From Risk to Resilience: Redesigning Defence Financing Frameworks

Summary

• Defence spending is increasing substantially across the UK and Europe, which is in turn driving greater private capital investment.
• Banks are struggling to meet the demand for financing due to concerns over sustainability, reputational risk, and the absence of defence-specific frameworks to assess the risks and opportunities of lending to defence companies.
• To close the financing gap and facilitate informed and compliant defence financing, banks must adapt their existing lending and risk assessment frameworks by incorporating defence-specific criteria, adapting the due diligence process, and considering working with government to introduce innovative mechanisms like ‘Compliance Passports’.

From Peace Dividend to Security Premium

Defence financing in the UK, Europe and NATO has grown as an area of public interest in recent years. The rapidly evolving geopolitical landscape and the proliferation of global conflicts exposed decades of underinvestment in defence by the UK and other European nations. The defence budgets of European governments have risen as a result, with an ambition for greater warfighting readiness, and to establish greater defence industrial sovereignty, international competitiveness, and autonomy.

Between 2021 and 2024, the total defence expenditure of EU member states rose by more than 30 per cent. This growth has been driven primarily by significant increases in the defence budgets of Eastern European countries, though Western European defence budgets have also grown substantially. In 2024, it reached an estimated €326 billion - about 1.9 per cent of EU GDP. Expenditure is expected to rise by more than another €100 billion in real terms by 2027¹. In the UK, there is an ambition for defence spending to reach 2.5 per cent of GDP by 2027, estimated to cost between £5bn and £6bn per year.² The UK government has a stated objective to increase the amount of private investment in the defence sector.³ The ambition to increase public defence spending is intended to lead the way for investors to crowd in afterwards. Across Europe, government spending is focused on developing sovereign technologies, nurturing an innovative and agile industrial base and delivering defence production at scale. 

Historically, private investment in defence has been curtailed for a multitude of reasons, including high cost-to-invest, the risks of limited markets, and reputational considerations. Despite the challenges, measures to support defence lending are being gradually introduced. For example, EU programmes such as the European Defence Fund, the Digital Europe programme and the Strategic Technologies for Europe Platform are set to be amended to facilitate funding toward defence.⁵ Meanwhile, the European Investment Bank announced earlier this year that it would issue a €500 million loan to Deutsche Bank which would then be loaned onwards to SMEs across the EU's security and defence supply chain.⁶ To streamline the process, Deutsche Bank has formed an internal group across various departments to focus on defence financing. Earlier this year, British banks were also encouraged by Members of Parliament to stop categorising defence investments as ‘unethical’, to boost the arms industry in the UK.⁷

The growth in public investment in defence has also encouraged a greater interest from the financial sector for investing in defence. Investors seek to take advantage of the increased significance of the sector, while mitigating risks to other investments caused by wider geopolitical instability. The growing interest in defence investment can be seen across the spectrum: from private sources and equity sources to debt instruments, and hybrid public-private organisations. In Private Equity (PE), there has been a surge in investment activity across different company growth stages. PE investment in Europe’s defence and aerospace sector has increased, attracting €620 million (around $703.7 million) across 12 deals in the first half of 2025. Private equity firms are focusing on bolt-on acquisitions in cybersecurity and defence, where roll-up strategies are of growing appeal.⁸ Venture Capital (VC) interest in defence startups has also grown in recent years. In Europe, VC investment in defence and related technologies grew 24 percent in 2024 to $5.2bn, bucking the trend of waning VC interest in European startups more broadly in 2024.⁹ 

Other initiatives have been announced to leverage broader capital markets to help finance defence and security goals. Multilateral financing institutions, backed by states but supported by borrowing from capital markets, have been touted as a potential option to provide access to loans and guarantees, and to fund investment across the defence, resilience and security supply chain. An example of one such institution currently under development is the Defence, Security and Resilience Bank (DSRB).¹¹

The Challenges Ahead 

The financial sector faces increasing pressure to close the widening financing gap for defence suppliers and manufacturers. However, lending practices are constrained by nervousness about sustainability rules, reputational risk, and the lack of a framework to assess potential defence borrowers. Without a robust framework in place that would allow banks to assess defence financing holistically and consistently, banks face challenges in risk and performance assessment, thereby potentially under-serving a market that has been encouraged by recent government policies. For example, the distinction between permissible (e.g., dual-use technologies) and ‘red-line’ (e.g., controversial weapons) defence investments can be difficult to define and then apply consistently. There are also often complex sustainability and reputational considerations (internal and external) to navigate.

Given the complexity of the landscape, particularly from a regulatory perspective and the possible repercussions of non-compliance, it is crucial that risk frameworks account for defence-specific factors early and with transparency. Risk appetites may also need to be re-defined.

Credit risk assessment frameworks used by banks today leverage various tools to assess the potential borrower’s ability to repay their debt. Demand on defence companies for their goods and services is increasing and there are pressures on these companies to operate, innovate, invest and grow. However, defence companies continue to face issues with access to capital, and therefore existing risk assessment frameworks may need to be revised. Credit analysis also poses additional challenges in assessing Small and Medium-sized Enterprises (SMEs) due to limited information about ownership and a potentially lower regulatory standard for accounting and financial disclosures. SMEs may face further difficulties in accessing debt financing due to their revenue stability, counterparty risk and access to capital.

Areas such as Anti Money-Laundering (AML) and Know Your Customer (KYC) policies, strategies for addressing bribery and corruption, and client onboarding would also be impacted. Additional considerations for AML and KYC relate to complex ownership structures, for example through the use of shell companies obscuring foreign ownership, as well as the risks of illicit arms trading and any involvement from Politically Exposed Persons (PEP) in defence contracts. Another important consideration is the ability to identify Proliferation Financing – provision of funds or services to the so-called ‘proliferation actors’ who may use such funds or services to obtain expertise, materials, technology or data to enhance their chemical, biological, radiological and nuclear capability. Some red flags that banks should keep in mind as they conduct a Proliferation Financing assessment include whether clients are linked to higher-risk geographic jurisdictions, whether clients deal primarily in crypto-assets, or whether clients are involved in sales or shipments of dual-use goods.¹² Banks must ensure that transactions are effectively monitored to prevent the use of defence and dual-use technology by, for example, terrorist organisations.¹³

From Restriction to Enablement

A practical approach for banks to resolve the challenges they face in providing debt to defence companies is through leveraging existing lending and risk assessment frameworks and incorporating additional considerations and criteria, for example product and activity classification, strong internal compliance process, heightened due-diligence and KYC expectations for defence-related transactions.¹⁴ This would likely involve amending risk appetite statements, lending assessment frameworks and decisioning criteria.

A thorough understanding of the distinct features inherent to the defence and security sectors is essential for investors. This insight enables a more precise evaluation of financial risks, opportunities, and anticipated returns, whilst also shedding light on potential non-financial investment outcomes. To assess the viability of investments in terms of financial and non-financial risk and opportunity, aspects such as the type of company, technology or product that are the subject of investment decisions could be considered. These could also include such aspects as:

• Positive Non-Financial Outcomes: This could include contribution to national security objectives, sovereignty or supporting defence as an engine for growth in the pursuit of national prosperity – objectives outlined in the UK Government’s Strategic Defence Review (SDR) and Defence Industrial Strategy (DIS).
• Negative Non-Financial Outcomes: For example, ethical concerns about the investment could be guided by capabilities defined as controversial in the Ottawa Treaty, or the Nuclear Non-Proliferation Treaty. Hurdles in AML and KYC could be addressed through the introduction of a ‘Compliance Passport’ – a certification evidencing that a user has passed governmental due-diligence checks. Banks could rely on such passports to drive efficiency in client onboarding and their AML / KYC process.
• Lethality: Lethal capabilities have smaller customer bases and are subject to stricter regulatory and legal constraints as well as additional reputational considerations. On the other hand, civilian and dual-use companies generally have more diverse potential revenue streams, and civilian products often have quicker time-to-market.
• Sovereignty: Finally, aspects such as ownership and the sophistication of regulatory bodies in the country where a company is domiciled would need to be considered. For example, the National Security and Investment Act 2021 (NSI) can and has been used to unwind acquisitions deemed not to be in the public interest, and to prevent the movement of key technologies and IP abroad. The NSI does not just affect defence: 17 sub-sectors are included where the Government considers foreign ownership to be counter to national interests ranging from military and dual-use to energy and transport. While this might dissuade lenders, who would need a clear understanding of other creditors and investors to mitigate the risk of a deal being 'called in' under the Act, it simultaneously provides reassurance that the government values protecting the technology or intellectual property.

Conclusion

The increasing private sector interest in defence financing presents a set of complex challenges. As the pressure to bridge the financing gap for defence suppliers grows, banks still face sustainability concerns and reputational risks, and lack robust, auditable frameworks to assess risk and performance and to differentiate between permissible and 'red line' defence investments. Despite these complexities, measures are emerging to facilitate defence lending, but the increasing demand for defence financing calls for new frameworks quickly to be developed to better assess the options and risks involved.