Cross-Border Lending

FINANCE AND BANKING / by Miguel Gallardo Guerra

Cross-border lending refers to the provision of loans or financing by financial institutions in one country to borrowers in another country. These financial operations involve several legal, regulatory, and operational challenges, as international transaction laws vary from jurisdiction to jurisdiction. Careful legal planning, proper financing structuring, and compliance with local and international regulations are essential for successful cross-border lending.

a) Risks Associated with Cross-Border Lending

One of the most complex aspects of cross-border lending is the management of the risks inherent in these transactions. Major risks include:

1. Exchange rate risk: When loans are granted in a currency other than that of the borrower’s country, exchange rate fluctuations are risky. This may affect the borrower’s ability to repay the loan if its local currency depreciates significantly against the currency of the loan.
2. Regulatory risk: Laws and regulations governing loans may vary from country to country, and financial institutions must comply with the regulations of both the lender’s and borrower’s country. This includes complying with interest rate laws, capital requirements, and banking regulations.
3. Country risk: Country risk refers to the possibility that political, economic, or social factors in the borrower’s country will affect its ability to repay the loan. This may include changes in government policy, economic instability, or financial crises. It is also worth mentioning that some conflict or social instability situations may make market access and borrower companies’ operations even more difficult.
4. Compliance risk: In cross-border transactions, financial institutions must comply with local and international regulations, such as anti-money laundering (AML) and counter-terrorist financing (CFT) laws. They must also ensure that transactions do not involve persons or entities sanctioned by international organizations.

b) Cross-Border Lending Structuring

The legal and financial structure of cross-border lending is critical to mitigate the aforementioned risks and ensure the operation’s success. Some of the key elements to consider in structuring these loans include:

1. Currency of the Loan: The parties must decide which currency the lending will be granted. If the borrower generates income in a currency other than the currency of the loan, the borrower may be exposed to foreign exchange risk. In these cases, the parties may use financial derivatives such as currency swaps or forward agreements to mitigate this risk. Agreeing on contractual clauses that allow the loan terms to be adjusted according to currency fluctuations may also be possible.
2. International Guarantees: Cross-border lending is usually backed by guarantees that provide security for the lender in the event of default. Collateral may include assets in the borrower’s country, such as real estate, machinery, or shares. However, enforcing these guarantees in a foreign jurisdiction can be complicated, so it is essential that the guarantees are structured in accordance with local laws and that the lender has legal access to these assets in the event of default.
   1. Cross-guarantees: In some cases, the guarantees offered by the borrower may be located in different countries. In these situations, the lender must ensure the collateral is properly registered and enforceable in all relevant jurisdictions.

1. Risk Adjustment Clauses: Cross-border lending agreements often include risk adjustment clauses that allow the loan terms to be adjusted if key factors change, such as interest rates, exchange rates, or the regulatory environment in the borrower’s country.
2. Reporting and Audit Requirements: In many international transactions, especially those involving substantial amounts of money, financial institutions may require the borrower to provide regular financial reports and submit to external audits to ensure that its financial situation does not deteriorate during the life of the loan.

c) Regulatory Compliance in Cross-Border Lending

Regulatory compliance is one of the most critical aspects of any cross-border lending transaction. The lender and the borrower must comply with local and international financial transaction regulations. Some of the most critical regulatory aspects include:

1. Banking License Requirements: In many countries, foreign financial institutions extending lending to local borrowers must obtain a banking license or regulatory permit to operate in that market. For example, in some countries, local laws may require foreign institutions to establish a local branch or subsidiary to legally lend money.
2. AML/CFT Regulations: Financial institutions must comply with strict anti-money laundering (AML) and counter-terrorist financing (CFT) regulations in cross-border lending. This involves conducting a detailed analysis of the borrower to ensure that he or she is not involved in illegal activities and that the loan will not be used for illegal purposes.
3. Customer Protection Regulations: In some countries, individual borrowers or small businesses may be protected by customer protection laws that limit interest rates or impose restrictions on loan terms. Lenders must know and comply with these local regulations to avoid legal or reputational sanctions.
4. International Sanctions and Embargos: Financial institutions must ensure that the borrower and any parties related to the transaction are not subject to international sanctions or embargos. This includes reviewing lists of sanctions issued by agencies such as OFAC (Office of Foreign Assets Control) in the United States or the European Union, which prohibit transactions with certain countries, persons, or entities.

d) Execution of International Agreements

The enforcement of cross-border lending agreements in the event of default is a crucial aspect for lenders to consider. If the borrower defaults on the loan, the lender must go to court to enforce the agreement and foreclose on the collateral. However, agreement enforcement laws may vary considerably among jurisdictions. Some important aspects include:

1. Jurisdiction and Applicable Law: Cross-border lending agreements must clearly specify the competent jurisdiction and law governing them. This is crucial to avoid disputes over which court has the authority to resolve any disputes arising in the transaction. In turn, a clear choice of applicable law may influence the interpretation of the terms of the agreement, which could provide greater legal certainty to both parties.
2. International Arbitration Agreements: Parties to cross-border lending often include international arbitration clauses instead of resorting to local courts. International arbitration, through institutions such as the International Court of Arbitration of the International Chamber of Commerce (ICC), allows for faster and more efficient dispute resolution, especially in cross-border transactions.
3. Recognition and Enforcement of Judgments: Even if a foreign court issues a judgment in favor of the lender, it is not always easy to enforce that judgment in the borrower’s country. Therefore, lenders must verify whether there is a mutual recognition of judgments agreement between the borrower’s country and the lender’s country, which will facilitate the enforcement of court decisions.

e) Current Trends in Cross-Border Lending

Several trends in the cross-border lending market are transforming the way these transactions are structured and executed:

1. Infrastructure Project Finance: In recent years, cross-border lending has significantly increased to finance large infrastructure projects, particularly in emerging markets. These transactions often involve multiple parties, including international financial institutions, governments, and multilateral agencies such as the World Bank or the Inter-American Development Bank (IDB).
   • Trends according to ESG Criteria: The growing demand for sustainable infrastructure is driving financiers to consider projects that are profitable and meet ESG (Environmental, Social, and Governance) criteria to promote more responsible development aligned with investor and societal expectations.

1. Fintech and Digital Lending Growth: Fintech platforms are increasingly crucial in cross-border lending. These platforms allow borrowers to access financing more quickly and efficiently than through traditional banks but also present new regulatory and compliance challenges.
2. Growing Use of Digital Currencies: With the rise of cryptocurrencies and central bank-issued digital currencies (CBDCs), it is possible that cross-border lending will use these new forms of currency in the future. This could simplify transactions and reduce costs, although it would also involve new legal challenges related to cryptocurrency regulation and consumer protection.

Conclusion

Cross-border lending represents a complex area of financial law involving multiple legal, regulatory, and operational challenges. These challenges require financial institutions to ensure that they carefully structure their loans, manage the associated risks, and comply with local and international regulations to avoid sanctions and protect their interests. 

Institutions must implement effective strategies to identify and manage associated risks, such as exchange rate, regulatory, and country risks, ensuring that their decisions align with the current regulatory framework.

In short, success in cross-border lending depends on strategic planning and the ability to adapt and comply with a constantly evolving legal framework. Therefore, collaboration with experts in the field, such as lawyers specialized in international financial law, is essential to ensure that these transactions are carried out effectively and securely.

Let’s keep in contact!

Photo. Rights free.