Bank letters of credit keep global trade moving and have long been an accepted means for guaranteeing a company’s contractual and legal obligations. But obtaining letters of credit at a reasonable cost may become increasingly difficult for some companies because of Europe’s deepening financial crisis. At the same time, banks also face new capital requirements under the Basel III financial framework.
Banks may respond to these pressures by tightening lending practices, raising prices, and narrowing terms and conditions. In this environment, corporate risk managers may want to consider surety bonds as an alternative to bank guarantees.
Europe’s Financial Crisis
The financial crisis in Europe has been driven, in large part, by concern about rising government debt levels. European banks have been hit hard by the crisis because most have sizeable exposures to stressed euro-zone sovereigns and to counterparties that are themselves weakened by sovereign stress, according to a 2012 Moody’s report.
As a result, the rating agency was recently forced to downgrade the long-term debt and deposit ratings of a number of Italian and Spanish banks. Europe has not experienced any bank runs yet, but banks in Greece, Spain and, to a lesser extent, Italy have experienced bank “jogs,” in which depositors have withdrawn large amounts of cash. Meanwhile, in Greece, recent information has shown that 2012 was economically worse for the country than the beginning of the global recession in 2008-09.
New Capital Requirements
New capital requirements are also putting additional pressure on European banks. The European Banking Authority (EBA), for instance, required a minimum 9% core, “Tier 1” capital ratio by June 30, 2012. To meet this requirement, the EBA estimated that EU and Norwegian banks needed an additional €114.7 billion.
Under the Basel III framework, meanwhile, banks will be required to more than triple the Tier 1 capital they must hold, from the current 2% to 7%, by 2019. Implementation will begin in January 2013, when the requirement rises from 2% to 3.5%.
Financial institutions will also be required to enact a variable “countercyclical buffer” that will be set by national authorities. The buffer will work by enabling regulators to raise capital requirements during periods when credit is perceived to be expanding faster than gross domestic product. During times of low liquidity, regulators are able to decrease or suspend the buffer, in order to free up capital within the system, according to Standard & Poor’s. The takeaway of all this is simple—and expensive: To comply with the Basel III capital rules, the world’s 29 largest banks will need an extra $566 billion.
The combination of these factors—the increased capital requirements, the deteriorating credit and economic conditions in Europe, and the deepening sovereign debt crisis—will put pressure on banks to tighten their lending practices and increase borrowing costs. As banks adjust, companies with strong credit profiles may find that conditional surety bonds are a cost-effective alternative to bank letters of credit.
Surety Bonds vs. Letters of Credit
A surety bond is a contractual arrangement between three parties: the surety, the principal (your company) and the obligee (the beneficiary of the bond). The surety agrees to protect the obligee if the principal defaults in performing the underlying contractual obligation the principal owes to the obligee. As a conditional performance obligation, a surety bond has certain advantages over an unconditional letter of credit, which is an independent obligation of the issuing bank. The holder or beneficiary of an unconditional letter of credit, for instance, can typically draw down on that instrument at any time. Under a conditional surety bond, the particular conditions set forth in the bond must be met before the obligee has the right to assert a claim on the bond. Therefore, a conditional surety bond can provide the principal with greater protection against an unfair call or claim than an unconditional letter of credit.
Businesses in Europe tend to use letters of credit, but the financial crisis may make these instruments more difficult to obtain at a reasonable cost. Even companies that have high-quality, investment-grade credit ratings may encounter high prices and limited capacity. Global insurers that offer surety, while not immune to the financial crisis in Europe, have been relatively unscathed and have the ability to evaluate each company on its own, as opposed to having to make across-the-board decisions regardless of a company’s credit quality.
So, for companies with strong, investment-grade credit profiles, surety bonds may be a solution. Surety bonds, however, may not be as effective for companies with lower-quality credit profiles. In many cases, they might not save as much compared with a letter of credit. Or, they might be required to provide the insurer with collateral, which often takes the form of a letter of credit anyway.
Companies that develop surety capacity now will be in a position to have a stable source of guarantees to offset the impact of bank instability and further changes resulting from Basel III. At a time when banks in Europe are in crisis, global insurers with surety operations may be able to offer a port in the storm.