"Bank risk" may be defined as the risk that a bank which has added its name to a transaction will fail to honour its commitment.

A bank may "add its name to a transaction" by providing payment risk security in the form of a Guarantee or a Documentary Credit (LC), for example, or in various other ways.

In the case where a bank has provided security the ‘corporate risk of the buyer’ is converted into ‘bank risk’. However the seller receives the bank’s commitment to pay in addition to retaining the buyer’s commitment to pay. Therefore should the bank fail to honour its commitment the seller still has the right to call upon the buyer to pay direct, in terms of the contract. This is true even if the buyer has already paid the bank and given the bank instructions to transfer such payment to the seller. The bank acts as "the buyer’s agent" so if the bank goes bankrupt while the payment is in process this loss must be carried by the buyer. This means that a buyer whose bank fails may have to pay twice.

Nevertheless bank security is usually only obtained when the buyer’s financial condition is not known or it is financially weak or when the buyer has exceeded its credit limit with the seller. Alternatively bank security may be used as a means of transferring the country risk exposure of the transaction from the buyer’s country to the bank’s country.

Therefore it is important for a company to assess the financial strength and business ethics of a bank before it is accepted as a payment security provider.

The aim of such an assessment is to produce a list of acceptable banks, each assigned a monetary limit for exposure management purposes, confirmed by a senior company executive authorised by the Board of Directors.

Banks are generally highly leveraged entities. This means that they usually operate with a relatively small own equity and reserves base compared to the debts and contingent liabilities which they incur on an ongoing basis. They are therefore vulnerable and could easily fail should either a large debtor customer fail or should they incur a large loss trading financial instruments. Other dangers lurk in respect of fraud and country risk. The following examples will illustrate these points:

In view of the key role which banks play in the economic fabric of every nation and the world, the Group of Ten (G-10) Central Bank Governors set up the Basle Committee of Supervisors in 1974 to enhance bank supervisory systems and prudential standards. The G-10 consists of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States of America. [Note: The list contains the names of 11 countries - perhaps Belgium and the Netherlands were counted as one with Luxembourg, which joined the G-10 later. Belgium, the Netherlands and Luxembourg are often referred to as the "Benelux" countries and have closely integrated many aspects of commerce and law amongst themselves.]

The Basle Committee of Supervisors was established initially to address issues raised by the Herstatt and Franklin National Bank crises. The Committee’s task is to agree broad principles that will guide banking safety, banking soundness and reasonable competition standards. It meets four times each year on the premises of the Bank for International Settlements (BIS) in Basle, Switzerland. The BIS provides the secretariat for the Committee but the Committee is not part of the BIS per se.

In July 1988 the Basle Committee of Supervisors published the Basle Concordat¹ which addressed three main concerns, namely;

- the basis for convergence in the capital standards of major international banks,

- the legal status of the branches of banks and

- the bank supervisor’s role in the prevention of money laundering.

The Basle Concordat has since been amended and extended as the result of the lessons learnt from subsequent bank failures and banking crises. It provides the standard for capital adequacy rules which are applied in at least twenty jurisdictions worldwide.

"Capital adequacy rules" are designed to insure;

[1] that all banks which operate in such jurisdictions are being managed properly (that is that they are less likely to fail) and

[2] that such banks are competing with each other on the basis of the same rules, even when operating across international borders.

In terms of these rules banks are required to have a certain proportion of own funds in relation to the amounts of various classes of obligations or liabilities which they undertake.

Implementation of the capital adequacy rules promoted by the Basle Concordat has been a major force promoting the increase of bank capital and reserves generally. Basle Concordat based principles have also created a situation wherein no foreign banking establishment should escape supervision and such supervision should be of an adequate standard.

The Basle Committee of Supervisors has made a clear distinction between (1) branches, which have no separate legal status and are therefore integral parts of the parent bank, (2) subsidiaries, which are legally independent institutions owned by an entity incorporated abroad, and (3) joint ventures, which are legally independent institutions incorporated locally.

The Basle Concordat assumes that the solvency of a bank and its branches is indivisible. The opposite is true in respect of both subsidiaries and joint ventures. Therefore any risk assessment related to subsidiaries or joint ventures should be independent of the risk assessment of the parent bank.

Read about the New Basel Capital Accord (January 2001).

(1) Determine whether a bank is acceptable as a payment security provider. (A) This should be achieved by reference to the ‘rating’ given to the bank by one of the recognised international bank rating agencies. (B) Alternatively the company should obtain a satisfactory ‘credit reference’ from a known and trusted second bank, generally known as a "correspondent bank".

(2) Establish the amount of the own funds of the bank; that is the amount of the equity plus reserves.

(3) Decide a factor to apply to the amount of the bank’s own funds, in order to determine the ‘risk limit’.

(4) Regularly gather information as to the company’s risk exposure in respect of each bank and compare this with the bank limits. Take action to eliminate any exposure in excess of a particular bank limit.

(5) Regularly review and update bank limits to take account of changed circumstances.

"Determine whether a bank is acceptable as a payment security provider."

A publication called "The Bankers’ Almanac"² is one of several publications which provide a bank analyst with basic information about most international banks including their credit ratings where these exist. For instance it is reported in the January 1996 edition that Societe Generale (France) has the following Credit Ratings:

"IBCA: AA / A1+;

Moody’s: Aa2 / P-1;

Standard & Poor’s: AA- / A-1+;

BankWatch: - / TBW-1".

Where two ratings are shown (for example AA / A1+) the first rating (AA in this case) is the ‘Long-Term Rating’ which indicates the rating agency’s assessment of the bank’s ability to repay debt obligations with an original maturity of more than one year. The second rating (A1+ in this case) is the ‘Short-Term Rating’ which indicates the rating agency’s assessment of the bank’s ability to repay punctually, senior debt obligations with an original maturity of one year or less.

It is the Short-Term Ratings which are of interest in terms of the process here described.

Unfortunately each rating agency has its own way of describing its ratings. It is important for the company to decide which rating is the lowest acceptable rating in the case of each rating agency. The following tables illustrate this point:

Short-Term Ratings

A1 = the best,

A2,

A3 = "obligations supported by a satisfactory capacity for timely repayment",

B,

C = the worst.

[It is submitted by the author that banks rated A3 or better by IBCA are acceptable.]

Short-Term Ratings

TBW-1 = the best,

TBW-2,

TBW-3 = "capacity to service principal and interest in a timely fashion is considered adequate",

TBW-4 = the worst.

[It is submitted that banks rated TBW-3 or better by BankWatch are acceptable.]

Short-Term Ratings

A-1 = the best,

A-2,

A-3 = "have adequate capacity for timely repayment",

B,

C,

D = the worst.

[It is submitted that banks rated A-3 or better by Standard & Poor’s are acceptable.]

Short-Term Ratings

P-1 (Prime-1) = the best,

P-2,

P-3 = "an acceptable ability for repayment of senior short-term obligations",

NP (Not Prime) = the worst.

[It is submitted that banks rated P-3 or better by Moody’s are acceptable.]

It should be noted that rating agencies may change their ratings whenever new information is received. Therefore it may be prudent to contact a rating agency direct to obtain up to date information in some instances.³

All banks which operate internationally do so through the use of a network of correspondent banks. "Correspondent banks" are foreign banks with which a bank formally corresponds either by operating clearing and other accounts or simply by exchanging signature lists and test key arrangements.

In cases where a local correspondent bank of good standing holds the account of another bank it will have undertaken a due diligence check on the other bank to insure that it is properly constituted and supervised. In addition, in cases where it incurs any credit exposure, the correspondent bank will have assessed the ability and ethics of the other bank’s management and shareholders as well as its financial condition.

Correspondent banks are therefore a useful source of information upon which the company can base a decision as to whether to accept a non-credit rated bank as a payment security provider.

The Bankers’ Almanac usually lists the main correspondent banks of each bank included in the main directory. Alternatively most banks will supply a list of correspondent banks to the company upon receipt of a request.

It is advisable to approach a trusted correspondent bank with which the company has a relationship of some kind and establish;

(1) whether it knows the bank in question to be properly constituted, professionally managed and well respected and

(2) whether it is prepared to grant the bank unsecured (non-collateralised) credit facilities either by way of Letter of Credit confirmations or otherwise.

It is submitted that if both of these questions are answered positively by the correspondent bank the bank in question may be accepted as a payment security provider.

"Establish the amount of the own funds of the bank; that is the amount of the equity plus reserves."

The Bankers’ Almanac reports a summary of the latest financial information available from the banks included in its directory. If such information is not available from this source the bank in question should be requested to supply a copy of its latest audited annual report and accounts. Alternatively a correspondent bank may be willing to supply the company with a copy of the report and accounts.

It is reported in the January 1996 edition of the Bankers’ Almanac that the following figures appeared on the Consolidated Balance Sheet of SOCIETE GENERALE (France) as at December 31, 1994:

Capital FFr (French Francs) 15.103 million plus

Subordinated Loan FFr 29.919 million plus

[note that ‘Subordinated Loans’ may be considered part of ‘Own Funds’]

Reserves FFr 36.253 million

equals Total Own Funds of FFr 81.275 million.

This is equivalent to Total Own Funds of about US$15,23 billion when translated at a rate of FFr 5,3367 equals US$1.

It is also reported in the January 1996 edition of the Bankers’ Almanac that the following figures appeared on the Balance Sheet of UNITED OVERSEAS BANK SA (Geneva) as at December 31, 1994:

Capital SwFr (Swiss Francs) 105 million plus

Reserves SwFr 254 million plus

Profit Balance SwFr 25 million

equals Total Own Funds of SwFr 384 million.

This is equivalent to Total Own Funds of about US$293 million when translated at a rate of SwFr 1,3086 equals US$1.

"Decide a factor to apply to the amount of the bank’s own funds, in order to determine the ‘risk limit’."

The factor to be applied is a matter of judgment and should be reviewed from time to time in light of the company’s experience. It may also have to be applied flexibly on a case by case basis, taking into account specific circumstances applicable.

Nevertheless a standard factor which will accommodate most circumstances is a useful tool, for example it may be decided to utilise a factor of "10%".

Application of this factor to the ‘Own Funds’ totals shown above would yield the following bank risk limits:

US$1.523 million (being US$15,23 billion multiplied by 10%).

US$29 million (being US$293 million multiplied by 10%).

In the case of United Overseas Bank SA (Geneva) it may be decided that a larger factor could safely be applied because this bank is ultimately owned by two large and powerful banks; namely Banque Nationale de Paris and Dresdner Bank AG.

It should be noted that United Overseas Bank Limited (Singapore) is not related to United Overseas Bank SA (Geneva) in any way.

"Regularly gather information as to the company’s risk exposure in respect of each bank and compare this with the bank limits. Take action to eliminate any exposure in excess of a particular bank limit."

The company’s accounting system must be designed to produce a regular report (perhaps weekly) which shows an analysis of payment risk security outstanding by bank.

Other company exposures to the listed banks, such as money market deposits, derivative transactions and/or forward foreign exchange contracts, could be added to such a report.

Comparing such a report against the bank limits will highlight excess exposures so that action can be taken to transfer risks to other banks (by obtaining a second bank confirmation or counter-guarantee) or to limit business activities.

"Regularly review and update bank limits to take account of changed circumstances."

The financial and management strength of each bank is dynamic and subject to rapid change. In addition banks are interdependent so that a change which affects one will affect many, often in different ways. Nevertheless changes are often subtle so it is necessary to be constantly alert.

Positive changes are as important to note as negative changes. Positive changes bring with them opportunities to do more business and to beat the competition. For example this may take the form of reducing the costs related to a series of transactions by eliminating the need to pay a second bank for LC confirmations.

Individual bank limits should be reviewed formally at least twice every year and on an ad hoc basis if important developments come to the notice of the company. It is therefore imperative that a person or persons within the company must be given the responsibility to undertake regular reviews and to monitor developments in respect of all relevant banks on a daily basis. The latter task should be accomplished through giving attention to the news media, conversations with other banks and colleagues and through personal visits to major banking centres.

ooOOoo