European states’ pledges to accelerate defence spending will require significant support from trade finance lenders and insurers, particularly for hard-to-reach parts of supply chains, experts have said.
Nato’s 32 members committed in June last year to increase public investment in defence to 5% of GDP within the next decade and, following this year’s summit, announced US$139bn in additional funding for core defence had already been provided by its European participants and Canada.
Typically, procurement appears low risk, as contracts are awarded by sovereign buyers to investment-grade defence giants, known as primes, and are often backed up by guarantees from export credit agencies.
But General Sir Patrick Sanders, a former UK military chief of staff and now a senior strategic adviser to Santander, warned at an industry event last week that a defence contract “is not a normal supply chain”.
“I think of the defence industrial base as an iceberg. The primes are what you can see above the water, but the vulnerability lies below it,” he said at the International Trade and Forfaiting Association’s (ITFA) annual conference in Split, Croatia.
“A sophisticated missile will contain thousands of individual components. The inability to obtain one specialist component can halt the production of the entire system.
“What this does is create an unusual industrial problem, because the resilience of the system isn’t determined simply by the financial strength of the largest companies… but by the health of the weakest, strategically important suppliers.”
One challenge is that defence contracts are often slow to complete, with payment schedules that do not necessarily align with working capital requirements of deeper-tier, smaller suppliers, Sanders said.
Another is that defence demand tends to be cyclical, and for long-term projects, lenders cannot be certain a public spending commitment will extend decades into the future.
“A company’s board can’t just invest hundreds of millions of euros to sit in idle capacity because someone might need it one day, and a bank can’t pretend that political intent is the same as contracted cash flow,” Sanders said. “So someone has to carry that risk.”
Sanders told the event that trade finance instruments, including working capital finance guarantees, export credit and asset-based lending, have “strategic significance” for the sector.
A supplier able to use financing tools to expand a production line, accept a large order or buy a year’s worth of critical materials “is industrial resilience in practice”, he said.
Economist Rebecca Harding, chief executive of the Centre for Economic Security and a member of ITFA’s ESG committee, noted that lenders have historically been wary of the reputational risks associated with the sector.
“There’s a deep-seated discomfort with funding lethality in banks, and it’s that issue that banks need to have a philosophical conversation [about],” she said, for instance by viewing transactions as funding deterrence and not offence.
Jean-Marie Charollais, managing director and head of trade asset distribution at Wells Fargo, gave the example of missile or anti-missile technology.
“I’ve not heard of any commercial bank carrying it, or directly involved in the financing,” he said.
Additional complications come from political and regulatory constraints in the defence industry, including sanctions, foreign ownership and technology transfer restrictions.
Sanders noted that a “perfectly legitimate transaction can become impossible if the destination changes, or if an export licence is withheld, and that makes due diligence unusually important”.
Lenders also have to consider the strategic resilience of supply chains, he said, adding: “We have to ask not simply is the supply chain efficient, but can we trust it? Can it survive coercion? Can it operate during war? Who ultimately controls it?”
However, European lenders are increasingly willing to extend financing further down defence supply chains, said Philipp Pforr, vice-president of supply chain and commodities at Germany’s KfW Ipex-Bank and member of ITFA’s German regional committee.
“Ipex, as a state-owned bank, in the past was not allowed to finance defence,” he said at the event. “It was a no-go area, and things changed.”
For suppliers starved of working capital, Pforr said there is a “big need for supply chain finance”, and KfW Ipex is among those “stepping in [and] enlarging supply chain finance programmes”.
Chris Hall, global head of financial institution sales at WTW and ITFA regions head, said the insurance sector is also a “critical part” of expanding the industry’s risk management frameworks.
As well as structured, longer-term cover such as credit and political risk insurance, he said trade credit insurance can mitigate risks on receivables, while surety can provide guarantees in a form familiar to the banking sector.
“We still have war on the continent of Europe,” he said, yet lenders have “finite resources” to support ongoing defence requirements.
“That’s where the insurance industry can, and should, and will step in,” Hall said.
