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THIRD-PARTY PROTECTIONS



Category: Risk Management in Banking

Third-party protections include guarantees, support of a parent company, insurance and protection against credit risk from the seller of credit derivatives. The latter is a much newer concept than the others, and has different characteristics detailed in subsequent chapters (58 and 59).

Third-party guarantees are commitments, ranging from very formal obligations to simple statements, to face the obligations of a primary borrower if he fails to do so. Support is informal. It designates the willingness of a parent company to support a subsidiary unable to face its debt obligations. Legally enforceable guarantees imply a contract, even though the enforcement of this contract is subject to various legal uncertainties. Hence, all formal third-party protections are subject to legal risk.

When effective, third-party protections transform the credit risk on the borrower into a credit risk on both borrower and guarantor. Default occurs only if both borrower and provider of protection default together (double default). The corresponding default probability becomes a joint probability of default of both of them. This joint default risk of the borrower and guarantor is different from a pure transfer of risk to the guarantor, because such a transfer would simply consider that the exposure is on the guarantor rather than on the borrower, which is not the economic reality. However, the New Basel Accord adopts this second view and does not grant joint default probability benefits.

Guarantees

Guarantees allow entering into transactions that would not be feasible without them. A simple guarantee is an obligation of a third party to fulfil the obligation of a borrower if he does not comply with his debt obligation.

Guarantees are widely used in common transactions or in more structured deals such as back-to-back deals. In trade financing, they play a key role since they make trade financing feasible. In back-to-back deals, X does not want to lend directly to Y, but might be willing to lend to a higher credit standing third party. The third party T lends to Y and repays X and, in exchange for this service, gets a spread. Instead of issuing a formal guarantee that Y will repay X, the third party makes the market between counterparties that would not enter into a transaction directly.

Few contractual guarantees can be enforced easily. Some are binding, when the guarantor has to fulfil the obligations of a defaulting borrower. However, the range of guarantees covers a wide spectrum of obligation levels. Letters of intention, as their name implies, are not binding. Some guarantees are dependent on recourses of third parties other than the guarantor. The strength of a guarantee is context-dependent: it depends on its nature, the legal environment(s) that is (are) relevant, current practices and the context when the lender exercises his right.

Support

Support designates an informal relationship. Usually, support applies between a parent company and subsidiaries within a group. A holding company might not let a subsidiary default, although there is no binding rule applied to this. The effectiveness of support depends on intra-group economic links and the behaviour of the supporting entity. In addition, there are various types of support to consider and qualify:

• The support mitigates effectively the borrower risk, and is similar to a guarantee, when the holding company supports the failing subsidiary, whatever the reason (strategy, belonging to a core business of the group).

• Conversely, when the holding company does not support the failing subsidiary at all, for whatever reason (not belonging to core business for instance), without interfering negatively with the borrower, the lender faces the standalone borrower risk only, and the value of support is zero. When the subsidiary default triggers the parent company default, because the subsidiary is so big that the holding company cannot survive if it defaults, the risk remains the standalone credit risk of the direct borrower, and the value of support is zero.

• When the subsidiary credit standing is entirely dependent on the holding company, the holding company default triggers subsidiary default. The lender to the primary borrower, the subsidiary, ends up at risk with both holding company and borrower even though there is no exposure to the holding company!

• The holding company might deteriorate the credit standing of the subsidiary if it decides to dispose of its assets to improve its own standing. Not all legal frameworks allow this. Using other companies assets is illegal in some countries, if it jeopardizes the future of this entity. If it is feasible, the support becomes negative and increases the risk.

Rating Policy Implications

The implication is that direct exposures are not enough to specify risk. Often, the risk depends on third parties. Sometimes this dependency mitigates the risk with the borrower, sometimes it increases it. The risk assessment process should look at the borrower as a standalone entity and at relationships with third parties that mitigate or aggravate this risk. Table 40.1 summarizes the various cases. The practical implications are that both borrower and guarantor ratings, their intrinsic issuer ratings, are necessary as well as a rating of the value of support, in order to get the overall subsidiary rating.

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The support concept requires consistency with rating policy. For instance, it may be that a subsidiary has both a poor intrinsic rating and a good rating, thanks to the support of a highly rated parent company. On the other hand, the parent company might be poorly rated, but a subsidiary might have a good credit standing by itself. If support is neutral or positive, the subsidiary deserves a higher rating. If support is negative, this means that the parent company can weaken the subsidiary credit standing if it faces problems. Therefore, the subsidiary ratings cannot be higher than the rating of the parent company. The rule that caps ratings of subsidiaries based on the rating of the parent implies negative support. Nevertheless, this rule does not recognize that the resulting overall rating (or risk) might actually be worse than the parent company rating (or risk).

There are similarities with sovereign risk and corporate ratings. Capping a corporate rating to the sovereign country risk implies a negative support for companies of good credit standing. In this case, negative support might be the rule, since the materialization of transfer risk will result in risk materialization for any lender to any local company.


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