Unconditional Support?

Unconditional Support

This post is being written in order to provide a reference and explanation on Unconditional Support that may be required for future posts.   On its own it may be of interest to the Financial Community and particularly those involved in approving Credit Risk to Government Owned Arm’s Length Bodies (ALB).

I once worked for a company in South Africa that manufactured closures (bottle tops) for the bottling industry.   I recall one day the MD running into my office in a panic and telling me not to process any more orders for Pepsi as they were going bust.   Pepsi as you know is a huge global company and I couldn’t believe that they could go bust so quickly without reading about them being in financial difficulties in the press first.    This wasn’t global Pepsi though this was Pepsi South Africa Ltd which if memory serves me right was a privately owned franchise of Pepsi in South Africa.  Pepsi Inc didn’t own the South African company and they refused to provide the necessary financial support to prevent the local franchise from going bust – which it did.

Credit Risk

When financial institutions lend to their counterparties the first step is to assess the credit risk of that counterparty.  That is the risk that that counterparty will default on repayments.  Every counterparty is assigned a risk rating based on many factors including of course the rating the counterparty is considered to have by the three leading credit risk rating agencies, Moody’s, Standard and Poors and Fitch.   On a scale of one to ten, where ten is the least risk, then a counterparty with a ten rating can expect to be granted facilities of a larger amount and at a lower interest rate than the others because the risk of the counterparty defaulting on its obligations to the lender is extremely low.

Each of the three rating companies above tend to specialize in particular fields and Fitch ratings are generally accepted to be the specialists for Governments and their publicly owned entities known as Sovereign Ratings.   The following shows the tablature for the ratings that each of the companies use:

As you can see, for Fitch, the least risk is classed as AAA and at the moment only 11 countries in the world have such a high rating.  Sadly the UK is not included in those 11 and sits at the very bottom of the High Grade risk at AA-.  However banks will still be happy to lend to the UK and purchase their bonds because not only is it high grade but it will attract higher interest rates because it has been downgraded substantially from AAA.  Generally speaking, the risk rating of the ultimate parent of the counterparty is the overriding factor taken into account when deciding how much and at what interest rate the financial institution will lend to the counterparty in question.  There are of course many exceptions to this but in a global economy it would be almost financial suicide for a parent company not to provide financial guarantees to any borrowing undertaken by one of its subsidiaries.  For the most part these guarantees are sought and provided in legally binding documentation before the lending is approved.  This is known as guaranteed support.

Unconditional Support

There are however instances, particularly with Government owned entities, where legally binding documented guarantees are not sought by the financial institution.   This is because it is accepted and understood that the Government in question would not under any circumstances allow their wholly owned entity to fail, such as Post Office Ltd.   If Post Office Ltd were to approach a bank for a loan they would most likely be offered a significant discount on the interest rate payable and a hefty increase in the amount they could borrow based on their ownership by the Government.  Nowhere of course would there be any documentation saying that the Government would not allow POL to fail but you can just imagine the public outcry if it were to do so and POL went under.

Conditional Support

Well the UK Government it seems, has withdrawn unconditional support for POL.   They have ALLEGEDLY refused to provide them with the necessary funds to pay off the settlement and legal fees to the claimants and I can only presume they will extend this to the future compensation payments coming up from the overturned convictions as well as the ever growing Historical Shortfall Scheme.   This move is extremely significant because in the first instance, POL can no longer rely on any FI providing discount in lending terms to them based on Government ownership.  Given POL’s accounts, historical losses and future prospects on the High St, and having worked in Credit Risk myself I would say POL ‘should’ be classed as Speculative risk.  I say ‘should’ because of course I am not naive enough not to consider a quick unofficial phone call from a senior civil servant to the banks’ CEOs could swing things in POL’s favour.

Secondly though, quick words in ears do not and cannot carry favour with ratings agencies.  If that were ever found out not to be the case then that agency would lose its credibility overnight.   So should Fitch for instance ever be asked to provide a Risk Rating for POL in the future then they will need to take into account the publicly stated withdrawn support for POL from the UK Government and that wouldn’t look good for other UK Government owned entities.

Finally I would draw readers attention to the statement by POL’s legal team to the GLO Court and Justice Fraser that an unfavourable outcome (that being the payment of a large settlement and legal fees) would result in an existential risk to Post Office Ltd.  In their own words it can be inferred that the Government had told them they, the government, were prepared to let POL go under.   A very significant withdrawal of unconditional support!

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