The requirement under Basel III for financial institutions to hold higher capital will reduce the probability and severity of banking crises in the future. Financial institutions are expected to fulfill these requirements by January 1, 2013, which could negatively impact global trade.
If Basel III were implemented as it currently stands, Standard Chartered (StanChart) believes that it will decrease global trade by 2% in terms of volumes and 6% in terms of trade finance capacity that would be available to clients. Global gross domestic product (GDP) is also expected to fall by 0.5%.
“There are a number of unintended consequences that will impact trade finance as a result of the implementation of Basel III,” said Ashutosh Kumar, a Singapore-based head of cash and trade product at StanChart to Asiamoney PLUS in a telephone interview on April 3.
As a result, the cost of trade financing is predicted to surge up to 40% post-Basel III implementation, says StanChart.
Basel’s ‘one-year maturity floor’ – where financial institutions are required to maintain capital for credit exposures on their balance sheet for a minimum maturity requirement of one year – is one of the main reasons that could lead to the rise in costs.
The average tenor of trade finance transactions is less than a year and they have an array of maturity profiles – ranging from 90 days up to 150 days or more. As a result, banks would need to place at least three to four times as much capital for their trade finance positions.
This aspect was recognised during the implementation of Basel II in 2008, when national regulators were allowed to waive the one-year maturity floor. However, the varying responses of regulators to the new ruling created some discrepancies.
“Some of the regulators waived it, some did not and some partially,” declared Kumar. “As a result of [the one-year maturity floor], there will be a much higher capital level that was maintained for trade finance exposures when there should not have been. This became a challenge for the industry and this was amongst various other things.”
As a result, the Basel committee last October decided to completely waive the one-year maturity floor for issued and confirmed letters of credit – instruments that are particularly relevant for low income countries when they import goods.
This implementation of this new ruling by various national regulators remains uncertain, and could still potentially vary from country to country.
“For jurisdictions where it is not waived, banks still maintain capital on trade finance exposures as if the transaction will be on the balance sheet for a period of one year,” he added. “That will become a challenge for the capital side.”
In addition to the one-year maturity floor, Basel III’s assessment of corporate risk is similar for all credit products within the wholesale banking group.
This presents another challenge for trade finance instruments as Basel III’s asset value correlation – which measures the correlation of assets to movements in economic data – is standardised for all asset classes. This means trade finance is on par with other larger, riskier, more correlated products in the wholesale banking group like syndicated loans and bonds.
“We all know that trade finance is shorter in tenor, smaller in size self-liquidating and diverse in nature because individual trade finance has exposures to multiple geographies,” said Kumar. “All that doesn’t get captured in the ‘asset value correlation’… and trade gets deemed as that becomes more a riskier product, thus as you are required to maintain much higher capital.”
The asset value correlation varies between 15%-30% for financial institutions that have more than US$100 billion worth of assets on their balance sheet.
Leverage and liquidity challenges
The newly introduced leverage ratio – which prevents banks from building up excessive on- and off-balance sheet leverage – is another major concern for the banks as they prepare to move into the Basel III norms.
The Basel Committee is currently testing a minimum Tier I leverage ratio of 3% of bank exposure. Leverage ratio, as per the Basel III - is the ratio of Tier I capital to book value of assets that includes off-balance sheet items, poses a threat to trade finance as well.
“The unintended consequence of that was – even though it was for the intention of capturing derivatives and all the complex structured products – trade finance instruments like letters of credit and guarantees which are also off-balance sheet [items] got captured in that,” highlighted Kumar. “The requirement under Basel III was that this will be the same category as derivatives and hence, a 100% conversion to on-balance sheet will be applied.”
The 100% conversion onto on-balance sheet is not realistic for trade finance as these transactions support world trade and cannot be leveraged, says StanChart.
“You will see that from being a product which supports the real economy, you are not be able to leverage as you cannot do more than the underlying and it’s still a very small portion of the underlying,” said Kumar. “Trade finance does not 100% convert to on-balance sheet.”
Moreover, Basel III’s new liquidity standards are expected to have a negative impact on trade finance. StanChart notes that this is split into three categories: operational accounts, trade finance inflows and trade finance contingent.
Operational accounts monitor outflows specifically for the transaction banking side of the business and these flows tend to be more ‘sticky’ because the accounts are maintained by clients, says the bank. As a result, in a distressed scenario, these accounts will not be heavily impacted. But the issue here is that there is no clear definition of operational accounts.
As for trade finance inflows, Basel III assumes that these inflows tend to be around 50% for all corporate exposures in a distressed scenario. However, the level of trade finance defaults is very low, notes Stanchart.
“At such low defaults, allowing 50% of inflows probably does not make economic sense as it should be closer to 100%,” said Kumar. “That is the unintended impact because they did not distinguish between other forms of exposures versus trade finance.”
For example, the default rate for letters of credit is 0.077% while its rate of loss is 0.007% from 2008 to 2010, according to the International Chamber of Commerce (ICC) at the ICC Banking Commission meeting in Beijing last October.
As for trade finance contingent, Basel allows local and national regulators to decide liquidity requirements for letters of credit and bank guarantees, which is a problem says StanChart.
“The challenge with that is that it is not very well understood and is a new concept,” said Kumar. “Regulators would ask banks to set aside much higher liquidity than it actually requires.”
“The second issue is that when each regulator decides on its own, there would not be a harmonious implementation of this as each regulator will have a slightly different way of measuring liquidity which would create problems. Trade finance is a two way flow – if you have a challenge on one side, the other side will also suffer,” he added.
On December 13, 2010, the Basel Committee announced an international framework to promote stronger liquidity buffers in the banking sector and so improve the banking sector's ability to absorb shocks arising from financial and economic stresses, such as the liquidity shock that occurred during the early stages of the financial crisis that began in 2007.