Assessing Risks in Finance Contracts: A Guide for the Banking Industry

Date
April 7, 2022
Category
Date
April 7, 2022
Author
Gary Sangha | Founder & CEO
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Financial institutions write tens of thousands of contracts each year. Some are privately negotiated while others are negotiated through public exchange markets. Different types of finance contracts are drawn up to balance risks and rewards, but their review and negotiation processes should never be overlooked. Increasingly, artificial intelligence (AI) platforms are being implemented to standardize and fully redline financial contracts by type, saving time by performing more thorough risk analyses.

What Is Included in a Financial Contract?

A finance contract is a type of individually negotiated agreement involving commodities, currencies, securities, or other financial products. Financial services contracts are used in buying, lending, repurchasing, selling, and swapping transactions. 

Common types of contracts used in finance may include:

  • Forward contracts: Two private parties agree upon a price, quantity, and transaction date for an asset (such as precious metals, utilities, livestock, or foreign currencies). Since these agreements are not traded on an exchange, conditions can be more flexible. It doesn’t matter if the value of these commodities fluctuates throughout the term; payment is made at the term’s end and negotiated prices remain firm over the contract’s duration. The risk of default tends to be greatest with a forward contract.
  • Futures contracts: A futures contract is similar to a forward contract, but takes place in an exchange market. Buyers and sellers know what to expect, but buyers can change the quantity of purchase to suit their budget and needs. Standardized futures contracts settle on a daily basis, so both parties must be capable of handling price fluctuations over the lifetime of the contract.
  • Options contracts: An option gives the holder a right to buy or sell an asset at a specific price on a specific date, though it is not mandated. A call option is the right to buy, while a put option is the right to sell.

But finance contracts are also often saddled with various types of risk, including:

  • Credit risk: When a borrower fails to fulfill contractual obligations, the bank loses out on loaned money and revenue. The nature of the business makes it impossible to completely eradicate this risk, but banks can reduce exposure to categories by favoring borrowers with excellent credit history or leveraging collateral to back loans.
  • Operational risk: Human error can expose a financial institution to tremendous risk, particularly if the bank defaults on its contractual obligations. Fraud and cybersecurity issues are other sources of operational risk.
  • Market risk: Commodity prices, interest rates, and other market factors can be wildly unpredictable. Banks can reduce investment in capital markets and trading exchanges, but run the risk of losing out on potential gains by doing so. Diversification of investments is one way to reduce risk.
  • Liquidity risk: A bank run can occur when too many customers withdraw their money from a bank due to its possible future closure. Regulations now require banks to hold sufficient amounts of liquid assets to prevent a catastrophe as seen prior to the Great Depression.

How AI Legal Innovation Reduces Risks in Banking Contracts

When a financial institution deals with large volumes of contracts, mitigating risk should be a top priority. Luckily, legal-centric AI platforms offer financial institutions multiple ways to alleviate common contract review and negotiation pain points, including:

  • AI Digital Playbooks: Every financial institution has its own standard terms, conditions, and negotiating positions for dealing with different types of contracts. By uploading these playbooks to an AI-powered contract review platform, banks can free up their time and let attorney-quality AI review contract drafts for deviations, opportunities, and clauses for potential risk. What usually takes associates days or weeks to finish can now be completed in minutes.
  • Risk analysis: AI quickly reviews and compares contracts with the AI Digital Playbook, past contracts uploaded to the platform, and best practices templates to identify sections where revisions may be necessary. Clauses may be highlighted and coded by level of risk to streamline and prioritize review and negotiation work.
  • Revision suggestions: In addition to highlighting sections that require revisions, legal AI platforms can also offer context-based suggestions. This process can save a significant amount of time and obviate unnecessary back-and-forth emails between parties trying to understand why a change may be warranted.

Finance contract review platforms have the potential to greatly reduce risk while simultaneously improving a financial institution’s workflow and negotiation strategies. With them, legal teams can quickly tag and train provisions to run customized review protocols, search for nonstandard language, and update terms in bulk based on recently passed legislation. Bottlenecks and mistakes can become issues of the past with a finance contract review platform streamlining the entire process. 

LexCheck’s AI platform combines machine learning with industry-leading legal expertise to ensure your finance contracts are always up to date. To learn more, contact us at sales@lexcheck.com or request a demo to experience the technology first-hand.

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