A confirmation is insurance on the issuing bank and its country. Price it like insurance: the fee against the expected loss it takes off your books.
A confirmation is worth its fee when the fee is smaller than the expected loss it removes: the issuing bank's and country's default probability over the exposure period, times the loss if they default, times the amount. On an illustrative 2,500,000 credit exposed for 182 days, a 1.20 per cent a year confirmation costs 15,167 and removes 11,219 of expected loss, so it pays only if the annual default probability is above 2.03 per cent.
Worked in full in Trade Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An exporter ships 2,500,000 of equipment under an irrevocable documentary credit with 90 days' usance. The credit is advised and confirmed at issuance, so the confirming bank carries the risk through production, shipment, presentation and the usance period. The default probability and loss severity below are the exporter's own judgement of the issuing bank and its country; they are illustrative, not ratings.
| Input | Value |
|---|---|
| Credit amount | 2,500,000 |
| Production, days | 60 |
| Transit, days | 25 |
| Presentation and examination, days | 7 |
| Usance, days | 90 |
| Exposure period, days | 182 |
| Confirmation fee, per year, actual/360 | 1.20% |
| Minimum fee | 1,500 |
| Annual default probability, issuing bank and country | 1.50% |
| Loss given default | 60% |
Two numbers have to be put on the same footing: what the confirmation costs over the exposure, and what it saves over the same exposure. Measuring the fee over 182 days and the risk over a year is the most common way to get the answer wrong.
Fee = MAX(amount × rate × days / 360, minimum) = 2,500,000 × 1.20% × 182 / 360 = 15,167
Default probability over the period = 1.50% × 182 / 365 = 0.75%
Expected loss removed = amount × period probability × LGD = 2,500,000 × 0.748% × 60% = 11,219
Break-even annual probability = fee / (amount × LGD × days / 365) = 2.03%
Excel: =MAX(Amt*Rate*Days/360,MinFee)/(Amt*LGD*Days/365)
The fee is 1.35 times the loss it removes. At the exporter's own assessment, confirmation costs 3,947 more than it is actuarially worth, which is the price of certainty rather than a saving. Against a 7.0 per cent operating margin of 175,000 on the order, the fee is 8.7 per cent of the margin and the expected loss 6.4 per cent.
Confirmation is a bet that the issuing bank and its country are riskier than 2.03 per cent a year. The table shows where the line falls.
| Annual probability | Over 182 days | Expected loss removed | Fee | Net value of confirmation |
|---|---|---|---|---|
| 0.50% | 0.25% | 3,740 | 15,167 | −11,427 |
| 1.00% | 0.50% | 7,479 | 15,167 | −7,687 |
| 1.50% | 0.75% | 11,219 | 15,167 | −3,947 |
| 2.03% | 1.01% | 15,167 | 15,167 | 0 |
| 3.00% | 1.50% | 22,438 | 15,167 | 7,272 |
| 5.00% | 2.49% | 37,397 | 15,167 | 22,231 |
Against a strong issuer in a stable country the confirmation is expensive insurance. Against a weak bank, or a country where the bank may pay but the central bank may not release the currency, the same fee is cheap. The confirming bank's quote already contains its own view of that probability; the break-even tells you whether you agree with it.
Minimum fees change the answer on small credits. At 1.20 per cent over 182 days the 1,500 minimum bites on any credit below 247,253, and below that the effective rate climbs.
| Credit amount | Fee at the rate | Fee charged | Effective rate a year | Break-even annual probability |
|---|---|---|---|---|
| 2,500,000 | 15,167 | 15,167 | 1.20% | 2.03% |
| 250,000 | 1,517 | 1,517 | 1.20% | 2.03% |
| 150,000 | 910 | 1,500 | 1.98% | 3.34% |
| 100,000 | 607 | 1,500 | 2.97% | 5.01% |
| 50,000 | 303 | 1,500 | 5.93% | 10.03% |
On a 50,000 credit the issuer would have to be expected to fail at more than 10.03 per cent a year before confirmation paid. Small orders to sound banks are usually better left unconfirmed, or covered by credit insurance on a portfolio basis.
The mistake is to treat a confirmed credit as risk-free. Confirmation removes the issuing bank and the country; it does not remove the documents. The confirming bank pays only against a complying presentation, and a refused presentation that the applicant declines to waive leaves the exporter holding goods in a foreign port. Suppose there is a 3.0 per cent chance of that outcome and it costs 20 per cent of the value in demurrage, discounting and resale: the expected loss is 15,000, 1.34 times the 11,219 the confirmation removes. The cheapest risk reduction on many credits is a clean set of documents, not a second bank's signature.
Confirmation is often bought for a second reason: a confirmed usance credit can be discounted without recourse at the confirming bank. That is a financing decision with its own price, and the rate quoted on a discount is not its cost, as a 6.90 per cent discount against an 8.40 per cent facility shows.
The fee schedule with its minimums, the three forms of credit and the document risk are worked in the free workbook for this case, where the confirmation break-even is solved on the book's own order.
Usually as a rate a year on the credit amount for the period the confirming bank is exposed, from confirmation to payment, subject to a minimum. At 1.20 per cent a year over 182 days on 2,500,000, the fee is 15,167 on an actual/360 basis. Below about 247,253 the 1,500 minimum takes over and the effective rate rises.
No. The confirming bank pays only against a complying presentation. If the documents are refused and the applicant will not waive, the confirmation does nothing. In this case a 3.0 per cent chance of an unwaived refusal costing 20 per cent of the value is 15,000 of expected loss, larger than the 11,219 of bank and country risk the confirmation removes.
When the annual default probability of the issuing bank and its country, combined, is above the fee divided by the amount, the loss given default and the fraction of a year the credit is exposed. Here that is 2.03 per cent a year. A strong issuer in a stable country sits well below it; a weak issuer or a country with transfer risk can sit well above, where the same fee is cheap.
Confirmation is solved as a break-even, rather than argued, in the workbook for Chapters 6, 7 and 8 of Trade Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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