VI Changing Structures of Commercial Bank Lending
- International Monetary Fund
- Published Date:
- January 1993
In contrast to the resurgence of flows through securities markets, commercial bank lending to most developing countries, especially those which have had debt-servicing difficulties, has remained limited in recent years. In the main, it continues to be concentrated on more secure, transactions-based business, such as trade and project financing. While short-term trade finance has by its nature been a relatively safe business, medium- and long-term trade and project financing has increasingly been structured in nontraditional forms to provide additional security. This so-called structured finance has aimed to shift more of the financing risk from the lenders to other parties, through an application of a variety of techniques, including collateralization, securitization, innovative uses of export credit agency guarantees, and cofinancing involvement with multilateral agencies.
These changes in character of bank lending are the result of the confluence of several factors. Commercial banks are still smarting from their experience with sovereign lending to developing countries in the 1980s. More generally, the overall lending strategy of most banks has become more sensitive to market risks as a result of their recent losses in several other markets, especially real estate. At the same time, slow growth in the main deposit-taking centers and the capital constraints imposed by the full implementation of the Basle capital adequacy guidelines have restricted international banks’ capacity for new lending. As a consequence, banks have generally become more interested in lending with minimal capital requirements or related fee-generating off-balance sheet business, or both.
Short-Term Trade Financing
Short-term trade finance has continued to be available to most developing countries, virtually irrespective of their balance of payments and external debt situation, although terms have been sensitive to perceived risks. Such financing has traditionally been considered a safe business for banks: it is short term, based on specific transactions, and usually given priority in debt servicing. Nevertheless, higher premiums and collateral requirements are often applied to riskier countries and customers.
Most bank financing of short-term trade transactions is undertaken through the issuance of letters of credit (Box 1). Banks control risk from confirmed letters of credit by limiting overall exposure to individual countries, rationing the available lines to the more creditworthy and reliable customers, and setting premiums in line with perceived repayment risks. In addition, banks may require central bank guarantees or export credit agency cover. Implicit host government guarantees are obtained by limiting financing to imports of priority goods. In the riskiest countries, where export credit agency cover may require a confirmed letter of credit by a bank in another country or where an agency refuses cover altogether, banks require secure terms, such as a foreign-currency cash deposit. This may effectively amount to a prepayment for imports.37
For larger transactions with reliable customers, loan syndication has provided a means for risk sharing. Such loan agreements include sharing, mandatory prepayment, pari passu, and other clauses that raise the cost of default to the borrower. In the past, syndication had been most often associated with medium-term financing. Recently, however, banks have used syndication for short-term financing to countries with acceptable risk profiles. For example, publicly owned oil companies in Mexico, India, and the Philippines have recently had access to short-term syndicated import financing, and Zimbabwe has had access to short-term syndicated import and export financing without export credit agency guarantees or other security enhancements.
Medium-Term Trade and Project Financing
Following the experience of the 1980s, banks have considered medium-term financing to developing countries much riskier than short-term trade finance. Medium-term lending to countries that experienced debt-servicing difficulties in the 1980s has been limited and has almost always been structured so as to remove all but a controllable amount of medium-term commercial risk and leave banks with little, if any, of the transfer and market risk.38 These loans typically involve either offshore collateralization (asset backing) using a secure payments stream or the cover of an export credit agency for the financing of unsecured imports.39 In addition to these techniques, banks may convert the loans—both for export and import financing—into securities that can be placed with private investors, so as to take the loans off their books and eliminate almost all the risk.40 Such structured financing is a transactions-driven business with returns coming mainly from high fees.
In asset-backed lending, the borrower effectively extracts a liquid and marketable asset from its balance sheet and provides it as a credit enhancement to the lender. The use of such enhancements depends on the bank’s ability to repossess the collateral in the event of payment default, and thus typically involves assets that are outside the borrowing country’s jurisdiction. In its simplest form, this amounts to the use of existing assets as collateral to secure the loan. For example, Georgian Shipping Company of the Republic of Georgia recently signed a five-year syndicated loan, which was structured offshore and secured on four oil tankers.
A more complex technique is based on the use of future export receivables to collateralize the loan. One of Mexico’s first re-entrants into the commercial bank loan market was Mexcobre, which raised financing for a mine expansion by collateralizing the loan with receipts from future copper exports. The proceeds from a long-term copper sales agreement with a creditworthy West European copper refinery were pledged to the lender banks and designated to an offshore escrow account, thus creating a self-liquidating payments mechanism. The arrangement with Mexcobre included a hedging program to protect the payments stream from fluctuations in the world market price of copper. Similar deals have followed, with a variety of export receivables: Sivensa (Venezuela) using steel export receivables, Zambia using copper receivables, Ghana using cocoa export receivables, and Pemex (Mexico) using oil export receivables. This technique has also proved to be popular in financing commercial real estate projects in Eastern Europe and several countries in the former Soviet Union, since their financing can often be structured on a secure stream of foreign exchange earnings.41
Using collateralization and escrow account techniques, transfer and exchange rate risk are largely mitigated. Nevertheless, banks are still subject to performance risk. For example, the possibility remains that the developing country exporter will not deliver according to its sales contract, thus leaving the bank exposed. Such risk will of course be reflected in the interest rate charged on the loans.
Box 1.Letters of Credit
Letters of credit are usually issued by a bank based in the country of the importer. They guarantee payment to the exporter in the event of nonperformance by the importer (either nonpayment or refusal to accept delivery). For most exports to developing countries, exporters want additional protection and require that the letter of credit be confirmed by a bank in the exporter’s country, providing a guarantee of payment in the event the issuing bank fails to make payment. For the bank providing the guarantee, letters of credit are an off-balance sheet item and, until the recent implementation of the Basle capital adequacy guidelines, did not imply a capital requirement in most regulatory regimes. Under the guidelines, the related capital requirement is 1.6 percent of the value of the asset if unsecured, with further reductions in the capital requirement if the letter of credit has collateral, export credit agency guarantee, or other security.
In a twist to the asset-backed structure, banks have played an important role in the securitization of receivables that involve particularly low performance risk—for example, telephone and credit card receivables. This involves issuing a marketable security backed by cash flow from the receivables. In playing this role, banks in some cases may take on placement risk when they are underwriting an issue, but commercial and transfer risk are avoided.
Asset-backed operations are typically complex and time-consuming to arrange. They also often raise difficult legal issues, which may limit their applicability. Legal issues include problems arising from existing loan agreements, such as negative pledge provisions—especially for public entities—and local laws relating to the enforceability of liens and other security interests. For example, in order to comply with Mexico’s statutory law that prevents it from selling rights to oil reserves, Pemex's asset-backed securitization of future oil receivables had to avoid explicitly committing Pemex to producing or exporting oil.
These techniques may also have negative macro-economic implications if pursued too vigorously or if risk-sharing attributes are skewed too heavily against the borrowing country. A proliferation of escrow accounts, particularly in the public sector, may upset relations with other creditors as their loans effectively become subordinated, and thus may constrain access to new unsecured lending. The earmarking of foreign exchange revenues for particular creditors—especially for operations involving a country’s main foreign exchange earner—may also reduce the country’s flexibility in responding to a balance of payments crisis. In addition, such contracts can involve the use of prices significantly below market. Finally, they often entail large fees or interest rates, which can undermine a country’s foreign exchange position.
With regard to import financing, banks have aimed to limit risk exposure through the use of securitization techniques—such as à forfait financing—and through export credit agency guarantees and insurance facilities. À forfait financing covers import payments through the sale of securities—traditionally promissory notes—in the international capital markets. Fixed interest rate, medium-term paper is issued and often underwritten by a foreign bank and bears a local guarantee, usually from a local bank. The issuing bank bears the underwriting risk and the holder of the paper the interest rate risk, though it has become common to hedge the latter risk through the use of interest rate swaps and forward rate agreements. A large share of à forfait transactions initially consisted of trade finance with countries of the former Council for Mutual Economic Assistance (COMECON). After the collapse of this market, emphasis shifted to countries for which export credit agencies refused cover. The à forfait market has also re-emerged in countries where the shift by export credit agencies from flat rate premiums to flexible rate premium structures has made the à forfait structure more competitive. The market’s main focus has recently been Algeria and to a lesser extent Hungary and Latin America.
Recently, the securitization of import financing has also gained ground using the U.S. Eximbank-backed bundling program. This technique was launched by a bank in early 1989 to securitize medium-term export credits to Mexico. Under the bundling program, a foreign bank extends a U.S. Eximbank guaranteed loan to a domestic bank, which on-lends the proceeds in small amounts to local importers. When a specified amount has been disbursed by the domestic bank, the loans are bundled into promissory notes, which are then placed with private investors by the foreign bank.42 The foreign bank derives fees from structuring the transaction and can increase its lending without increasing its country risk exposure. The attraction to investors is that they are essentially buying U.S. Government risk, as the paper carries an Eximbank guarantee. The U.S. Eximbank-sanctioned program for Mexico was introduced in March 1990; it now has plans to create global bundles, which would aggregate trade receivables for several countries.
Aircraft financing has been one of the fastest growing segments of securitized finance and has been used by a wide range of countries, including China, India, most countries of Eastern Europe, and several countries in Africa. Aircraft financing combines asset-backed securitization, including in many instances the mortgage on the aircraft itself, with export credit agency guarantees. Risk sharing occurs through export credit agency guarantees up to 85 percent of the purchase, with the residual being distributed between bank loans (either as purchases or leases) or company equity.
Long-Term Project Financing
Banks have been especially reluctant to finance long-term, particularly infrastructure, projects in developing countries. Over and above the normal risks involved with their long gestation periods, these projects usually do not generate hard currency earnings. They also entail greater involvement with governments, with which banks have often had poor records. Where banks have been involved, the financing has usually included far more stringent performance agreements compared to medium-term financing. Moreover, lending is typically on a limited recourse basis so as to isolate the risk associated with the project itself from the risk of lending to the project’s host (typically a large company or the government). Loan arrangements also include risk sharing among several categories of lenders, with varying degrees of financial subordination. In this case, banks have relied on many of the risk- sharing techniques associated with medium-term financing mentioned above; that is, insurance and guarantees of export credit agencies (subject to limits on the import content of the project and the limits on maturity that can be covered under OECD agreements), asset-backed financing, and securitization. The complexity of such negotiations has often been one of the key stumbling blocks to finalizing such agreements.
In the precompletion stage of the project, the major risks relate to the possibility of cost overruns, completion delays (construction risk), and the failure of the project to perform to prior specification (start-up risk). These risks are usually borne by the project’s contractor, operator, or supplier through a completion guarantee that covers the risk that the project will not be completed on time and cost overruns. Usually, banks will only participate in projects involving reputable firms as contractors and proven technology.
In the postcompletion (or operating) stage of the project, banks rely on agreements with end-users of the project’s output and suppliers of the project’s input to protect themselves from commercial and market risk. A “take-or-pay” contract is an unconditional obligation by the end-user to make periodic payments in the future for fixed minimum amounts of product at fixed or minimum prices irrespective of whether they are required. A “put-or-pay” contract is an unconditional obligation to supply to the project a specified level of key inputs over a long period of time and at a predictable price, or to pay the project the difference in cost incurred in obtaining such inputs from another source.43
A limited recourse financing structure constrains the financial links between a project and its hosts. The project is set up by its sponsors (usually consisting of a contractor or operator) as a legal entity separate from the host government or company. As a result, the full repayment risk is placed on the earning capacity of the project, enabling banks to evaluate better a project’s risks. A variant of the limited recourse structure is often applied by developing country governments to finance infrastructure. The build-operate-transfer (BOT) approach grants operating concessions for the completed project to the project entity for a certain number of years, in return for which the entity is fully responsible for building and financing the project.44 This structure is used most often used when the country is facing fiscal constraints or desires to encourage private sector activity.
As well as delimiting the transactions risks involved, the limited recourse approach brings additional advantages. One is that as a new self-financing entity, the project can raise funds unrestricted by negative covenants and borrowing limits that may apply to an existing corporate entity, and is not liable for claims against the project’s host. Also, as the lending banks are involved from the initial stages of the project, they can exercise control over the planning and management of the project. The benefits to the project’s host government or company are that the nonrecourse borrowing does not affect its own balance sheet.
Governments have provided various types of performance guarantees and tax benefits to encourage project financing. For example, in Malaysia, where project financing on a BOT basis has been particularly prevalent, the Government provided large precompletion and postcompletion loans, and guarantees covering interest rate movements, taxation policies, and completion delays arising from government actions.45 But Malaysia’s experience of high economic costs in this regard has raised some questions as to the efficiency of BOT infrastructure projects. In general, it is difficult to measure the benefits from involving the private sector against the “avoided” costs from the project being implemented by the public sector. Experience suggests, however, that the benefits may increase with the number of BOT projects implemented.46 A country’s first projects have often been hampered by their slow implementation, arising, in the main, from cumbersome negotiations over the legal basis of the project and the pricing of the project’s output (decisions which are usually in the public sector domain), as well as other complexities in the financing structure.
Cofinancing and Guarantees
In recent years, substantial amounts of long-term project finance have been provided to developing countries from both official and private sources through cofinancing with multilateral financial institutions (MFIs). In general, such cofinancing brings two advantages to the cofinanciers: first, MFI involvement provides project appraisal and other important information about the project and, second, the association with the MFI may be perceived as providing some protection against sovereign risks. In addition, under cofinancing operations, an MFI can extend to private cofinanciers direct guarantees against specific noncommercial risks.
The World Bank Group (including the IFC) accounts for about two thirds of multilateral resources provided through cofinancing. The total amount of resources channeled to developing countries through cofinancing with the World Bank Group has increased over a ten-year period by more than 135 percent to $27.9 billion in 1992 (Table 14).47 The share of official bilateral creditors and export credit agencies in cofinancing with the World Bank Group averaged 19 percent and 9 percent, respectively. In contrast, the share of private cofinanciers has remained quite small, as private participation has been limited to an average of 7 percent in the 1988–92 period.
|(In millions of U. S. dollars)|
|Total cost of projects cofinanced with International Bank for|
Reconstruction and Development
|Total cofinancing resources to borrowers||10,291||14,689||25,215||25,332||20,438||25,323|
|International Development Association (IDA)||…||2,469||2,726||3,423||3,407||4,109|
|African Development Bank2||…||553||669||573||418||1,080|
|Asian Development Bank||…||88||386||1,102||371||783|
|Inter-American Development Bank (IDB)||…||106||457||1,531||1,570||2,106|
|From bilateral creditors||2,866||4,162||6,083||5,092||3,267||3,474|
|From export credit agencies||1,939||935||2,013||3,519||1,195||3,337|
|From private sector||995||1,244||1,260||646||434||1,057|
|Resources from borrower||9,645||5,378||16,058||23,932||10,023||11,578|
|Total cofinancing resources with the International Finance|
|Total cofinancing resources to borrowers||10,291||15,701||26,630||27,164||22,812||27,869|
|Export credit agencies||1,939||935||2,013||3,519||1,195||3,337|
|Regional distribution of IBRD and IDA cofinancing Total||100.0||100.0||100.0||100.0||100.0||100.0|
|East Asia and Pacific||9.5||12.4||26.3||28.4||7.8||25.3|
|Middle East and North Africa||2.7||7.7||8.6||2.7||10.9||9.7|
|Latin America and Caribbean||50.5||16.6||22.4||33.5||20.4||20.0|
|Europe and Central Asia||5.2||9.2||8.8||5.5||14.7||3.1|
The mechanisms in cofinancing have evolved. Parallel lending was one of the original forms of cofinancing between official and private creditors. Under this structure, financing from the MFI and commercial banks are covered by separate loan agreements. The commercial bank loans are usually linked to the MFI loan through a cross-default clause, which gives each creditor the right to accelerate repayment of the loan in the event that other creditors declare an event of default.48 In addition, a memorandum of agreement is typically signed between the MFI and the agent for the commercial bank to facilitate the flow of information between the MFI and the commercial bank.
An alternative form of cofinancing is known as a complementary financing scheme (CFS). Under the scheme, an MFI originates two loans. The first loan is retained by the MFI and therefore requires the MFI’s capital. The second loan is sold to private creditors on prearranged commercial terms. Nevertheless, the MFI remains the lender of record, and the borrower cannot distinguish between the MFI and commercial banks in servicing the loans. The CFS structure has become the most common form of cofinancing and has been used by the World Bank, Inter-American Development Bank (IDB), the African Development Bank, the Asian Development Bank, and, more recently, by the European Bank for Reconstruction and Development. The World Bank had introduced such a scheme (known as the “A” loan program) in the 1970s. The other multilateral institutions introduced similar schemes in the early 1980s as commercial creditors began to lose confidence in parallel lending, which in practice did not provide much protection to banks since their loans were rescheduled along with other commercial debt.
The IFC runs a syndication participation program that is similar to a complementary financing scheme. The main differences are that under a syndication, the IFC originates only one loan composed of two tranches and the borrower is a private sector entity. The first tranche is funded by the IFC’s own resources and is retained on the IFC’s books. The second tranche is funded by commercial banks pursuant to participation agreements. The IFC still appears as the sole lender of record and loan administrator. This protects the private cofinancier from sovereign risks in the same manner as the CFS.
In 1983, the World Bank extended the scope of its cofinancing instruments by offering direct participation agreements and guarantees to commercial bank syndication under its B-loan program. Under a direct financial participation, the MFI participates in the later maturities of a syndicated loan cofinanced with commercial banks in order to extend the maturity of the loan. In general, such participation has been limited to 10 percent of the total loan amount, although occasionally it has been extended up to 25 percent. A guarantee can be extended against a specific or a general risk and may therefore effectively guarantee the later maturities of a commercial bank loan. Alternatively, MFIs can offer cofinanciers a put option on later maturities. If the guarantee is called by the cofinancier, the MFI would acquire a direct exposure to the borrowing country; in order to meet such a contingency, the MFI would have to originate a new loan to the borrowing country.
Under the B-loan program, the World Bank had by 1988 extended about $4.8 billion in credits to about 24 projects. The bulk of these operations entailed direct participation in commercial banks’ syndicated loans. At the time of its inception, it was felt that the B loan would help banks to overcome the constraints that had restricted syndicated lending to developing countries. As the debt crisis evolved, however, a number of debtor countries began facing more acute debt-servicing difficulties, including the accumulation of interest arrears. This environment posed a potential operational hazard for the Bank, for under the legal structure of cofinancing syndications, the Bank could have had its freedom to lend to a member country restricted if a cofinancier bank were to declare a default or request an acceleration of its loan.
Against this background, in 1989 the World Bank replaced the B-loan program with the expanded cofinancing operation (ECO) program. The ECO restricted the universe of eligible borrowers to developing countries that had not restructured their external debt within the past five years, with the aim of facilitating voluntary market access for these countries. At the same time, private sector projects became eligible for assistance under the new facility.
The ECO can offer a partial guarantee of debt service on medium- and long-term commercial bank loans or sovereign bond issues. Under modifications to the ECO program approved in 1992, the present value of the debt service (principal or interest, or both) guaranteed would normally not exceed 50 percent of the total amount of financing obtained through the associated loan. In the case of private sector projects, the program can extend a guarantee against a well-defined sovereign or political risk of up to a maximum of 100 percent of the amount of financing obtained, which may be particularly useful for BOT projects. Payments by the World Bank under this type of guarantee would be triggered in the event that the government fails to honor one of these commitments. The ECO can also be structured as a contingent obligation, such as a put option for the private creditor to be exercised against the World Bank.49 The Asian Development Bank also operates a guarantee facility whereby the institution issues a guarantee covering amounts due on the second loan of a complementary financing scheme for those maturities extending beyond those that would normally be available from bank lenders.
A different form of guarantee that aims at encouraging direct foreign investment flows to developing countries is extended by official investment guarantee agencies in a number of creditor countries.50 These agencies offer investors insurance against political risks through a variety of guarantee programs that are geared to protect investors against losses arising from political risks (including those arising from expropriation, civil disturbances, and war), as well as from noncommercial currency transfer risks.
The Multilateral Investment Guarantee Agency (MIGA) is the investment guarantee arm of the World Bank Group. MIGA insures up to 90 percent of new investment projects, including the expansion of existing investments, privatizations, and financial restructurings. Coverage can be extended for up to 15 years (or 20 years, on an exceptional basis) and is capped at $50 million a project. In fiscal year 1992, MIGA insured 21 projects amounting to $1 billion in direct foreign investment (and $313 million in contingent liabilities against MIGA).
This system for financing trade breaks down when no reliable banks exist in the importing country. This has happened in the former Soviet Union and has led to the revival of countertrade, essentially nonsimultaneous barter transactions. Though dominated by trading companies, several West European banks have been attracted to countertrade by the prospective fees from arranging these deals.
An additional attraction of structured finance to commercial banks is its potential to reduce their provisioning costs from lending to countries with otherwise high provisioning requirements. As discussed in Section IV, regulators have shown flexibility in lowering provisioning requirements on such loans if the financing structure is perceived to reduce the loan’s risks.
For medium- and long-term financing, export credit agencies provide guarantees for up to 85 percent of the financing.
An alternative to these techniques, which aims to protect against medium-term risks, is the use of put options to enable a bank to reduce a loan’s maturity.
A similar concept underlies the concept of international factoring: a technique for financing short- and medium-term trade transactions. A factor, often an arm of a bank, will provide postshipment financing to an exporter up to a fixed percentage of the value of the shipment in exchange for being assigned the export receipts. In recourse factoring, the factor repays the loan upon payment by the importer, and releases to the exporter the remaining portion of the export receipts minus its fees. In nonrecourse factoring, the factor bears all the repayment risk in exchange for a larger share of the receipts. The benefits to the exporter are increased liquidity, and in the case of nonrecourse factoring, the security normally associated with a letter of credit but without its costs and administrative problems.
This method of financing is essentially a pooling of à forfait transactions.
There are many variants to these types of agreements. For example, a take-and-pay contract is similar to a take-or-pay contract, except that the unconditional obligation to pay is contingent on the delivery of the product.
There are several variations of BOT financing, such as build-operate-own (BOO), build-operate-own-transfer (BOOT), and build-lease-transfer (BLT).
Outside Malaysia, BOT-type projects have mostly been used to finance the construction of power plants (e.g., Colombia, Pakistan, and the Philippines) and toll roads (e.g., Hungary, Mexico, and Thailand).
International Finance Corporation, BOT Operations: IFC’s Experience, M/92/134 (Washington, July 24, 1992).
Figures refer to the year ended in June.
If default occurs, lenders have the right to cancel any undisbursed amounts of the loan and to require the immediate repayment of the disbursed amounts. A default can be triggered by the breach of a covenant or by a failure to make timely debt-service payments.
As an example of an ECO operation, in 1990 the World Bank approved an ECO to provide a nonaccelerable guarantee of the entire principal amount of a ten-year Eurobond issue by a Hungarian government-owned entity. The Bank guarantee would be activated in case the borrower defaults on the bullet payment due upon maturity. In 1991, the Bank approved in principle an ECO to assist in the financing of an energy project in Pakistan, although the financing has yet to be assembled. The Bank would guarantee 100 percent of the debt service due to a private company in the event of a default resulting from the Government’s failure to implement its obligations under a concession agreement with the project company.
Private insurance companies may also sell insurance against investment risks.