”  If you define guarantee as an independent undertaking to pay against documents, then developments by regulators and lawmakers would now lead us to answer: “Yes, U.S. banks can and do issue guarantees!”