LMA lobbying efforts on eligibility of guarantees as unfunded credit protection bear fruit18 March 2019
The Loan Market Association ("LMA") is pleased to announce that, following lobbying efforts by the association, certain of its members and other industry bodies, the Prudential Regulation Authority ("PRA") has published a policy statement ("Policy Statement") on credit risk mitigation ("CRM"), which alleviates many of the concerns expressed by respondents, including the LMA, in a previous consultation.
The policy statement, in particular:
- does not implement the original proposal which would have stipulated that any guarantor be required to pay out "within days" of the date on which an obligor fails to make payment. This proposal would have invalidated or prevented the use of certain established CRM techniques.
- removes the proposal that any legal opinion required to be provided in support of a guarantee specifically considers the eligibility criteria. This would have been a difficult requirement to fulfil, particularly since many of the factors to be considered in this regard are matters of fact, rather than law, to which a legal opinion is manifestly unsuited.
The policy statement also, however:
- advises that certain exclusions often found in credit insurance policies (such as the nuclear exclusion) "may be contrary" to the EU Capital Requirements Regulation ("CRR") requirements unless “in all circumstances the clause is immaterial to the guaranteed exposure and the risk of an obligor default under that exposure”. This would indicate that a policy containing this exclusion may still be eligible as CRM, but a bank will need to demonstrate that it has satisfied this condition;
- indicates that, since, in some cases, the PRA believes that the use of guarantees as CRM has proved to be less effective than expected, resulting in residual risks, in certain circumstances the PRA will expect a bank to hold additional capital, even if the instrument meets the CRR criteria for CRM; and
- includes a new expectation around risks arising from eligible guarantee arrangements, requiring firms to identify risks arising from guarantees, "including the risk of non-fulfilment by the firm of a contractual obligation that could render the credit protection ineffective".
Commenting on the PRA statement, Amelia Slocombe, LMA Managing Director, said:
"An initial review of the policy statement would indicate that this is very good news for the market, since it removes two proposals which would have been particularly problematic. The LMA will, however, continue to review the detail of the policy statement in conjunction with its members and will liaise with the PRA to the extent that there are any other issues which still need to be resolved."
The PRA released a Consultation Paper in February 2018 entitled "Credit risk mitigation: Eligibility of guarantees as unfunded credit protection". The consultation sought responses from market participants on a series of proposed clarifications to the eligibility criteria for any "guarantee" intended to be used by institutions for the purpose of credit risk mitigation under the Capital Requirements Regulation (CRR). The proposals would have impacted those UK regulated firms which had adopted either the Standardised Approach or the Foundation Internal Ratings Based Approach.
Whilst the purpose of the consultation was to provide clarity on the underlying CRR requirements, the LMA was concerned that, if published in its then current form, the use of certain widely used, financially robust and well tested CRM techniques (such as credit risk insurance, risk participation agreements and guarantee/guarantee-like products provided by, for example, multilateral development banks and export credit agencies) would have been adversely impacted. This would have caused unnecessary disruption to what is currently a well-functioning and stable market. Furthermore, given the absence of grandfathering provisions or transitional arrangements, the LMA also believed that there was a potential risk to stability (at least on a short-term basis) within the financial system and that this risk was more likely in view of the very wide usage of these products across the market, as well as the reliance of firms on them for the purposes of complying with the CRR. The LMA therefore highlighted these issues as part of a detailed response, and also commented on specific points within the proposals which required greater clarification.