Cross-guarantee
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If you are struggling with a triangular set-off scenario you might consider having the affiliated entities provide cross-guarantees of each others’ obligations to buttress the set-off analysis. Well, you should: it is the only way a triangular set-off can be made to work. But they have their own problems.
A cross guarantee works as between a customer and two or more affiliated entities—usually two, but it could in theory be more—by having each involved group entity guarantee the obligations of each other involved group entity, thereby effectively creating a direct claim against each group entity guarantor of the liabilities of each other group entity. This transforms what would have been an ineffective “triangular set-off” situation into a bilateral one, where as we know set-off and netting works perfectly well.
There are some considerations:
- Guarantee strength: The guarantee is only as good as the guarantor’s creditworthiness — or the extent to which it actually owes you money, and a set-off can be implemented. But in a cross-guarantee/triangular set off all you are trying to do is implement multiparty netting, and obviously there is none to do if none of the entities owe you any money.
- Corporate authority: Not all entities within a group may have the corporate authority to issue cross guarantees.
- Regulatory capital: Cross-guarantees can affect how regulators view capital requirements and exposures within a group. They may require additional capital to be held against guaranteed exposures. Also bear in mind that banking conglomerates set up multiple affiliates for important reasons, usually to do with optimising tax and regulatgory capital by segregating trading books and liabilities. To the extent cross-guarantees undermine that segregation, don’t expect banks to be keen on them.
- Guarantees are weird and scary things: Being creatures of contractual magic guarantees are intimidating and can go formally wrong, so lawyers are natually a bit phobic about them.
- Upstream/downstream issues: Guarantees from subsidiaries to parent companies (upstream) often face more legal scrutiny than parent-to-subsidiary guarantees (downstream), due to corporate benefit concerns.