Credit Enhancement is a complex structured financial transaction. It requires strong knowledge and financial capacity of the guaranteeing institution. It is known as a strategy for improving the credit risk profile of a business or of a structured financial transaction.
Investopedia’s James Chen defines Credit Enhancement as a strategy for improving the credit risk profile of a business, usually to obtain better terms for repaying debt. In the financial industry, credit enhancement may be used to reduce the risks to investors of certain structured financial products.
“A business that engages in credit enhancement is providing reassurance to a lender that it will honour its obligation. This can be achieved in various ways: By providing additional collateral, obtaining insurance guaranteeing payment, arranging for a third-party guarantee, a company might also want to improve its equity ratio or take other internal measures to demonstrate its ability to pay its debts. Credit enhancement reduces the credit risk/default risk of the company’s debt and thus can make it eligible for a lower interest rate.”
A quick Summary
For investment products, Credit Enhancement serves as a cushion that absorbs potential losses. Credit Enhancement can save money through smaller interest rates. In business, Credit Enhancement can help access funds on better terms.
What is Credit Enhancement?
Credit Enhancement is known as a strategy for improving the credit risk profile of a business or of a structured financial transaction. Through Credit Enhancement smaller companies can access loans, start or build projects or trade products and commodities.
Why get Credit Enhancement?
In business, credit enhancement is usually applied to make a company more creditworthy and places any company in a better credit position. This reduces the cost of borrowing and enables finance. The gains outweigh the costs of financing by far.
Who requires Credit Enhancement?
Large corporations use Credit Enhancement to maximize profits on the strength of their financial background. Smaller companies generate (additional) revenues they could not generate without Credit Enhancement.
Who is the beneficiary and who benefits?
The beneficiary of a Credit Enhancement Instrument can be the client or the client’s own bank, an exporter, or a third party lender. The Client significantly benefits from the leverage effect
The eBook emphasises on options for small and medium sized companies usually not qualified for credit. The Author Geordon Saraveloz, takes a closer look at the general possibilities that are available to a company in need of Credit Enhancement and lack of funding, rather than big corporations using Credit Enhancement to optimize profits. The author also dives into the actual tools, the financial instruments, to structure finance and enable Credit Enhancement. You can download the full version!
Concepts and procedures to enhance your credit
If you have a well established company, you are a long terms client of a bank, and have sufficient cash in the bank or investments, then Credit Enhancement can leverage profits. Your own bank will gladly help you with relevant structures, instruments and concepts.
Some measures of credit enhancement only require just a closer look at your balance sheet to improve and optimize the overall financial picture of your company. It is just working on your balance sheet. This can lead to a better equity ratio, improve your rating and with this access to funds. There are some simple steps you can take to leverage your finances and profits. Anybody can have that regardless of the size of your company. All you need is a well versed accountant or financial consultant.
If your company is not within either of the above described scenarios and in such a fortunate and financially well backed situation, then things look completely different. You still will have to have a good banking relation. And, you will have to have funds to pay for Credit Enhancement. For what is available at no, or lowest costs to cash rich enterprises, you will have to pay for in cash, also mostly in advance. But this can be well worth your while. Credit Enhancement enables additional transactions and projects you cannot conduct or build without credit support and additional liquidity.
If you do not have relevant wealth, but a good banking relation, then you can borrow securities and cash backed financial instruments to be used as collateral, primarily at your own bank. Your bank pays for the lending fees once the collateral instrument arrives at your bank and you do not have to pay anything in advance if your annual revenues are in line with the value of the instrument that you seek. If you also cannot prove relevant revenues, you can probably compensate this by placing a refundable retainer.
If you are not supported by your own bank to enhance your credit, you can only expect and access Credit Enhancement provided by low rated banks and financial institutions. These are so called “willing banks” support transactions your own bank would not be prepared to serve. In that case, you would appoint a professional (mandate) who has built up personal relations with such banks over years, and place a retainer to structure your credit Enhancement transaction in a professional way to avoid financial and legal problems at a later stage. Once the transaction is ready to go, you will have to be prepared to pay for the service before (in case of a bank instrument), the guarantee is actually sent to your receiving bank, or supplier.
The Possibilities and the Service you can be qualified for.
There are two main areas in which Credit Enhancement can be applied.
In Financial Services
In the financial service industry, credit enhancement is used to protect an investor against some risks of an investment.
In business, credit enhancement is usually applied to make a company more creditworthy to reduce the cost of borrowing. Credit Enhancement can place any company in a better credit position to access loans, to start or build projects or trade products and commodities.
Cash rich and well established large corporations get this service through their banking relations at lowest rates and with this have a leverage on available capital
Smaller enterprises will have to pay heavy fees to qualify for a credit enhancement service in the first place. However, revenues that can be generated by applying credit enhancement to achieve financial leverage usually outweigh the costs of financing significantly.
Financial challenges you may have and Credit Enhancement solutions
Access Capital by Enhancing your Resources.
• If you seek a better credit rating leveraging available cash to access capital
• If you seek a loan and have to demonstrate that your company has the ability to pay back its debts
• If you have to assure a lender that the liabilities of a debtor will be met
• If a company wants to import products or commodities and has to secure payment for a seller
• If you seek to secure annual or longer contract terms
• Evidence the existence of a loan or a line of credit that has been extended to you
• Demonstrate cash flows generated by a foreign project that cannot be immediately repatriated to the parent firm because of capital flow restrictions imposed by the host government or if your financial assets are blocked, or deposited abroad for a certain period of time
• Advising available (third party) collateral or financial assets on your behalf or to your benefit
Access Government Grants and Contracts and generate Business.
• Create Equity in a Company to make it acceptable for Government Grants or loans
• If you have to affirm that a company has the required funds necessary to carry out a project
• If you have to demonstrate that a bank or financial institution is prepared to proceed on your behalf with a specified financial transaction
Now here are the Tools of Credit Enhancement
Credit Enhancement tools are financial instruments which may come in these formats and are usually advised on a bank to bank basis.
L/C and DLC – Letter of Credit and Documentary Letter of Credit
SBLC – Standby Letters of Credit
BG – Bank Guarantee
Bid or Tender Bond
RWA – Ready, Willing, Able confirmation
POF Proof of Funds and BCL Bank Comfort Letter
BF– Blocked Funds
CD –Certificate of Deposit
Pre-Advice via bank to bank SWIFT
Banks certainly provide Credit Support!
Credit Enhancement in business is usually sought when a bank or a seller is not fully satisfied with a client’s financial background or collateral capacity.
Banks provide Credit Enhancement Support but only for well established companies with a solid financial background. It is important for banks to build up a long-term stable business relationship and to have customers of substance and good standing. To get a bank’s support you and have to be qualified. Banks follow certain protocols to evaluate an application. Banks look for the borrower’s Capacity, Collateral, Capital, Character and general Conditions. These are the basics of credit analysis to evaluate the application for the loan or to provide a client with a financial service. The better your financial business background, the better will be the terms that you can get. But this also works the other way around. In extreme situations of a poor financial and business background, you hardly can expect any kind of support from a bank.
“In the real world of banking, those clients who actually would not need the support of a bank can expect to be served easily and on favourable terms.
Can you get an instrument from your bank?
If you have ever asked your own bank to issue a Letter of Credit, then you will know that banks are inclined to issue financial instruments for companies who have sufficient cash, investments and financial assets in the bank to cover any eventual financial risks. If you are not in such a fortunate financial situation, it is not only a question of terms to arrange an instrument and a question of price, but it becomes an issue if an instrument is considered to be arranged for you in the first place. Only if you are holding sufficient cash in your bank, they will provide you with such a service. If you don’t, you probably will have to deposit 100% or more in cash to get the same service a financially well situated bank customer can access (almost) for free.
Supportive Banks can get you Credit Enhancement!
If a bank client is not cash rich, does not have significant financial assets on account or on safekeeping in a bank, then no bank will ever provide Credit Enhancement, issue, or send an instrument for a client, and definitely not for free, or wait until a client pays from future generated business. A bank never engages into risks that are not covered by existing wealth parked with them. They will never engage into a transaction and provide any financial service hoping to get paid in the future. It is a completely different story if a client is cash rich or holds significant assets in a bank.
Credit Enhancement may be available, but hardly on your terms
In business, Credit Enhancement is a service usually required by companies who would not receive Credit Enhancement from their own bank. It is based on special professional financial structures that have to be arranged followed by the emission of relevant financial instruments.
Considerations regarding a financial instrument and the principal amount that is involved
No one will ever lend a valid financial instrument to a third party for a small fee if the borrower is not qualified, can evidence an established business, or is able to account for an eventual financial risk that may be created on the basis of the Credit Enhancement instrument. If you have tried your own bank, and got rejected, on what basis do you expect the service from an alternative providing entity? Just think of what happens in case you default on your commitments, and the instrument backing up your transaction or the loan that you take out is being called by your lender? You have learned this already, no bank will take the risk on a transaction for a customer, unless the bank is covered by hard cash, bankable assets or investments deposited in the bank.
If you do not get the service from your own bank, you may create a significant credit risk if somebody issues a Standby Letter of Credit, a Bank Guarantee, any kind of a Documentary Letter of Credit or a Proof of Funds to your benefit. It simply becomes a very risky business for any third party as you can’t cover such liabilities effectively in a bankable way. If you would be able to do so, you would not need the service as your own bank would provide it to you.
On lending collateral instruments to clients, there is also a country risk that will have to be taken into consideration. The biggest financial institutions on the planet like Euler Hermes regularly evaluate country risks, a credit insurance company that offers a wide range of bonding, guarantees and collections services for the management of business-to-business trade receivables. They evaluate and rate country risk level from AA to D while AA is the lowest risk level and D is the highest. See the section “Country and Industry Risk Assessment” for more details on that important subject.
Obviously, there are Fees and there has to be a financial commitment!
All banks charge fees to reserve, to emit, and to transmit a bank Instrument on behalf of a client. No bank will do that for free or wait until a client is willing pay. No bank provides any kind of a service unless the client has already sufficient cash in the bank to cover the costs and an eventual risk.
In Credit Enhancement there are basically two types of transactions. One is about borrowing and lending of valid and verifiable financial collateral. This type of transaction (Euro 10 million and up) is based on genuine fully cash backed, assignable and divisible bank instruments issued by major world banks. This transaction generally is secured by a clear understanding of terms agreed between the issuing and the receiving bank and is secured through a conditional commitment provided by an acceptable receiving bank before the instrument is emitted and sent.
The second type of Credit Enhancement transaction is based on “contract and verbiage controlled instruments” issued by “willing” private banks.
This type of transaction can be available for transactions starting at Euro 250,000. Flexibility comes with the willingness of a bank to engage into an enhancement transaction and avail the required to achieve Credit Enhancement at the client’s own bank, a third party, or a seller. This comes however with a delivery protocol that requires that the agreed upon fees are deposited in cash with the provider before the instrument is emitted and sent.
The procedure to get Credit Enhancement structured usually starts with the appointment of a professional manager empowered through a mandate and the placement of a retainer.
Absolute Confidentiality is an essential part of the transaction
Credit Enhancement in business is always based on confidential structures and a direct relation of the facilitator with the issuing bank of the Credit Enhancement instrument.
Enabled is Credit Enhancement through relationships that usually have grown over years. You cannot walk into any bank and ask for Credit Enhancement, or even ask for a service on your terms. The issuing bank will have to be “willing” to support a Credit Enhancement transaction and the client will have to understand that there are financial risks involved for the bank and legal issues which will have to be taken care of. Very few private banks support this since they have a reputation at stake and money to lose. You can download the full version of this e-Book!