The Existing Infrastructure is Under Stress: How Coronavirus is Impacting Financial Services’ Future.
In our previous article focusing on the global supply chain, we touched upon how the coronavirus pandemic has impacted the available liquidity within global financial services, with policymakers acting in unison by taking actions beyond monetary policy to cushion supply chain disruption and keep illiquid firms solvent. Put simply, governments are playing their part by injecting liquidity at the top level. This will trickle down but it takes time, and the efficiency of this process is dependent on good, solid trades happening at the foundation level. We expect the financing of stock at destination, diversification of products supply channels, and the borrowing base type structures to become the heroes of this turbulent time.
A Tsunami of Borrowing
At present, the environment for lenders is unprecedented, with businesses drawing on every available USD, Euro or any other currency permitted by pre-Covid-19 agreed loan terms, rather like those who we’ve seen rush to the supermarket to buy far more pasta and toilet roll than they normally would. Companies become less discerning about the type of loans they draw down upon as their priority becomes immediate access to cash, meaning that loans that are normally more expensive because they are unsecured and thus are undrawn or partially drawn, are now drawn down in addition to secured loans. For example, just last week McDonalds Corp drew down on a $1 billion loan at a higher cost than an alternative untapped line. When one considers the impact this has on those at the other end of the supply chain, it is not obviously sensible. If smallholder producers cannot fund their business, the whole supply chain collapses and McDonalds can’t get the potatoes they need to make their chips!
Conversely, the disrupted transport infrastructure is showing signs of a clogged up storage system, generating unprecedented demand for financing stocks at origin, thus a tsunami of secured financing which the banks would normally chase. If we look to Brazil, we can see this happening in real time. Following the collapse in oil price and the huge drop in car usage, Brazilian Sugar Mills will prefer to produce sugar over ethanol, much of which will be exported. This comes at a time of bumper exports for soya and corn, meaning that supply chain infrastructure will be put under immense pressure. We are already concerned that demand for vessel loading at the port of Santos will exceed maximum capacity from July to October this year. Commodities will therefore need to be in storage longer and thus require financing to control cashflow: a situation that is normally perfect for banks as it leads to secured financing. However, secured finance is usually defined as goods secured in a third party warehouse, and there is no guarantee that these will be available when companies need them and for the period required. An alternative is to leave the crop in the field longer and process more slowly. However, this is bad for cashflow and can often come with weather risks resulting in the possibility of crops remaining unharvested.
What Does this Mean for Funding?
In light of overflowing stocks and governments stimulus, anyone operating within the commodities space is puzzled by just how little interest, or indeed base rate reductions, has filtered down to the borrower so far.
The answer is simple. Banks assess lending risk on the basis of a multitude of complex factors, at the heart of which are three principal questions – am I going to get my money back, how, and when?
In basic terms, the entire investment banking infrastructure, certainly within the space of natural resources finance, is centred around a repayment schedule driven by the timely movement of goods, from farmer to manufacturer to the grocery store, with money transactions which repay a loan moving in the opposite direction to goods (i.e. physical delivery vs sales). However, when shipments are delayed or postponed due to port closures, and component parts are not delivered into a factory on time, this has a knock-on effect on all concerned and ultimately the repayment schedule.
Meanwhile, at times of financial markets’ disruption, banks’ credit committees become less receptive to fundamentals of the transactional cycle which might slow down, more stringent in their controls, and infinitely more sensitive to collateral valuation and the security issues, including perfection AND enforceabilty. All this comes at a time of remote working, with physical documents arriving to empty offices, having to be re-routed, getting lost, delayed, and the front-line teams struggling to satisfy the long-outdated requirements for physical signatures with authorised signatories self-isolating on different continents, never mind in different countries.
The above is only a view from the outside looking in. The stormy weather caused by Covid-19 is made worse by the internal factors impacting the banks due to:
- multiple sectors suffering at the same time, for example tourism, hospitality and entertainment;
- increased regulatory capital due to credit migration from collateralised asset-backed lending to unsecured RCFs (Revolving Credit Facilities, or facilities that repeat);
- clients looking to access additional capital to help them get through the downturns, for example assistance with flexibility in getting locked stock from port to end-user, or longer terms to allow for slowed down transportation channels, as discussed above.
The Need for Liquidity but Computer says “Wait”
As the virus went global in a matter of weeks, a majority of publicly listed companies on the exchange saw their stock values go down. On March 12th, the FTSE 100 dropped 9.3% and had the worst day since ‘Black Monday’ in 1987. This volatile environment led to record sell out on stocks and shares, and the buybacks that followed the coronavirus “globalisation” have posed a major risk to the banking community in terms of changing ownership of publicly listed borrowers. A combination of record profit margins, strong cash flows, strengthened balance sheets and the low cost of debt over the last few years has created an opportunity to change the ownership landscape for large industrials and private investors alike, capitalising on the recent drop in equity and stock prices. This saw those in search of further capital sell their stocks while others bought it at now lower prices, changing the ownership landscape and causing another unwelcome distraction for the finance community, as they are required to satisfy the ever increasing scrutiny around corporate governance, KYC (Know Your Customer Questionnaire requirements) and Compliance requirements which demand the banking community to track ultimate ownership of their borrowers at all times.
All the above is also true for insurance companies.
Last but not least, it’s important to remember that banks and insurance companies are all remunerated on the basis of the absolute value of the trades, not physical volume. Given the falling price of most commodities coupled with low interest rates, incomes will fall while risks will rise, which comes on top of the current credit events in Asia.
Attempts to Fix the Problem
Consequently, there has been talk of repricing however this exercise alone is unlikely to be the driver in better managing the risk. What it really means is that banks will strengthen their front and credit teams, who will be more discriminating in the type of deals they work on, with the latter likely to become bigger in value with potential for scalability, more structured, and more transparent for Due Diligence checks. Therefore, the size of transactions will need to be bigger and scalable, so that whatever you put in place has the opportunity to grow. These are all work-intensive, requiring larger teams to implement them and thus becoming more expensive for both the bank and the borrower.
The current environment will change the way we all operate, introducing agility and digitalisation in operational processes across all industries. Employees will become more adept at working from home and communicating in new ways to ensure efficiency. However, when it comes to the regulated world of banks and insurance companies, any change takes time.
While this creates an opportunity for alternative lenders to step up as they are able to act with more flexibility than banks, and may be able to fund collateral that sits outside of the traditional third party warehoused definition, the funds’ community have their own fires to fight in the short-mid-term.
Funds Fighting Their Own Fires
Funds are not too dissimilar to banks in terms of their assessment of risk, except their stakeholders are faster to react. With redemption terms ranging from months to years, an investment decision in selecting an asset class would normally be taken with a term in mind. On a positive side, one would expect that a term view would be less sensitive to immediate market volatility, as immediate volatility would be expected to settle over longer periods of time. However, in the wake of Covid-19 introducing complete uncertainty beyond the medium term, what are the chances of a “term” to “term out” if an opportunity to exit presents itself? On the investor side, it can be tough to overcome basic human nature when the headlines are screaming concern. Private and institutional investors want to better understand asset selection methodology, rating rationales, documentation flows, and repayment track records: quite simply, the physical location of goods within the supply chain and who holds the title. This means due diligence visits, investigative questionnaires, reporting on operational processes and procedures, cashflow forecasts, derivatives’ positions etc. All these arrive in an environment of disbursed teams, crashing home WiFi’s, and inability to travel across international borders, placing further stress on the entire finance system.
All in all, it is clear that the normal finance community infrastructure is under stress. Return on capital becomes less important than staying operational and avoiding large, unpayable debt.
Using the example we’ve given in our previous article of the NHS trying to first take care of the sick while the healthy are asked to stay at home, the entire finance community is currently working on making sure existing borrowers continue to have access to funding and in case of delayed repayment, are not subject to a default because the latter will have a knock-on effect on reduced returns for funds, provisions for banks, and diminishing liquidity for borrowers. However, we are seeing some examples of banks adapting their funding terms to specifically address the pandemic. The Asian Development Bank, for example, are pivoting their activity towards short-term solutions and support, prioritising emergency funding for medical equipment. Could we see banks become more flexible as a result of this crisis?
In conclusion, it is our expectation that post-crisis, the finance community will favour larger transactions in absolute terms, which in agricultural commodities, food, ingredients and packaging, means multiple product types stored in multiple jurisdictions, congregating in a storage location from various transit channels. Such a structure can be created under a single umbrella syndicated facility, therefore giving the banks scale while at the same time ensuring diversification of sources of supply and products for end-buyers. Storage in one secure location, in a foreign investor-friendly jurisdiction, will help banks with security and due diligence checks. Proximity to consumer location would help producers with flexible “just in time delivery” options. As a win-win for all concerned, the industry is well prepared for these changes. Commodities is a cyclical business and the TCF (Trade Commodity Finance) will come out of it, as it did before. Traditional commodity finance banks will go through re-assessment of internal process, recalibrate, and infrastructure will become stable once more, as structured self-liquidating deals built around the movement of physical goods demonstrated before with their resilience through more than one set of financial crises.
As supply chain managers, it is of paramount importance that the industry is prepared. The IT platforms must be capable of reporting stock of accumulated component ingredients getting ready for shipment, managing the voyage, accounting for every tonne of material discharged at destination, stored in close proximity to clients, and released with a corresponding invoice. We do this in every corner of the world, supporting our multi-national and regional clients in diversifying their sourcing channels as well as their product offering. Post Covid-19, we expect banking to go back to basics in supporting storage and transit done in a responsible and transparent way, and we are well prepared for it.
Author: Tanya Epshteyn
Images: Floriane Vita, Ilyuza Mingazova, Marcin Jozwiak, Denys Nevozhai