Leasing Risks

Leasing risks

We know already the many benefits, which leasing can bring to the lessee. At the same time, there are quite a few leasing risks, associated with the service, which are good to consider prior to using the service. Further, we will look into all these leasing risks, as well as give some advice for their mitigation where possible.

At first sight it seems that all major leasing risk and dangers from the leasing transaction sit with the lessor – currency risk, interest rate risk, risk of over-millage penalties, risk of damage to the leasing asset or its total destruction, risk of its extensive use, risk of non-payment of lease installments, residual value risk. Should we read carefully each leasing contract we will notice that all these risks have been transferred to the lessee. Here is how:

Currency Risk

The currency risk is the danger of unfavorable changes in the exchange rate in which the leasing contract is denominated and the currency of the cash flow of the lessee. We should mention immediately that if the above two parameters are denominated in the same currency the currency risk does not exist. However, on the Bulgarian leasing market, the currency risk is very much a fact.

Living and working in Bulgaria, our income is usually in Bulgarian Lev. It only seems logical that the leasing contracts should also be denominated in the same currency. It will be hard to find such a contract on the market in Bulgaria. All leasing contracts are denominated in Euro.

Leasing currency risk

Let us give an example of this leasing risk using a similar financial service – bank credit. During the first decade of the new century, a new financial product came into being – „credit in Swiss Francs“. The formal idea was that the interest rates in the Swiss currency are very low. Banks in Bulgaria (and not only there) actively marketed this new product. Accordingly, there were quite some clients willing to benefit from credits in Swiss Francs, even though their income was in the local Bulgarian Lev. The risk, sadly, materialized in late 2007. On 20th October 2007, the exchange rate EUR/CHF was 1.67. Exactly one year later, in October 2008, the exchange rate was 1.47, or an EUR decrease of about 12%. The drop continued in the following years and in October 2011 reached 1,20, or a decline of about 30% just in four years. How does that affect the debtors? … well, a 10, 20 or 30% increase of all the credit used which respectively had to be paid back.

As the exchange rate BGN/EUR is pegged at 1,95583  by the Currency Board, seemingly there is no risk or danger of unfavorable changes in the exchange rate and losses, due to this, for the lessees. And still – all leasing contracts are denominated in Euro. The reason is that such a risk does exist – the risk being a suspension of the Currency Board or a change in the exchange rate between the two currencies upon the entry of Bulgaria in the Euro Zone.

How can the lessee mitigate this leasing risk? The answer is that no practical solution exists. Hedging of the risk would greatly appreciate the leasing transaction and it will be difficult to find an appropriate financial instrument. Another solution would be for the lessee to try to find earnings in the currency of the leasing contract. This may be possible, but for most lessees, it would not be achievable.

Never the less, it is important for the lessees to be aware of this leasing risk, and to be certain that even if a negative change in the exchange rate BGN/EUR occurs, this will not lead to the impossibility of fulfilling the obligations under the leasing contract.

Interest Rate Risk

The interest rate risk outlines the danger of changes in interest levels in a negative direction for the lessee, e.g. the rise of interest. Today, near the end of 2018, this risk is more valid than ever.

It would be nice if lessors offered leasing contracts with fixed interest rates. The Bulgarian leasing market has seen lessors offering fixed interest leasing. Sadly, today all leasing contracts have floating interest rates. This means that the leasing installments are linked with some popular interest rate (like EURIBOR) and with its rise, the interest on the leasing contract will rise accordingly, which will increase the monthly installment. It sort of comic that upon changes in the opposite direction, to the disadvantage of the lessor, not reduction of the leasing rates is mentioned in any leasing contract.

interest rate leasing risk

This risk too is hard to avoid. The good news is that interest rate levels change very slowly (with but fractions of a percent annually), unlike the above example with the currency risk of credits in Swiss Francs. The other good news is that this risk only affects the future interest under the leasing contract and not the principal (like the CHF example). This means that the lessees need to be able to absorb without difficulties changes in the leasing interest rate with a few percentage points. Thus they will be sure that the interest rate risk will not bring difficulties. As a benchmark, you may view the changes in interest rate levels of the  EURIBOR in the last 20 years – fluctuation between 5% and 0%. These are also the boundaries of the interest rate risk which the lessees bare.

We may also wish for a lessor to come, who will offer fixed rate leasing products.

Risk of Over-mileage Penalties

This leasing risk is characteristic of vehicle leasing. Most of the leasing contracts have some limitation for the mileage of the leased vehicle. If under the financial leasing contracts such limitations are seldom met, in the contracts for operational and open end financial leasing they are a must. In Bulgaria, these are usually 10, 15 or maximum 20 thousand kilometers per year. Lessees seldom take notice of this requirement, eager to hop on the new car. However, these limitations are also linked to an over-mileage penalty for every kilometer above the limit. The penalty may vary from a few cents to (in some extremes) the fares charged by the taxi drivers.

leasing risks - over millage penalty

This leasing risk may be mitigated and even totally avoided by the lessees. First, they have to check if such limitations exist PRIOR to signing the leasing contract. If so, they need to know what mileage will the leased car pass each year. Then they need to mark-up this number by about 25%, and eventually negotiate with the lessor this mileage as a limitation if such need be.

It is important for the lessee to note this leasing risk and such limitations by the lessor. There are also some lessors who are willing to take advantage of the mileage limitations and corresponding penalties. Be careful.

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