practical information

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1 practical information hermes cover special Commercial risks march 2012

2 practical information hermes cover special Commercial risks i. consequences arising out of the shift in the causes of loss For more than 60 years, the Federal Export Credit Guar - antees have proven to be a successful and indispensable instrument for the promotion of foreign trade. The Fed er - al Government offers a wide range of products to support exporters and financing institutions during all stages of the export transaction, thereby creating a level playing field for German exporters in the international competi - tive environment. One of the strengths of this instrument is its flexibility and swiftness with regard to changes taking place in markets and economic fundamentals. The shift in the causes of loss from political towards commercial reasons has been a particular challenge for several years and has placed new demands on the risk management of the Federal Government and the banks. Thus, against the background of officially supported export credits being subject to the break-even objective, the risk assessment of eligible export transactions, the monitoring of covered risks, and the development of strat - egies for potential losses or losses which have already occurred, becomes increasingly important. All this re - quires the performance of an effective risk management both by the Federal Government and the banks which is based on partnership and close cooperation to ensure that the German export industry will continue having a strong and reliable partner at its side. major changes in the risk structure During the last ten years there has been a notable shift in the structure of covered export credit risks: While in the past due to a high level of trading activities with foreign state entities the main emphasis lay on covering political risks, since the mid-nineties the number of cover applications for commercial risks in particular insol - vency of the foreign buyer but also his non-payment (protracted default) has clearly risen. This trend re - versal can be attributed to the increasing privatisation of formerly state-controlled economic sectors and a more restrictive policy with regard to the issue of sovereign guarantees. development of commercial claims in percent '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 2 Export Credit Guarantees of the Federal Republic of Germany

3 development of commercial claims in million eur Year Commercial claims Total ,603 3,366 3,704 1,812 1,327 1, between the governments of the debtor and creditor country, is by comparison less complex and far more successful. Hence, the current high surplus achieved by the export credit guarantee scheme is primarily the result of high recovery payments under rescheduling agreements which are, consequentially, used to reduce the deficit accrued under claims payment arising from political risks in the past. ii. risk management for medium-term business recent developments in export guarantee business Looking at the overall claims development over the past years, it is clearly discernible as can be seen in the chart that there has been a steep rise in the propor - tional share of claims due to commercial causes. This rate, which until 1997 had not even reached the 10 per cent mark, has remained at 70 per cent for several years now. This development is mainly due to the occurrence of major claims under buyer credit cover. This ongoing trend has significant consequences: Re - coveries under commercial claims are although de - pending on the individual case relatively low com pared to recoveries under political claims. However, the pro - cessing of the claims is very time consuming and expensive. Long and tedious restructuring negotiations with debtors and other creditors, or the institution of legal proceedings are well-known scenarios that are part of the restructuring practice. In contrast, the processing of claims under bilateral rescheduling agreements, which are, as a rule, based on a Paris Club Agreed Minute risk management performed by the banks Apart from the eligibility for cover, the realistic assessment of the commercial risks involved in an export transaction is one of the key factors for deciding whether to grant buyer credit cover. The risk-adequate analysis of the borrower s credit application has been an important aspect of the banks risk management practices for some years, not least with regard to the so called Basle II framework, i.e., the regulations governing risk-sensitive capital requirements for loans. The financing institutions reacted to the requirements stipulated in the Basle II framework by introducing internal rating systems which evaluate the probability of default by the borrower. The ratings are, as a rule, calculated annually and determine the monitoring procedure to be applied after credit approval. Also, to ensure compliance with the requirements of the German Banking Act, the borrower is bound by contract to regularly submit up-to-date annual and interim reports, as well as provide information with regard to its market position and management. In ad - dition, the stipulation of financial covenants, e.g. com - pliance with certain financial ratios, may be necessary. Export Credit Guarantees of the Federal Republic of Germany 3

4 practical information hermes cover special Commercial risks The conclusion of a loan contract is based on a detailed creditworthiness analysis which is performed by the lending bank. If the bank submits an application for buyer credit cover, the Interministerial Committee for Export Credit Guarantees (IMC) must be able to rely on the decision made by the bank that the risk is justifiable, i.e. that no claims are expected to occur during contract performance. risk management performed by the federal government Against the background of the increase in the demand for cover for transactions with private buyers, the mandataries Euler Hermes Deutschland AG and PricewaterhouseCoopers Aktiengesellschaft Wirtschaftsprüfungs - gesellschaft, which handle the official export guarantee scheme, review and improve their own creditworthiness analysis on an ongoing basis taking into account the joint experience made together with the policyholders. When deciding on an application for cover, the mandataries systematically scrutinise each transaction eligible for cover. a) Enhanced creditworthiness analysis As in the past, the analysis of the borrower s credit - worthiness is based on the assessment of preferably audited annual reports and up-to-date interim figures. For the analysis of the borrower s financial and assets position, as well as its profit and loss situation, key balance sheet ratios are established and evaluated. In particular, the analysis of cash flow from operational activities becomes increasingly important. Furthermore, aspects such as the borrower s market position or man - agement skills are taken into account. b) Analysis of economic efficiency In many cases, it does not suffice to solely base the assessment on data from the past, i.e., on annual re - ports, to be able to ultimately and satisfactorily assess the risks involved in a transaction. It is rather necessary to focus on an analysis which takes into account future developments. Especially if the buyer intends to finance an investment which has a higher-than-average volume in relation to the size of his enterprise or amount of equity, an enhanced analysis of the economic feasibility of the transaction will be required. Depending on the individual case, the enhanced analysis may include an assessment of the cost structure, market position, or the ability to generate foreign exchange. The bank applying for buyer credit cover may assist the mandataries in preparing the cover application for the decision to be made by the IMC by providing financial models or forecasts which have been analysed beforehand by the bank itself. In addition to export credit guarantees issued for a tra - ditional credit extended by a bank directly to a foreign buyer, the Federal Government also offers cover on the basis of a structured finance or project finance scheme. For these types of financing, the economic viability of the transaction in combination with a project-specific securities scheme (escrow accounts) is per se of vital importance. Furthermore, in case of project finance transactions an independent expertise is required. 4 Export Credit Guarantees of the Federal Republic of Germany

5 securities Within the process of the creditworthiness analysis the question of whether the transaction requires a securities scheme has to be decided. According to the experience of the Federal Government and the financing institutions, the amount of losses recovered from a secured claim can be expected to be higher than from an unsecured claim. Therefore, if traditional personal payment guarantees are not available, cover may be granted on the basis of the provision of asset-based securities (ownership reservation, lien, or mortgage). The appropriate securities scheme has to be negotiated between the policyholder (lending bank) and the foreign buyer. The IMC does take account of the fact that the bank has to consider such aspects as practicability and availability of certain types of securities, enforcement of securities in the event of loss, the legal system of the buyer country, costs, or the competitive environment. Also, the fact that there may be cases in which securities are provided only after cover has been granted shall not adversely affect the underwriting decision. It suffices if the policyholder is entitled to dispose of the security at the time when a loss has actually occurred. Securities will only be required if the decision to grant cover were otherwise not justifiable. As a consequence, a close cooperation between the policyholder and the Federal Government as early as during the application stage is of great importance to be able to decide on the appro - priate volume of securities. As a rule, the enforcement of securities in the event of loss is no prerequisite for indemnification. monitoring Pursuant to the German Banking Act, after cover has been granted by the Federal Government the bank is obliged to monitor the covered risks throughout the entire credit period. Depending on the individual case, the bank is required to include financial covenants or other stipulations in the loan contract. This may com - prise, e.g., the submission of up-to-date annual reports and interim figures, financial forecasts, progress reports, or information with regard to the development of the buyer s market position. To be able to react as early as possible in the case of a deterioration of the risk, the Federal Government has stipulated that irrespective of the general duty of notification of any risk-increasing circumstances in case of buyer credits exceeding EUR 20 million the financing institution must immediately and without exception give notice of any delays in payment by the debtor which exceed 14 calendar days. In such a case, the bank is then required to provide the Federal Government with a risk assessment and, if necessary, indicate what measures it proposes to take for the prevention or mitigation of loss. Also at this stage, the importance of a close cooperation between the policyholder and the Federal Government becomes evident. Export Credit Guarantees of the Federal Republic of Germany 5

6 practical information hermes cover special Commercial risks iii. claims management In case of a potential loss, or if a loss has already oc curred although precautionary measures had been taken, it is in the interest of both the bank and the Fed - eral Government to mitigate the loss. According to the General Terms and Conditions, it is the obligation of the policyholder to take appropriate measures with regard to the mitigation of the loss or the restructuring of the amounts due under the buyer credit. Hence, it is the turn of the banks to take the appropriate steps because it is they who, in relation to third parties, still act as con - tracting party to the debtor. There is a broad spectrum of possible measures available in the event of loss. A close cooperation with the Federal Government is advis - able and indeed required for the Government to be able to provide effective support. However, there is no general catalogue of measures to choose from because each transaction constitutes an individual case. Rather, all further steps must be tuned to the requirements of each individual transaction. The mandataries support the ne - gotiations with the debtors and, if required, coordinate meetings if other export credit agencies or policyholders are involved. Prior to indemnification, the Federal Gov - ernment may participate in costs arising from the pros - ecution of legal action, but it requires, among other things, the approval of the Federal Government. If necessary, the Federal Government may contact the German embassy in the respective country, or, in case of a sovereign borrower, directly participate in the negotiations in the debtor country. loss prevention and mitigation The first and foremost question should always be whether the debtor is commercially viable. If this is the case, the bilateral postponement of payment or re struc - turing of the debt are, in principle, adequate solu tions. The financing bank then has to work out the details in close cooperation with the Federal Government. The bank must conduct extensive negotiations with the debtor as a rule in the debtor country as well as with other creditors. If this requires the participation of the Federal Government to improve the outcome of the negotiations, such a step may be considered. However, in relation to third parties the responsibility remains with the bank. If a debt restructuring agreement is successfully concluded the bank is required to accompany the debtor throughout the entire restructuring period. If the debtor is not commercially viable, or is not willing to cooperate, measures such as composition or liquidation proceedings, enforcement of securities, or the institution of legal proceedings must be taken into consideration. Here, the bank is also required to first develop a strategy which will then be coordinated and decided on in close cooperation with the mandataries. 6 Export Credit Guarantees of the Federal Republic of Germany

7 iv. outlook The IMC is willing to accept the challenge of assuming liability for commercial risks. In doing so, the IMC is re - liant on a close cooperation with the banks. Therefore, one has to look very favourably on the fact that today the Federal Government and the policyholders, which have comparable interests, are engaged in an ongoing effort to improve the assessment of these risks. What is at stake here is no less than the stability and flexibility of the Federal Export Credit Guarantee scheme. To guar - antee this, an active and intensified dialogue between the Federal Government and the policyholders from the application stage throughout the entire credit period, including indemnification or restructuring periods, is one of the key factors. Ernst Stöckl-Pukall Export Credit Guarantees of the Federal Republic of Germany 7

8 Euler Hermes Deutschland AG Export Credit Guarantees of the Federal Republic of Germany e 0812 Postal address Hamburg Visitors should call at Gasstraße 27 Hamburg - Bahrenfeld Phone: +49 (0)40/ Fax: +49 (0)40/ info@exportkreditgarantien.de Branch offices: Berlin, Frankfurt, Hamburg, Cologne, Munich, Stuttgart