European defense financing and banking

Trump 's position on the war in Ukraine represents, if unchanged, a spectacular reversal of the US alliances with its post-World War II allies. This geopolitical shift has generated a clear response from the EU, whose leaders have agreed to significantly increase defense spending. Specifically, during an extraordinary summit on March 6 in Brussels, EU heads of state and government pledged to mobilize up to €800 billion to strengthen the continent's security. To achieve this goal, they have proposed, among other measures, greater flexibility in EU fiscal rules and the approval of new common financial instruments.

Since a common defense policy is still a long way off, it is clear that the annual budgets of the member countries will have to increase their spending on this area. Since the increase in this item of public spending is permanent, all else being equal, there should be an increase in taxes or a reduction in other spending items. Since the benefits of greater European security are spread over time, tax increases (or spending reductions) could be phased in , but an agreement among the countries' main political parties should be required, otherwise there would be a perverse incentive to postpone the most unpopular measures.

The security and defense spending component of the EU budget could also be increased (for example, the allocation for the European Defense Fund, which for the 2025-2027 period is almost five billion euros). A more disruptive but very powerful alternative is to replicate what was approved to combat the pandemic, that is, the European recovery and resilience plan . This would be another very significant example of risk pooling in the EU and would fit very well with the financing of cooperation projects between European companies in this sector (such as, for example, the combat air system).

Since public military spending requires the existence of a defense industry, which can include both public and private companies, there is a clear role for the financing of this industry by banks and financial markets. This is the way to reach the aforementioned €800 billion. In this article, we will focus on bank financing.

When granting loans to companies in this sector, banks must consider the characteristics of some of this demand (a high number of small and medium-sized enterprises without a long credit history, projects with long-term maturity, significant weight in research and development, etc.). The conclusion is that these characteristics fit poorly with banks' usual risk appetite frameworks.

One public policy alternative is to consider the security and defense sector as a priority and approve public guarantee programs to cover part of the credit risk of these operations. For example, the European Investment Bank (EIB) , the majority shareholder of the European Investment Fund (EIF) , has a significant guarantee program, in which the cost of the guarantee is reasonable and covers a significant portion of the credit risk. Under some form of this guarantee program, bank loans do not consume capital (for the portion covered by the guarantee).

Another obstacle to bank financing for the defense industry has come from the environmental, social, and governance (ESG) rules that banks apply to their lending activities. Since the defense sector is not expressly excluded from the European taxonomy of sustainable finance, each bank can decide within its sustainability policies. This has led many institutions, in response to the policies of many institutional investors, to limit financing to this sector. Many banks have followed the recommendation of the Sustainable Finance Platform (a group of independent experts established by the European Commission in October 2020) to consider arms production a harmful activity. Clearly, if we want to stimulate private financing for the defense sector, the current stigma surrounding ESG must be eliminated.

An alternative to traditional bank financing would be greater participation by banks in so-called direct or private financing . This is a type of corporate financing channeled outside of banks, typically through funds and platforms, with a significant market share in the US and the UK . This financing is more tailored to the specific needs of each company and has more flexible financial conditions, although the spreads applied are higher than those of traditional bank lending operations.

Credit risk

Direct financing is not usually included in the ordinary risk appetite framework of banks, as these are operations with a higher credit risk and a repayment structure that combines a long repayment period with a principal payment schedule heavily biased toward the end of that term. This alternative can be channeled by banks through co-financing agreements with these funds and platforms, as well as through investments in the fund's management companies. An example of this direct financing would be an innovative company with a long maturity period for its research projects that obtains a "balloon" loan (i.e., whose repayment is largely deferred until maturity, thus using the cash flows generated by the project once it is fully operational). The companies that are typically targeted for this type of financing are medium-to-large enterprises in the expansion phase and with high operational efficiency.

This alternative could be encouraged from a regulatory perspective (capital consumption), as it combines two very positive characteristics: first, risk diversification, since, in one way or another, one participates in a broad pool of financing; and second, the specialization and professionalization of management by these funds and platforms. The granting of public guarantees for these operations (such as those already provided by the EIB) could also be increased.

What banks generally don't engage in is investment in corporate capital, precisely what innovative startups in the defense sector (and other sectors) may need. For this type of investment and some financing options less suited to typical banking activity, one might consider the participation of the EIB or the European Bank for Reconstruction and Development. Traditionally, bank investment in corporate capital has been penalized due to its high risk (they have a minimum weighting of 250% in the calculation of capital consumption). An interesting way to indirectly enter into corporate capital would be investment in venture capital firms, characterized by greater risk diversification and professional management. Considering these last two characteristics, regulation could apply a lower capital consumption to these investments than to direct bank investments in corporate capital. Mobilizing a huge amount of money in security and defense requires a major effort from both the public and private sectors. In addition to increased public spending, it is worth mentioning an ambitious program of public guarantees for credit operations and greater regulatory flexibility for banks to enter into operations (direct financing or venture capital) that do not typically fit within their risk appetite framework. With political will, this goal can be achieved.

Antonio Carrascosa Morales . Professor of the Master's Degree in Financial Regulation at the University of Navarra.