To offset US sanctions risk, banks bake in China loan clauses

Global lenders seek to hedge against the threat of US sanctions on China – which seems unlikely to ease under Biden

As diplomatic tensions spike between the US and China, global banks in Hong Kong are introducing loan contract clauses to mitigate the risk of sanctions. The language allows a lender to terminate its contract early if a counterparty falls subject to sanctions during the deal’s lifetime.

This same rationale is prompting lenders to re-examine their onboarding processes – to make sure they are appropriately modelling potential linkages between firms.

US sanctions risk in China has been steadily rising for the past couple of years, as trade wars between the two countries have intensified. Few believe that a change of administration is likely to change that. In the run-up to the election, president-elect Joe Biden talked tough on China’s alleged human rights abuses, foreign land grabs and use of illegal detentions. He made clear that penalties against complicit firms and individuals will be used as an active diplomatic weapon under a Democratic regime.

For banks, the risk became more acute this year, as the US started to impose sanctions – for alleged human rights abuses in Hong Kong and the northern province of Xinjiang, and for China’s controversial island-building spree in the South China Sea – on entities and individuals. The possibility of fresh sanctions arose in Hong Kong, after a new law from Beijing barred anyone who supports independence from holding office in the country.

“Some of the sanctions that have come out in the last year have been effective immediately, and so we are a bit concerned as a bank: if we have a three-year term loan, how can we get out of that, so we are compliant with the sanctions?” says one Hong Kong-based chief risk officer (CRO) for a global bank.

“We’ve been looking at [whether we can] embed terms and conditions in clauses that allow us to get out of any term exposure if our customer is sanctioned.”

People are starting to understand that, given the political nature of these sanctions and [their] unpredictability, banks may want to be able to continue their business with these entities if they can

Nicholas Turner, Steptoe & Johnson

“Looking back over the past six months, it has been really quite astonishing to see how many entities and individuals have been targeted by US sanctions,” says the CRO.

“That exposure has come out of nowhere, and dramatically increased in a very short period of time.”

Given the importance of the US dollar funding market, no global bank can risk falling foul of penalties imposed by Washington and potentially losing access to US dollar clearing in New York – leaving them unable to convert client funds held in different currencies to the greenback.

French bank BNP Paribas was shut out of the dollar clearing market for the entire year in 2015 for breaching US sanctions against Sudan, Cuba and Iran, which forced it to clear its US dollar trades through a third party – a penalty few other banks want to experience.

“Since last year, we have been slowing down our onboarding process and, for those clients already on our books, working out which pose greater levels of sanctions risk,” says a second regional CRO from another large global bank.

“In cases where we have identified a clear sanctions risk, we want to provide an orderly exit, to give our client the opportunity to find an alternative counterparty.”

Certainty for all 

Introducing these clauses can provide certainty – for both parties – about how provisions can be unwound, should an agreement suddenly fall out of diplomatic bounds.

“Sanctions clauses have historically been drafted to be very broad. The assumption was: if somebody is being sanctioned, then there is probably a reason for it – and banks would want to exit this position as quickly as possible,” says Nicholas Turner, a lawyer with Steptoe & Johnson, an international law firm that has been helping firms deal with sanctions risk.

“But people are starting to understand that, given the political nature of these sanctions and [their] unpredictability, banks may want to be able to continue their business with these entities if they can, so more flexibility in the lending agreement is needed.”

Turner declines to give a specific example of how a sanctions clause could be reworded, but says that, rather than end the relationship with a sanctioned party altogether, the bank would look at how it could maintain this relationship while still being in line with US sanctions.

The first Hong Kong CRO is also keen to make sure that loan agreements allow for rapid unwinding of positions, should the sanctions imposed be effective immediately.

“It’s all about understanding how fast sanctions can be implemented, and how quickly we are able to react and reduce our exposure when we need to,” he says.

In the past, many sanctions would have had a notice period of 90 or 120 days, which would allow the banks to help customers find alternative arrangements, he says. But in some of the recent sanctions, banks are expected to unwind their positions immediately.

Non-US banks are potentially at a disadvantage, since US regulators may be less willing to grant them a temporary exemption from the sanctions – under what is called a ‘financial sanctions licence’ – than to US domestic banks.

By and large, mainland clients have been very understanding about rewriting sanctions clauses, says the CRO. The difficulties have arisen when negotiating with multinationals sitting outside of China, but with enough interest in China to warrant rewriting the clauses. “They still don’t understand why we need to do this,” he says.

KYC concerns

Given the challenge of renegotiating loans clauses with clients, banks have also been working hard to strengthen their internal KYC – or know-your-customer – systems, so they can locate the largest risks and prioritise those customers for action.

“If you look at things from an industry perspective, there’s more risk sensitivity with the high-tech sector and some of the e-commerce names, so that is more of a focus of ours at the moment than traditional manufacturing companies,” says the second regional CRO. “But who knows in which direction the US will head next?”

“We also look at the concentration of US sales for Chinese companies, as well as their dependency on US technology, both hardware and software,” he adds.

But building up an accurate map of the market is not always easy in a country such as China.

“The reality is that there are large quantities of data available for entities to build up a robust KYC process. However, organisations sometimes run into problems because that information can be challenging to locate,” says Guy Harrison, general manager at Dow Jones Risk & Compliance.

To get a better understanding of who these companies are – and the sanctions risk they pose – global banks are now dedicating more resources to performing the necessary due diligence onshore in China.

“We’re asking a lot more from customers in mainland China about their ownership structures, shareholdings and board members than we would in a normal environment, in order to identify any indirect links to a sanctioned party,” says the first CRO.

“No-one can afford not to have a strategy for China. Whether your board sits in London, New York or Frankfurt, you’ll be doing something in China,” says a managing director from one data vendor in the region.

“Sanctions risk is a price worth paying, but you need to think about how your long-term domestic aspirations and US policy could evolve in different directions.”

 

Editing by Louise Marshall

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