The implementation of the Basel global banking standards has been a prominent topic in the financial services sector for several years. How these rules are interpreted and applied in different jurisdictions is hotly debated today.
Rules stemming from Basel III will not only impact the banks and other financial institutions directly supervised under them, but also providers of different products and services to banks. This is because the treatment of these instruments is likely to change in various ways.
One such aspect is the use of credit risk mitigants by banks and how these tools are dealt with in the models of different kinds of institutions. ICISA has regularly reported on the prominent discussions currently underway about the use of credit insurance as a credit risk mitigation technique by banks (For example, here, here, and here).
A likely increase in the value of the loss given default (LGD) banks apply to credit insurance protection may have an impact on the use of the product by banks, and ultimately, to the financing underpinned in this way. This topic is discussed in more detail in recent ICISA articles which you may find useful for context.
However, the use of surety bonds in different aspects of bank financing is also likely to be impacted by changes in how such products are accounted for within bank models. While different to credit insurance, surety bonds are also used by banks for credit management purposes by protecting different obligations underlying bank financing to clients.
Sureties also support banks through Risk Participation Agreements (RPA). These are issued under a Master Risk Participation Agreement (MRPA) framework with the aim of reducing exposures on individual limits. This is possible because the RPA functions like an on-demand guarantee (surety bond). Changes to risk weightings and the treatment of credit risk mitigation tools more broadly may therefore have an impact on the ways banks interact with sureties in the future. It should be noted that this largely relates to the European context of Basel implementation. The impact of such changes on other markets and the interaction with local regulatory requirements is a further variable.
While these kinds of changes may signal uncertainty for surety markets, other aspects of these changes could have positive secondary impacts on demand for the kind of protection sureties provide. Changes in the ability of banks to accept different volumes of exposures on particular risks may drive interest in alternatives. This could see large multinational corporates which currently rely on certain services from banks having to engage the surety market in ways they have not previously, or only on a limited basis.
Why and how do banks use surety?
There are several reasons why banks use surety. While these benefits are somewhat similar to the uses of credit insurance by banks, the differences between the way these products work also defines how banks use them. For example, surety bonds can be used by banks to manage internal limits on corporate obligors. Banks benefit from the use of surety products to reduce their capital requirements (i.e. RWAs), but also as a way to optimise revenue generation.
On top of capital efficiencies, the normally strong ratings of surety providers are another reason making them attractive partners for banks. Sureties can also support banks under RPAs on a wide variety of bond types– i.e. bid bonds, advance payment bonds, margin call bonds, as well as several commercial bond types (albeit, excluding financial guarantees). This demonstrates the flexibility of surety providers in meeting the needs of financial institutions.
Surety bonds are also straightforward and predictable in the protection they provide to banks. This means they are usually callable on demand and without exclusion fitting with bank requirements. This is an essential element for the use of any risk management tool. In this way, when a bond is being claimed and the bank’s obligor defaults, the surety will pay the relevant claim.
How might Basel III impact the market?
There are several key areas in the Basel standards as they are implemented around the world which impact how banks manage risks and hold capital relative to these. Credit risk is undergoing substantial changes, with stricter requirements and increased capital reserves being mandated for banks.
Tools used by banks to mitigate credit risk, such as credit insurance and surety (as part of an RPA), are impacted by extension. This may result in weakening the value of offloading credit risk even when the protection provider is highly rated. The intention of doing this is to prevent banks from relying too heavily on such methods, but also to ensure that banks are managing their own risk at a fundamental level.
The impact then of these changes is potentially similar for surety as it is for credit insurance where the benefit of certain forms of credit protection is limited. This could have the effect of diminishing the usage of MRPAs and other instruments involving sureties where these are done with capital relief as the primary goal. Due to changes in risk weightings and how these are managed, the quality of risks brought by banks to the surety market may decrease.
This has been seen in some markets where Basel III is already implemented. In those cases, it was more capital efficient for banks to keep high investment grade risk on their balance sheet than to distribute it into insurance markets. Changes in the quality of risk coming into the surety market could have a knock-on impact on insurer appetite.
Challenges and opportunities for sureties
Beyond these direct impacts of the changing banking framework, are there other secondary effects which may be created by Basel implementation? As noted above, the quality of risk coming to the market may impact the appetite of insurers, however, it would also impact pricing. With a need to manage margin carefully on such business, profitability may become a greater concern for sureties too, forcing changes in the approach of some players. A further change could be that banks direct obligors to the surety market to mitigate part of their risk rather than working directly with sureties via fronting arrangements or other forms of participation.
These kinds of changes in the market may also have the effect of forcing insurers to look wider in the market and innovate to meet demand, or even to create new demand. This could see sureties develop into new or underserviced areas to meet the changing needs of the market, or where gaps arise. Similar short-term trends were seen in the energy market in the initial period of the Covid pandemic when liquidity constraints created opportunities for sureties. Could the Basel changes create similar kinds of demand-side incentives?
Whether such opportunities are genuine and whether they emerge is unclear. However, sureties will likely have to develop deeper understanding of these kinds of markets as the needs of beneficiaries change in response to the regulatory environment. Equally, increased limitations on banks may also drive large corporates to seek alternative arrangements. This too could emerge as an opportunity for sureties.
To take advantage of this, greater engagement between the surety sector and those potential bond users will be essential. So too will upskilling to meet the different challenges. These developments could also stimulate further discussions within the surety market about cross-border surety. While this is an existing conversation and has seen some progress in recent years, challenges remain in place related to legal uncertainty and limited availability of information.
Basel III implementation will have a profound impacting on the banking sector. Those who provide support to banks and other financial institutions to manage their risks will also feel the impact of these changes. This will necessarily include the surety sector.
To overcome the challenges that arise and to grasp new opportunities that emerge, sureties will have to invest in new skills. They may also have to develop greater experience and understanding of less familiar risks, such as efficiency risk, to take advantage of new opportunities. The skills required by underwriters may need to broaden from pure financial expertise to also include engineering or other industrial expertise. Even more important may be investment in new relationships and expanding cooperation with potential customers. Rather than sitting back, surety providers can adapt to these changes and seek to use the evolving circumstances to innovate and grow.
