Financial firms should act to safeguard against supplier financial challenges

Apart from the challenges of an uncertain economic climate, one factor behind the increase is the rise of collaboration between newer fintech companies and more established players, often on essential areas of business.

While these newer companies can be innovative and appealing, they also pose a risk of running into financial trouble and even collapse. The risk this poses to the institution is much higher when those fintech companies are responsible for crucial services for the business.

Financial troubles are not limited to fintechs and there are well-known cases of mature suppliers in the financial services sector also facing financial difficulties and collapse. All firms who outsource essential services should review their contracts to ensure they are protected should a supplier fall into financial difficulty, or at least reduce the risk.

Pre-contract due diligence

Before signing a contract, financial services institutions will naturally be doing due diligence on a potential supplier. This is not only a good business practice, but also a regulatory obligation. Part of that due diligence will concern financial strength.

When considering new businesses, one difficulty for financial services institutions can be the scarcity of financial data available to base a judgement on, or the absence of general experience. However, there are ways institutions might be able to ease any concerns.

One example would be for the fintech to procure a letter of credit from its bank, which could give some comfort. If these are even available from the bank, this can be an expensive exercise for the fintech, which they might find off-putting. There is also the prospect of a parent company guarantee, but this will depend on the corporate structure of the fintech. If it is private equity-backed then it is unlikely that the parent company will grant a guarantee and, if it does grant a guarantee, it may be limited in terms of scope or level of liability.

Some very successful businesses also frequently fall short of financial rating criteria. This could be because of performance or other factors like internal dividend policy transferring profit from the entity to a parent. It might be possible to reduce the perceived risk by asking for a guarantee from the parent company, but it's important to do some research on the parent company as well.

Provisions in the contract

There are many actions that financial services institutions can take at the contracting stage which will enable them to detect and deal with future financial distress. Financial services institutions and their regulators need to consider whether they will have the ability to detect problems early, and whether they will have the ability to reduce risks and enforce remedies in case of a financial distress event.

Detecting problems early

The ability to get early warning of financial distress is important, especially given the regulatory focus on operational resilience and ensuring ongoing service to customers.

We can define financial distress in the contract as including a fall in financial ratings such as Dun & Bradstreet or S&P Global. There may also be other triggers that customers will seek to include, such as a major litigation arising for the service provider or a public investigation into fraud or other financial impropriety.

Suppliers will be keen to ensure that the defined financial distress events are sufficiently material and preferably linked to service delivery, to avoid them becoming ‘hair triggers’.

Step-in rights versus more oversight rights

The customer may not want to pull the plug on a service which is in financial trouble, even if it has the right to do so. It might prefer to have choices that allow it to keep the service going, either to get out of the arrangement smoothly or to help bounce back. That's why financial distress events can also be a trigger for step-in, allowing the customer to take over control of the provision of services from the supplier.

Customers who are unable or unwilling to exercise step-in rights may ask for more oversight rights if the supplier faces financial difficulties. More oversight can be agreed on an individual basis, but examples of the kind of provisions include more frequent reports from the supplier and the right for the customer to join internal supplier meetings.

Financial sector customers face a dilemma. They would prefer to act before their suppliers run into financial trouble, but they don't want to trigger a crisis by acting too soon. They need to find a way to balance their own interests with the supplier's need for stability.

Other contractual provisions

Apart from the more severe contractual actions of increased supervision and intervention, ordinary contractual terms can be useful in alerting customers to financial trouble. Services contracts will contain duties on the supplier to provide management information. This will include reporting on topics such as service quality but could also cover provisions about the supplier’s financial situation.

Governance is another important contractual provision. For both business and regulatory purposes, financial institutions need to monitor the services that third parties offer. Governance meetings allow this to happen, including asking about situations that may indicate or threaten a financial distress event.

As well as governance and management information provisions, services contracts will include "early warning" obligations requiring service provides to advise the financial institution if a development arises which could have a material adverse impact on the services. This aligns with regulatory requirements under Prudential Regulation Authority Supervisory Statement  2/21 and the European Banking Authority’s guidelines on outsourcing arrangements. While notification is useful, the main thing is what financial institutions can do to solve the problem.

Exit plans

Sometimes things don't work out and cutting ties with the supplier is the only option. FS institutions need to be ready for this scenario and have an exit plan in place to smooth the transition from one supplier to another, or to bring the service back in-house. This is a key regulatory and business priority. It is important to have an exit plan that is frequently updated and contractual duties that cover supplier collaboration in an exit situation.

Another issue is how to access software when the supplier fails. Usually this is done through escrow arrangements that allow access to source code if certain distress situations happen. It is important for the customer to verify that what is put in escrow – that is, held separately – is going to help them if the supplier fails and that the customer can access any related software needed to make the overall solution work.

With an unpredictable economy and increasing engagement with early stage fintechs, financial institutions need to think about how to deal with the risk of financial distress in their services contracts. Through pre-contract due diligence and contractual provisions, financial institutions can mitigate risk and protect ongoing delivery of services to their customers.