Banking StandardsWritten evidence from the Association of Corporate Treasurers

“Simple” derivatives for ring-fenced bank clients

Several aspects of the subject may be important.

Do smaller companies need access to a provider of non-complex financial derivatives including commodities?

What should be included among non-complex derivatives?

What restrictions or safeguards might apply?

Customer need

Need arises in mitigating some risks from companies basic business—in its costs and revenues—the actual exposures being very contingent on its own circumstances and those of the industry in which it operates. It can also arise from its financing.

Foreign exchange: in revenues and costs or arising from the activity of competitors and, sometimes, from financing.

Interest rates in financing contracts—including sales finance or leasing, not just borrowings.

Commodity prices.

For a smaller number of firms—particularly those supplying the government sector or regulated utilities—general inflation hedging may be required. Few companies use credit derivatives.

The ICB’s conclusion on derivatives was in prudential terms of reducing the risk to the bank from unrestricted derivative business and this can be justified in terms of the increased exposure of the bank to the other financial institutions from an unrestricted book. It is unlikely that material increased risk to the bank arises from transactions with its own corporate customers. This is for two reasons. Banks restrict derivative business with a corporate client as part of the overall corporate credit exposure management and non-financial firms show low correlation among themselves or relative to financial firms.

To be able to deal derivatives the bank will need to allocate a credit line for the company. A bank that gains a variety of business from the company may be willing to do this but for a small company seeking alternative banks willing to do the occasional transaction is difficult. Small companies will normally have a limited number of bank relationships.

Of course, if ring-fenced banks that deal with a customer routinely cannot provide derivatives, the firms would have no alternative but to turn to other providers—non-banks or non-ring-fenced banks, but this will not be easy. This should remain a possibility for companies but smaller companies should recognise the need for care here.

Protection of the Bank

On prudential grounds we see no reason for further safeguards for ring-fenced banks from dealing with corporate clients and the consequential transactions in laying off with other financial firms any arising (net) positions of the bank.

However, on conduct grounds further safeguards may be appropriate. Mis-selling may give rise to financial and reputational costs that may begin to have repercussions on a bank’s credit standing.

Protection of the Smaller Corporate Customer

Perhaps smaller customers (other than those especially qualified) may need explicit protection from mis-selling by the bank as well as reform to some banks’ culture. Smaller customers run the risk of being charged exorbitant prices for financial services and products but this is no different from any other procurement decision. The onus is on the customer to seek alternative quotes and to negotiate on pricing.

The finance staff of smaller firms are, if qualified at all, often from an accounting background and with some experience in the operational aspects of smaller firm financing. Rarely will they have significant relevant experience or education in financial price risk management or in other financing contracts. They lack the conceptual frameworks against which to evaluate novel proposals. This may remain true to some extent even for companies with several hundred millions of turnover. Good external advice is often difficult for firms to buy-in. Understanding advice (bought in or from a well-intentioned bank) may be difficult. It is unlikely that other senior staff of the firm from other disciplines will have much ability or willingness to help.

So this raises the question of conduct requirements for banks dealing in this area.

Of course, the ICB proposed that ring-fenced banks might provide non-complex derivatives, simple derivatives.

What might be meant by simple derivatives?

First, outright forward contracts to buy or sell or for settlement of movements in prices (non-deliverable forwards, forward rate agreements, etc.) and similar clearly qualify.

For a broader picture, it is necessary to understand the nature of most corporate exposures. Most corporate exposures are of a contingent rather than outright nature. For example, an exporter selling in foreign currency may publish a price list annually and will be able to estimate its likely sales, but cannot be absolutely certain. Where an exposure is small, these contingencies may not be seen as material. But if the exposure is large in the context of the firm, the contingent exposure can be important. This may be seen starkly with a small auto-components supplier selling to continental European vehicle assemblers. Such contracts are usually placed for several years on a “call-off” contract basis. If the supply is not called off, no sale is ever made. If it is, the fixed price agreed at the outset applies: small firms have little leverage to require customers to carry the risk of price movements during the life of a contract. The supplier probably needs a currency option for this type of protection. Academic studies suggest that companies grossly under-hedge generally and use options far too little—usually because firms are unfamiliar with their use and perceive them as “expensive”.

Straight forward options bought by the customer should be seen as included in “simple”. There is an upfront cost to a bought option so this in itself will discourage companies that do not properly understand the product.

However, any option in a derivative that may be exercised by the bank should make it “complex”. Smaller firms (and some larger ones too) usually lack the systems and expertise to manage financial price options granted to others. This also applies to “knock in” or “knock out” or so-called “low cost” options. It would not prevent a firm buying an option with an exercise price less favourable than the relevant price at the time of entering into the option—this just representing the firm saying it can cope with a small but not a large adverse fluctuation.

It may be argued that a further safeguard might be in the area of excessive length of hedge—e.g. where a bank insists that a borrower hedge interest rates on a five-year floating rate loan for 20 years without especial justification. The credit risk for the bank in a long hedge should make it reluctant to enter into such contracts for small firms unless the bank has an early termination option. But such an option would make it a complex derivative (see above) in any case.

We think generally that it would be unreasonable to require a bank to substitute its own judgement as to the appropriateness of the product for what ought rightly to be the judgement of the company. But a bank could be required to tell a company if it was asking for an unusually large (time or money) hedge and ask it to confirm that it really did want to proceed. In the investment field, the Markets in Financial Instruments Directive requires banks, for some clients, to consider appropriateness and suitability of what is being considered., but that might represent an extra burden for both bank and customer.

Of course a bank should have agreed with the company proper arrangements for verifying instructions from the company and exchange of confirmations and for supply of statements of outstanding positions etc. with the company.

More broadly, as part of their marketing to smaller firms and as a socially useful activity, banks can and do provide simple training matter to smaller clients using derivatives.

1 November 2012

Prepared 2nd January 2013