The global banking environment has been rapidly evolving since the 2008 financial crisis and banks have been facing ever increasing pressure from regulators to reform. The recent high profile bank failures in the US and Europe have sharpened the focus on the need for tighter regulation across a wider group of financial entities.
The implementation of Basel IV will place a greater strain on the balance sheets of banks that may result in increased pricing and/or reshaping of some existing relationships going forward. The insurance companies that issue guarantees (the 'surety market') is able to play a significant role in supporting both banks and treasurers to mitigate against some of these challenges.
The planned implementation of Basel IV will have a significant impact on capital treatment for banks with some global systemically important banks (GSIBs) having already become early adopters.
One of the material changes recommended is an increase in risk-weighted capital allocation on performance obligations from 25% to 50%. While negotiations are ongoing between EU banks and regulators on this, the expectation is that it will be implemented and is likely to halve the returns on like-for-like guarantees and letters of credit for banks that may either result in reduced capacity or rising pricing to accommodate this change.
The capital calculation under the current Solvency II framework applicable to the surety market is currently deemed less punitive to sureties. This treatment provides significantly more headroom to the surety market in terms of both appetite and pricing relative to banks.
The surety market is becoming an important component within the treasurers overall working capital toolkit, however, a number of misconceptions remain. The market is often unaware that sureties can act as direct lenders/participants in committed or uncommitted syndicated facilities in respect of unfunded obligations. Sureties are also able to enter into Loan Market Association agreements and Common Terms Agreements alongside banks. Sureties can enter into on-demand irrevocable instruments (URDG758) issuing either directly or via a bank issuing a standby letter of credit ('SBLC') or bank guarantee.
Another important aspect which the market is unaware of, is the capacity and appetite within the surety market for carbon intensive assets. Sureties are typically impacted less by ESG constraints due to lower levels of overall historical exposure to carbon intensive sectors.
The growth trends in infrastructure development as well as an accelerated investment in clean energy initiatives will result in an increased demand for guarantee facilities.
Treasurers facing liquidity pressure because of reduced bank capacity can turn to the surety market to provide lines for a vast array of unfunded obligations (performance guarantees, letters of credit etc), thus freeing up bank capacity towards core funded lending activities.
Specialists such as Howden CAP, a division within insurance broker Howden, have identified the challenges facing the current market environment, partnering with market-leading banks to offer syndicated solutions to treasurers backed by the surety market.
The primary benefits of syndicating the unfunded facility are to achieve funding scale, flexibility and competitive terms.
The specialists typically work in partnership with the bank market on syndicated deals to arrange and syndicate the unfunded facility to the surety market. The sureties have credit ratings that are often higher than banks; for example, all of Howden CAP’s preferred sureties are rated 'A' or better by Standard & Poor’s.
The banks would continue to be the primary source of funded obligations while the surety market would provide a secondary layer of unfunded participation. The nature of this type of unfunded facility would only be relevant to a select group of borrowers with specific contingent liability requirements and would not be applicable to those lenders merely seeking backstop or liquidity lines.
Numerous deals have already been successfully closed on this basis with a strong pipeline of deal flow currently in the market.
In addition to typical contractual performance guarantees, the surety market has also been supporting the following instruments:
The wider bank market is faced with a number of further challenges including balance sheet capacity constraints, single borrower concentration risks and a focus on reducing exposure to carbon intensive sectors, to name a few.
However, specialists such as Howden CAP, in partnership with the surety market, are able to source solutions to these challenges by offering support to banks through fronting arrangements and risk mitigation solutions.
Where treasury teams are seeking to diversify and build guarantee capacity and beneficiaries commonly require SBLCs or bank lines of credit, fronting banks critically can retain a strategic relationship with the underlying corporate borrower, but with the sureties taking obligor risk and banks taking surety risk.
Thus, fronting can be utilised to assist banks with their balance sheet optimisation and distribution initiatives, indirectly providing benefits to corporates through both stable pricing and liquidity.
The need for greater collaboration between corporates, banks and the surety market will be key to remaining competitive in the changing regulatory and challenging macroeconomic environment.
Warren Withfield is head of syndications, Surety at Howden CAP. He can be contacted at Warren.Withfield@howdengroup.com. Howden is the world’s largest independent insurance broker providing a range of specialist insurance solutions to clients around the world. Howden CAP (Capital, Advisory and Placement) is a specialist division created to meet increasing demand for capital and insurance solutions.
Howden at the ACT Annual Conference (16-17 May 2023): If you would like to discover more about the topics raised in this article, join Howden at its panel discussion during the conference (Day 2, 10.15-11.05am, Stage L – Complementary financing solutions: Combining bank and surety capacity in syndicated guarantee facilities), where speakers will include representatives from BNP Paribas, Lightsource BP, Swiss RE as well as Howden.
