Unfunded risk participations in trade finance: guarantee or credit derivative

Many DFIs support trade in emerging markets by taking unfunded risk participations: under a master risk participation agreement, the DFI agrees to reimburse a confirming or financing bank for a share of its loss if an issuing bank or importer in a frontier market fails to pay letters of credit, trade loans or supplier-finance payables. No cash is advanced, but the DFI carries real credit risk and earns a fee. The accounting depends on the exact trigger: if the DFI pays only to reimburse the bank's actual loss when a specified debtor fails to pay when due, the contract is a financial guarantee contract measured at the higher of the ECL allowance and the unamortised fee; if it pays on a broader credit event, or without the bank having to hold the exposure and suffer a loss, it is a credit derivative at fair value through profit or loss. The two models produce different profit patterns and different capital and disclosure outcomes.

Does the DFI's obligation arise only when a specified debtor (the issuing bank, importer or buyer) fails to make a payment when due under the terms of the underlying trade instrument? Must the protected bank hold the underlying exposure and suffer a loss, and is the DFI's payment limited to that loss? Or can payment be triggered by events such as a rating downgrade, a restructuring of the debtor's other obligations, a sovereign moratorium or transfer and convertibility events, regardless of the bank's actual loss? Is the fee received upfront, periodically or deducted from recoveries? Are risk participations entered under a master agreement with individual transaction confirmations, and which is the unit of account? Has the DFI previously asserted that such contracts are insurance contracts?

1. Read the participation terms against the IFRS 9 definition of a financial guarantee contract: a contract requiring the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due under the original or modified terms of a debt instrument.
2. If the definition is met, recognise a financial guarantee liability when the DFI becomes party to each participation (usually on confirmation of each transaction under the master agreement), initially at fair value, which for an arm's-length participation is normally the fee received or receivable.
3. If the definition is not met (payment on a credit event without a requirement for the holder's loss, or protection that the holder can sell on independently), recognise the contract as a credit derivative at fair value through profit or loss.
4. For financial guarantees, measure subsequently at the higher of the ECL allowance and the amount initially recognised less cumulative income recognised on the IFRS 15 pattern.
5. Recognise the fee in profit or loss over the guarantee period.
6. On a call, recognise the payment against the liability and recognise any right of recovery against the defaulted debtor as a financial asset, measured under IFRS 9.

For a financial guarantee, ECL is the expected payments to reimburse the protected bank for credit losses, less amounts the DFI expects to recover, over the remaining life of each trade instrument (often 90 to 360 days), using the issuing bank's or obligor's probability of default, the DFI's share of the exposure and the expected loss given default, including sovereign transfer risk where relevant. The liability is carried at the higher of that ECL and the unamortised fee. For a credit derivative, fair value reflects the market price of protection on the reference obligor (or a proxy curve), discounted, with changes in profit or loss and no separate ECL.

Disclose: (1) the nature of the risk participation programme and the accounting classification applied; (2) the maximum exposure to credit risk, being the maximum amount the DFI could have to pay; (3) the carrying amount of financial guarantee liabilities and the related ECL, with a reconciliation and staging; (4) concentrations of exposure by country, issuing bank and sector; (5) for credit derivatives, notional amounts, fair values and the hierarchy level; (6) fee income from risk participations; (7) amounts paid under calls and recoveries.

• Treating unfunded participations as memo items with fee income recognised when received
• classifying every risk participation as a financial guarantee without reading the payment trigger
• applying IAS 37 instead of IFRS 9
• recognising the full fee upfront rather than over the guarantee period
• measuring ECL on the DFI's whole programme limit rather than on outstanding confirmed transactions
• ignoring sovereign transfer and convertibility risk in the issuing bank's probability of default
• confusing a funded participation (a loan asset of the DFI) with an unfunded one