(b) EDC's risk level and performance

6.27 According to Canada, EDC operates on commercial principles and is self-sustaining, as attested to by the fact that it earns a net interest margin that is equal to or better than most commercial financial institutions of similar credit rating. Canada states that net interest margin represents the difference between gross interest income and gross interest expense on all interest bearing assets, divided by the value of all interest bearing assets, and thus is a useful measure of how well a financial institution's assets are performing. Canada submits that EDC ranks just behind Chase Manhattan Bank and Citibank, and well ahead of other banks such as Barclay's Bank, Deutsche Bank, and the Union Bank of Switzerland.¹⁷³

6.28 In response to a Panel question in light of Brazil's arguments concerning the risk level of EDC's portfolio, regarding whether EDC's credit rating is attributable to the fact that it is a Crown Corporation of Canada, Canada replied that EDC's credit rating of Aa2/AA+ is based upon the rating accorded to the Government of Canada, and that the EDC has - on more than one occasion - requested Moody's and Standard & Poor's to rate the EDC separately from the Government of Canada, based upon the EDC's portfolio of assets, but that these agencies have indicated that they see no benefit in providing such a rating.

6.29 Canada asserts that in making an assessment of a financial institution, the rating agencies would assess, among other things, the sufficiency of the financial institution's provisioning levels. Based on regular discussions with the rating agencies, EDC provisions so that it maintains a notional rating for its total portfolio of business at a targetted level of Aa2/AA+. According to Canada, the balance sheet of the EDC remains at the Aa2/AA+ level due to the overall level of its provisions and the EDC's conservative accounting treatment of non-performing loans.¹⁷⁴

6.30 In turn, Canada states, the EDC's provisions have been funded by the risk margins charged by the EDC to its clients. According to Canada, the EDC maintains an overall Net Interest Margin (NIM) - which takes into account the carrying costs of the non-performing loans on which no income is earned -- which compares favourably with a number of private financial institutions. ¹⁷⁵ The net interest margin is a useful measure as it allows an apples to apples comparison of financial institutions.

6.31 Canada argues that EDC employs one of the largest pools of trade financing experts in Canada, and has experience in over 200 markets and expertise in many highly specialised fields. According to Canada, private financial institutions such as Citibank or Bank of America employ a similar pool of talent,¹⁷⁶ and like Citibank and Bank of America, the "competitive edge" that EDC gives Canadian exporters is EDC's experience and expertise (para. 6.49).

6.32 Canada notes, in reply to a Panel question, that EDC pays business taxes, but not corporate income tax, and does not normally pay a dividend. For Canada, these facts are not relevant for the net interest margin calculation because the net interest margin is calculated before tax and before dividends are paid. That is, whether or not a financial institution pays corporate income taxes or dividends does not affect its cost of funds, or the risk margin charged.

6.33 Regarding Brazil's assertion that EDC's portfolio is riskier than the portfolios of other commercial financial institutions, Canada disagrees with Brazil's conclusion that the EDC's net interest margin is insufficient given the level of the EDC's non-performing loans in its portfolio, because net interest margin already takes non-performing loans into account (para.6.12 - 6.15).

6.34 According to Canada, when a loan becomes non-performing, all financial institutions, including the EDC, cease to recognize interest income on that non-performing loan, but continue to carry the interest expense of that non-performing loan. That is, the gross interest income is the interest income on performing loans, but interest expense is the cost of funding all loans in the portfolio, performing and non-performing. Therefore, Canada maintains that it is incorrect for Brazil to assert that a further deduction should be made from the net interest margin to cover the cost of funding these non-performing loans, as this would be double-counting.

6.35 Regarding Brazil's arguments about EDC's non-performing loan portfolio, Canada argues that EDC recognizes three classes of loans: 1) investment grade - which corresponds to an S&P credit rating of AAA to BBB; 2) below investment grade - which corresponds to the range BB to B and 3) speculative grade, which is CCC. Canada states that EDC's civil aviation portfolio is as follows: 65 per cent investment grade; 13 per cent below investment grade and 22 per cent speculative grade, before security has been recognized. According to Canada, every commercial loan in EDC's aircraft portfolio is secured against the aircraft in the transaction, much like a mortgage on a house. Canada asserts that credit rating agencies suggest that a credit can improve by up to two categories if secured.^{177 178} Canada maintains that securing the loan against the asset - the aircraft - improves the credit rating of the credit typically by one to two rating designations, and that where EDC is over-secured, the credit enhancement is even greater. Canada argues that after considering the value of the security, 91 per cent of EDC's aircraft portfolio is investment grade or higher - in other words BBB or better.

6.36 Canada characterizes Brazil's comparison of spreads between corporate bonds, on the one hand, and secured lending, on the other hand, as fundamentally flawed. Canada states that corporate bonds are unsecured and generally have "bullet" payments, in which the full amount of the principal is paid in a lump sum at the end, while EDC's lending is secured, and the principal is amortized over the life of the loan. For Canada, there is obviously a considerable difference between the two, which has an impact on the credit risk. According to Canada, EDC is not, therefore, engaged in the high risk lending in the civil aircraft sector that Brazil implies.

6.37 Regarding Brazil's assertion that "'EDC's allowances for loan losses as a percentage of total loans is 13.2 per cent, compared with amounts between one and two per cent for each of three major Canadian banks and the US industry average'" (para. 6.14) [emphasis added by Canada], Canada argues that EDC allowances for loan losses are at this level to ensure that EDC's total portfolio maintains an equivalent credit rating of at least AA. In Canada's view, the only thing that matters is how much money is lost on a portfolio and whether there is adequate provisioning. Canada states that the EDC's write-offs against provisions have never exceeded 0.15 per cent of gross loans receivable over the past 8 years, in comparison to the Canadian commercial banks, none of which in that same period have had write-offs of less than 0.21 per cent and which in one case has been as high as 1.52 per cent. Canada notes in addition, quoting from Brazil's Exhibit 86, that the US Federal Deposit Insurance Corporation stated that the net write-offs of the US banking industry amounted to 0.63 per cent of average loans in 1997, down from a peak of 1.59 per cent in 1991. Thus, in Canada's view, EDC's write-offs against provisions are more conservative than any of these other institutions.

(iii) Rebuttal of Brazil on EDC's risk level and performance

6.38 Regarding Canada's arguments concerning EDC's credit rating (para. 6.28) Brazil argues that the fact that Moody's and Standard & Poor's have "'indicated that they see no benefit'" in rating EDC separate from the Government of Canada does not mean that EDC has earned an Aa2/AA+ rating by having reserves for loan losses commensurate with the risk of its portfolio; rather, it means that Moody's and Standard & Poor's recognize that the EDC is backed by the Government of Canada. Based on the evidence of the riskiness of EDC's portfolio (paras. 6.12- 6.15), Brazil submits that were Moody's or Standard & Poor's to consider it necessary or beneficial to rate EDC independently, EDC would be accorded a rating significantly lower than the Aa2/AA+ rating accorded the Government of Canada.

6.39 Concerning Canada's rebuttal arguments on net interest margin, the ratio of gross impaired loans/gross loans receivable and the allowance for losses on loans/gross loans receivable, Brazil argues that on net interest margin Canada's response ignores the fundamental premise of Brazil's argument, which is essentially the risk/return principle: "'Investors increase their required rates of return as perceived risk (uncertainty) increases.'"¹⁷⁹ For Brazil, simply asserting that EDC's net interest margin is roughly in line with those achieved by commercial banks ignores the fact that EDC should, in fact, earn a much higher return as compensation for the higher risk of the portfolio. Brazil notes Canada's statement, with respect to "Analysis of EDC's Financial Performance,"¹⁸⁰ that EDC's "'average portfolio of business is of a poorer risk quality'", and disputes Canada's statement that Brazil argues that a further deduction should be made from the net interest margin to cover the cost of funding these non-performing loans. Brazil states that it made no such assertion, but instead asserts investments with higher risks demand higher returns, which higher return compensates the investor for taking on additional risk, not for the cost of funding the investments.

6.40 Regarding the ratio of gross impaired loans/gross loans receivable, Brazil notes Canada's acknowledgement (para. 6.47) that EDC's non-performing loans comprise 14.4 per cent of gross loans receivable, and recalls that this same ratio is approximately one per cent for The Royal Bank of Canada, The Bank of Montreal, Canadian Imperial Bank of Commerce, and the average of all US FDIC-insured commercial banks.¹⁸¹ Brazil also notes that non-performing (also called "impaired") loans are defined by the EDC as follows:

6.41 Brazil notes that Canada provides a breakdown of sovereign versus commercial non-performing loans and notes that the EDC's level of non-performing loans has been declining in recent years¹⁸³. For Brazil, Canada fails to respond to Brazil's assertion that the overall level of impaired loans provides strong evidence that the riskiness of the EDC's overall portfolio far exceeds those of commercial banks and should be accompanied by a much higher return on the portfolio.

6.42 Brazil argues that Canada's argument actually focuses on the EDC's performing loans, omitting a discussion of impaired loans, and notes Canada's acknowledgement (para. 6.45) that the EDC's civil aviation performing portfolio is classified by the EDC itself as 65 per cent investment grade, 13 per cent below investment grade, and 22 per cent speculative grade. Brazil argues that in the same paragraph and without citation to any source, Canada asserts that the EDC has apparently misclassified its own loans, with the result that 91 per cent of EDC's aircraft-related loans should be considered, according to Canada, of investment grade or higher. Brazil finds the EDC's own classification, with 13 per cent below investment grade and 22 per cent speculative grade, to be more credible than the speculation offered by Canada.

6.43 Regarding the allowance for losses on loans/gross loans receivable, Brazil states that Canada acknowledges that the allowance for losses on loans/gross loans receivable reflects the "'poorer risk quality'" of the EDC portfolio¹⁸⁴, which is precisely the point made by Brazil; that is, that the allowance ratio of 13 per cent (versus one to two per cent for commercial banks) provides strong evidence of a much riskier portfolio than those of commercial banks.

6.44 Brazil notes Canada's conclusion (para. 6.37) that "'the only thing that matters is how much money you lose on your portfolio and whether you have adequately provisioned against this loss'", and the information on EDC's write-off history provided by Canada as evidence that the EDC has not lost much money on its portfolio. Brazil notes that Standard and Poor's Banking Industry Survey states that "'[w]hen management deems a loan uncollectible, it's written off the books and a deduction is made from the reserve for loan losses.'"¹⁸⁵ Brazil states that managers exercise a great deal of discretion in deciding when to write off a loan, and argues that the EDC's 1997 net write-offs of 0.15 per cent of gross loans receivable is absurdly low, particularly given the very high level of impaired loans. For Brazil, the level of write-offs does not provide evidence that the EDC "'has not lost much money'", but rather begs the question of what criteria are applied by the EDC in determining when loans are written off, and whether or not these criteria are similar to those employed by commercial banks.

(iv) Response of Canada on EDC's risk level and performance

6.45 Regarding Brazil's response to Canada's discussion of EDC's risk level, Canada comments that Brazil ignores that the cost of carrying non-performing loans lowers the EDC's NIM, recalling that the EDC's non-performing loans comprise 14.4 per cent of gross loans receivable, in contrast to one to two per cent for commercial banks, and arguing that if it were not for the fact that the EDC's portfolio contains a relatively higher level of non-performing loans, the EDC's NIM would be higher. In spite of these non-performing loans, Canada argues, the EDC maintains a NIM that is equal to or better than many commercial banks with a comparable credit rating, that according to Brazil have less risky portfolios and lower levels of impaired loans. Thus, contrary to Brazil's assertions, the EDC's NIM does not indicate that the EDC does not earn a return commensurate with the risk of its portfolio.

6.46 Canada also denies that it asserts that the EDC has misclassified its own loans, stating that Brazil ignores the explanation Canada provided (para. 6.35) regarding the effect of taking security on these loans. Canada notes that it focussed on the EDC's aircraft portfolio and noted that these loans are secured against the aircraft in the transaction, which according to Canada is common in aircraft financing¹⁸⁶, and effectively raises the percentage of investment grade assets from 65 to 91 per cent¹⁸⁷.

6.47 Regarding allowance for losses on loans/gross loan receivable, Canada maintains that a more complete quotation of its exhibit¹⁸⁸ than that cited by Brazil reads "Due to the nature of the business; EDC's provision charge is higher than that for a commercial bank because the average portfolio of business is of a poorer risk quality..." [emphasis added by Canada]. According to Canada, this higher provision charge has resulted in higher allowances for losses on loans¹⁸⁹, and these allowances effectively offset the risk in EDC's portfolio.

6.48 Canada rejects Brazil's suggestion that EDC employs different criteria for loan write-offs than do commercial banks, and refers the Panel to a letter from Canada's Auditor General reproduced at page 43 of the EDC's 1997 Annual Report¹⁹⁰. According to Canada, this letter confirms that the EDC's financial statements are presented in accordance with Generally Accepted Accounting Principles, which cover financial disclosure by all entities that are subject to them, including both the EDC and commercial banks. According to Canada, essential elements of Generally Accepted Accounting Principles are the criteria applied and the consistent application of those criteria when valuing and writing off loans, and an auditor must be assured that management applies these principles on a consistent basis so that the value of assets would not be overstated or manipulated, and thus the Auditor can opine that the financial statements present fairly in all material respects the financial position of the entity. Canada argues that Brazil provides no evidence to support its assertion that "'managers exercise a great deal of discretion in deciding to write off a loan'", or that EDC uses criteria different from those employed by commercial banks.

To continue with Contingency on export performance

¹⁷³ Bankstat, Net Interest Margin Chart, 2 October 1998 (Exh. CDN-38).

¹⁷⁴ (EDC 1997 Annual Report at p. 47, "Net Loans Receivable" - Exh. BRA-21).

¹⁷⁵ Exh. CDN-101.

¹⁷⁶ Bank of America, "Industry Expertise" on line: Bank of America Homepage (http://www.bankamerica.com( (date accessed: 5 November 1998) (Exh. CDN-39); Citibank, "Small Business & Professional" and "Global Banking Services" online: Citibank homepage (http://www.citibank.com/US/businessbanking/main.htm ( and (... /global.htm( (date accessed: 3 November 1998) (Exh. CDN-40).

¹⁷⁷ Exh. CDN-98 and 99

¹⁷⁸ Standard & Poors, S&P's Corporate Finance Criteria, (McGraw-Hill, 1994) at 53-54 (Exh. CDN-98); Moody's, A Sense of Security - Moody's Approach to Evaluating Bank Loan Structure and Collateral, (New York, Moody's: 1997) (Exh. CDN-99).

¹⁷⁹ Frank K. Reilly, Investment Analysis and Portfolio Management, Fourth Edition (Dryden Press), pg. 25.

¹⁸⁰ Exh. CDN-101

¹⁸¹ Exh. BRA-79.

¹⁸² EDC 1997 Annual Report, pg. 47 (Exh. BRA-21).

¹⁸³ Exh. CDN-101

¹⁸⁴ Exh. CDN-101, Section I(b) ("Due to the nature of the business, EDC's provision charge is higher than that for a commercial bank because the average portfolio of business is of a poorer risk quality.").

¹⁸⁵ Standard and Poor's Banking Industry Survey, dated 11 June 1998, pg. 21 (Exh. BRA-86).

¹⁸⁶ Exh. CDN-48

¹⁸⁷ Exh. CDN-98 and 99

¹⁸⁸ Exh. CDN-101

¹⁸⁹ Exh. BRA-79.

¹⁹⁰ Exh. BRA-21