Did you know that the leasing industry is projected to reach over £291 billion by 2030? Despite its growing importance, many businesses and banks often overlook its strategic potential.

Understanding leasing could be the key to unlocking greater liquidity and fuelling growth. However, leasing remains an industry that is not well-understood. Its complexity, including lease status on balance sheets and insurability, has made some organisations wary. Gaining a clear understanding of this complexity can help businesses potentially unlock more liquidity and boost growth. Those that effectively manage their risks can expand their offerings and tap into a productive and growing market.

The fundamentals of leasing

Leasing — the process of renting assets with the option to buy them later — has been around since the Bronze Age, when Sumerians leased agricultural tools and land. Since then, the practice has evolved; today, everything from sports cars to high-tech IT equipment can be leased, with an expanding number of companies offering this financing service. 

In essence, leasing is a financial agreement where one party, the lessor, allows another party, the lessee, to use an asset (like machinery, equipment, or transportation) for a specific period in exchange for regular, periodic payments. Unlike a purchase, the lessee gains temporary use and the economic benefits of the asset, often with an option to buy it at a discount at the end of the lease term, while the lessor retains legal ownership. 

Leasing offers significant benefits for businesses, enabling them to scale up operations and access expensive equipment without a lesser impact on liquidity. Leasing is common for companies that need transportation assets, such as trucks, ships, or aircraft engines, or complex machinery like agricultural or IT equipment. 

Purchasing assets outright requires companies to allocate funds for maintenance and amortisation, which may tie up capital for years. Leasing, by contrast, improves liquidity and preserves capital without long-term financial commitment.

Leasing types: Financial vs operating

Different types of leasing carry varying levels of credit risk. In a financial lease, ownership transfers to the lessee, who essentially finances the purchase of the asset. In this case, the bank or lessor acts as a financier. These contracts are usually non-cancellable and cover most of the asset’s useful life.

In contrast, an operating lease keeps ownership with the lessor and typically has a shorter term. This increases certain risks such as early termination, residual value uncertainty, and potential non-payment. Additionally, the methods for recognising the value of leased assets on balance sheets can differ, potentially reducing the benefits of leasing. 

From a bank or lessor’s perspective, leased goods often serve as collateral, reducing the risks of the loan. If a company defaults on a loan, for example, the financier can repossess, resell, or re-lease the goods to mitigate some of its losses. 

Leasing for bank risk management          

While leasing offers flexibility for businesses, it also presents unique challenges and opportunities for banks, especially when it comes to managing risk and capital.

Although leased goods function similarly to collateral — reducing loan risk — the EU’s Capital Requirements Regulation (CRR), for example, limits how banks can recognise collateral on their balance sheets. Banks following the standardised approach generally cannot count leased assets as collateral for capital adequacy purposes. However, banks employing the CRR’s Internal Ratings-Based approach can recognise a portion of the leased asset’s value when assessing credit risk. 

Even then, the recognised value is often heavily discounted (by about 40% under the CRR) to account for valuation uncertainties, market, and liquidity risks, meaning that only a fraction of the leased asset’s true worth is included in the bank’s capital calculations. This conservative approach aims to safeguard financial stability by preventing overestimation of collateral values. 

Banks are able to implicitly recognise the value of the collateral through credit insurance, which protects repayment streams. Credit insurance used as an eligible guarantee on leasing exposure helps banks optimise capital while managing non-payment risk.

The approach can benefit multiple stakeholders:

• Banks can reduce exposure by transferring non-payment risk to insurers, thereby seeking to preserve profitability even if lessees default. 
• Businesses can increase confidence to take on more risk or enter new markets, with cash flow protection.
• Credit insurers can diversify their risk pools and portfolios.

The power of credit insurance for leasing

Leasing companies generally fall into two categories: those that own the assets they lease and those that don’t. Companies that don’t own the assets provide non-recourse financing. Those that do — like car leasing firms with their own fleets — can use credit insurance to protect against missed payments and as an eligible guarantee on loans.      

Marsh, a global leader in offering credit insurance solutions, helps leasing companies safeguard against non-payments. For example, a metals leasing company supplying raw materials to manufacturing and pharmaceutical firms used insurance obtained by Marsh to cover up to 90% of credit risks, which enabled the company to offer lower rates and improve its position among competitors.

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Credit insurance and leasing may be lesser-known components of global trade, but they are crucial facilitators of the world economy. A solid understanding of the regulatory and insurance dynamics associated with leasing can help companies potentially reduce costs and aim to thrive in an ever-evolving, increasingly competitive world.