Question ID:
2017_3576
Legal Act:
Regulation (EU) No 575/2013 as amended by Regulation (EU) 2019/876 – CRR2
Topic:
Credit risk
Article:
213
Paragraph:
1
Subparagraph:
(c) (iii)
COM Delegated or Implementing Acts/RTS/ITS/GLs:
Not applicable
Article/Paragraph:
not applicable
Type of submitter:
Credit institution
Subject Matter:
Timely payment requirement for unfunded credit protection provided under credit risk insurance policies
Question:

Does unfunded credit protection - which a bank has purchased in order to hedge a loan exposure and which provides the protection-seller with the contractual right to compensate credit losses according to the original scheduled payment dates of the hedged loan - fulfil the timely payment requirement for unfunded credit protection in a situation where the loan becomes due and payable prior to the original scheduled payment dates?

Background on the question:

Credit risk insurance policies provided by insurance companies may contain so called non-acceleration clauses which grant the protection-seller the contractual right to compensate credit losses according to the original scheduled payment dates of the loan in a situation where the lender (in line with the contractual terms of the loan contract) accelerates the repayment of the loan and the obligor subsequently defaults on such repayment.

In the following, a stylized example (using a zero recovery rate) is used to illustrate the question: A bank grants a loan to a corporate in the amount of EUR 100 million on 1 January 2017 and the corporate has to repay this loan in quarterly instalments of EUR 10 million plus interest each (i.e. the loan will be fully repaid on 30 June 2019). The bank uses unfunded credit protection in the form of a credit risk insurance policy to mitigate the credit risk of the loan. The residual maturity of the insurance policy is at least equal to the residual maturity of the protected loan. For the sake of simplicity (and because this aspect is not relevant for the question at hand) it is assumed in the example that the credit risk insurance policy covers the full loan amount whilst ordinarily in these contracts the lender retains a specified portion of the risk (i.e. the amount of loss the bank will have to bear in an insurance claim before the insurance coverage begins).

Case 1: The credit risk insurance policy covers all types of payments the obligor is expected to make under the loan, i.e. principal and interest payments are covered by the insurance policy. If a bankruptcy proceeding is initiated with respect to the corporate on 15 January 2018 (after four instalments of EUR 10 million plus interest each were paid by the corporate), then the non-acceleration clause in the insurance policy provides the insurer with the right (at its discretion) to either - reimburse the bank for the loss incurred at the point in time of the default, i.e. EUR 60 million (assumption of zero recovery rate), within [30] days after the default has occurred, or to - make use of the non-acceleration clause and to indemnify the bank for the loss incurred, i.e. principal and interest payments, according to the original payment schedule. This means that the bank will receive all principal and interest payments at the same dates and in the same amount it would have received them if the obligor had never defaulted on any payments over the full lifetime of the loan. The non-acceleration clause therefore provides the insurance company with the right to indemnify the bank based on original scheduled loan payment dates and amounts. Article 213 (1) (c) (iii) CRR requires that the protection provider is obliged to pay out in a timely manner in the event that the obligor fails to make any payments due. This is understood as referring to the original payment schedule. Therefore, this credit risk insurance policy fulfils the timely payment requirement since the insurance provider is obliged to compensate the loss under the loan in a timely manner in accordance with the original payment schedule. The bank will receive the respective payments at the same dates and in the same amount it would have received them if the obligor had never defaulted over the full lifetime of the loan. With regards to Article 215 (1) (a) CRR, the bank therefore has the right to pursue, in a timely manner, the insurance provider for any monies due in accordance with the original payment schedule.

Case 2: The credit risk insurance policy covers only the principal payments If a bankruptcy proceeding is initiated with respect to the corporate on 15 January 2018 (after four instalments of 10 million plus interest each were paid by the corporate), then the non-acceleration clause in the insurance policy provides the insurer with the right (at its discretion) to either - reimburse the bank for the loss incurred at the point in time of the default, i.e. EUR 60 million (assumption of zero recovery rate), within [30] days after the default has occurred, or to - make use of the non-acceleration clause and to indemnify the bank for the loss on the principal amount incurred according to the original payment schedule. This means that the bank will receive all principal payments at the same dates and in the same amount it would have received them if the obligor had never defaulted. As far as the principal payments are concerned, we refer to the arguments provided for Case 1 above: The requirement in Article 213 (1) (c) (iii) CRR to pay out in a timely manner in the event the obligor fails to make any payments due is understood as referring to the original payment schedule. Therefore, this insurance policy fulfils the timely payment requirement.

As far as the interest payments are concerned, the non-coverage of interest payments does not impact the eligibility of the guarantee as unfunded credit protection as such. This follows from Article 215 (1) (c) (ii) CRR: Where certain types of payments are excluded from the insurance policy, the bank must adjust the value of the guarantee to reflect the limited coverage. This is fulfilled since only the principal amount is deemed to be ‘protected’ whereas the accrued interest shown on the balance sheet prior to a default is treated as ‘unprotected’, i.e. the risk weight of the obligor is applied.

Date of submission:
27/10/2017
Published as Final Q&A:
26/07/2019
EBA Answer:

A contractual right of a guarantor to compensate credit losses according to the original scheduled payment dates of the guaranteed exposure, rather than immediately compensating the full outstanding amount, does not hamper the fulfilment of the eligibility requirements for guarantees.

Article 213(1)(c)(iii) of  Regulation (EU) No 575/2013 (CRR) requires that the guarantor is obliged to pay out in a timely manner in the event that the obligor fails to make any payments due, but not that amounts not yet due under the claim in respect of which the protection is provided are paid out in advance. The same applies for Article 215(1)(a) CRR which only requires the right to pursue the guarantor for any monies due under the claim in respect of which the protection is provided. 

This is irrespective of whether the institution’s contract with the obligor contains a clause under which the loan becomes due and payable prior to the original scheduled payment dates (e.g. a close out netting agreement) where this acceleration is not covered by the guarantee, because such accelerated claim is not the claim in respect of which the protection is provided.

On the eligibility of credit insurance as unfunded credit protection, see Q&A 768.

Status:
Final Q&A