BAFT: Transaction banking challenges and solutions

Scrutinizing auto-extension best practices

When Canadian commercial firms export and import goods across borders, they may also issue or receive guarantees or letters of credit to mitigate risk in the overall transaction. These letters of credit and guarantees then become important instruments, representing significant value to both client and lender balance sheets. As a result, best practices regarding the renewal terms for guarantees and letters of credit, including provisions that automatically extend these instruments, are warranting greater scrutiny.

Key insights

  • The importance of trade to the strength of Canada's economy in 2019 cannot be underestimated, with the United States remaining its largest trading partner
  • Canadian banks that facilitate trade may have letters of credit and guarantees representing billions of dollars of value on their balance sheets at any given time, making it vital to ensure these arrangements can be renewed as required
  • A global working group to identify best practices for auto-renewal provisions in letters of credit and guarantees is expected to report back to BAFT by the end of 2019, providing targeted guidance for financial institutions that facilitate trade

In January 2019, the Bankers Association for Finance and Trade (BAFT) hosted a two-day Canada Trade Finance Workshop in Toronto, attended by financial institutions from around the globe that are actively engaged in international transaction banking.

Vincent Barboza, Head of Trade Finance and Cash Services at RBC Investor & Treasury Services, led a session focused on issues and challenges associated with letters of credit and guarantees used in transaction banking, specifically in respect of clauses that may automatically extend the terms of these arrangements.

Guarantees and letters of credit provide security in banking transactions

In Canada, banks may enter into arrangements with commercial clients by lending against receivables and inventory. Under these arrangements, the bank takes a general security agreement on the company's assets, which acts as security for the credit extended. During the normal course of business, the client then repays the borrowed funds to the bank.

As part of the overall lending arrangement, clients often take guarantees or letters of credit as security for exports and issue letters of credit or guarantees for imports of merchandise. On a case-by-case basis, receivable insurance may also be used to protect export receivables and mitigate the risk of non-payment.

Auto-extension provisions can pose concerns for lenders

At any given moment, Canadian banks that facilitate trade can have letters of credit and guarantees representing billions of dollars of value on their balance sheets. The requirement to keep these instruments “on the books" can result in a need to extend their terms, which may be facilitated through “auto-extend" provisions contained directly in the letters and guarantees.

The liberation of data
has the potential to
facilitate greater
competition within
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The use of auto-extension provisions has periodically proven challenging for lenders. To explore potential solutions to the issues that may arise through the use of auto-extensions, BAFT has formed a working group with representative members from around the world. The group is tasked with identifying auto-extension best practices to be disseminated through the development and publication of a white paper, expected at the end of 2019.

A strong tradition

In his remarks to workshop attendees, Barboza outlined RBC's longstanding focus on international trade. RBC was initially created in 1864 by a small group of maritime trade merchants as the Merchants Bank of Halifax, and its sole purpose was to facilitate trade and commerce. As a result, commented Barboza, “trade finance is very much a part of RBC's DNA." Over the past 150 years in Canada, he added, “transaction banking has become a ‘table-stakes business’ for Canadian banks generally."1

The pace of open banking
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Barboza also described the size and scope of Canada's current trading arrangements. On a daily basis, he commented, Canada exports more than CAD 1 billion to the United States (US). In 2017, Canadian exports totalled CAD 546 billion, of which 75 percent (CAD 414 billion) went to the US. On the import side, in 2017 Canada imported CAD 561 billion of goods, of which 51 percent, or CAD 288 billion, came from the US.2

Best practice solutions to address auto-extension challenges

There are challenges associated with auto-extension of letters of credit and guarantees. Barboza highlighted six areas to help guide finance professionals who develop and implement auto-extension provisions as part of their day-to-day lending practices.

1. There is a difference between renewal versus extension. The terms ‘renewal’ or ‘non-renewal’ should be avoided in favour of the terms ‘extension' or ‘non-extension,' so it is clear that the terms of the original arrangement will persist.

2. Notification periods should be clearly specified. As a best practice, notice periods should be identified as “at least 90 days prior" to an expiry date, versus “90 days from the receipt" of a notice.

3. Demands for payment in response to a non-extend notice should meet any certification requirements. In drafting and structuring a notice of non-extension, care should be taken to ensure any certification requirements are met.

4. Careful communication is required when a non-extend notice amends the terms of a letter of credit. If a non-extend notice amends the terms of a letter of credit, drafters should ensure this change is clear and apparent, and plans are in place if the beneficiary refuses the new terms.

5. Documentation best practices are required. In the case of a non-extension, what documentation should be retained to protect the bank's interests, and how should that documentation be stored?

6. A process should be in place to address the implications when a non-extend notice is rescinded. When a non-extend notice is rescinded, the implications for lenders and clients should be clearly communicated.

“The importance of keeping our borders moving smoothly cannot be underestimated," Barboza concluded, given the scope and importance of imports and exports to the Canadian economy. Ensuring that the auto-extend provisions in letters of credit and guarantees adhere to globally accepted best practices can help safeguard the strength of trade finances.

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Sources

  1. Bankers Association for Finance and Trade (January 25, 2019) 2019 BAFT Canada Trade Finance Workshop, "Auto Extension Challenges – What Should You Do?"
  2. Global Affairs Canada (November 2018) Annual Merchandise Trade