One of the most essential forms of finance behind economic growth has become an unintended victim of the market’s fear of risk.
Trade finance, one of the staples of corporate banking across the world, looks set to be unevenly impacted by the adoption of the Basel III capital rules that enter usage on January 1, 2013.
As the new capital rules stand, banks would have to place a great deal more capital against trade finance deals, raising their effective cost and potentially crimping world trade.
This is an unfortunate irony, given that trade finance is one of the least risky forms of bank lending. Default rates are typically well under 1% of loans made – and stood at under 0.03%, according to analysis by the International Chamber of Commerce (ICC).
The troubles result from Basel III’s attempts to encompass all forms of risky lending in its rules, with a particular focus on off-balance sheet deal making and the need to hold minimum levels of capital for any sort of offering.
That is a bad idea at a time the world’s economy is only just beginning to regain some momentum, powered particularly by rising trade flows to and from the Asia region.
Devil in the details
On December 13, 2010 the Basel Committee announced a new international framework to promote stronger liquidity buffers in the banking sector.
The idea was to improve the financial industry’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.
Under Basel III’s proposed new capital rules, banks need to hold higher reserve capital against their deals.
Reducing the probability of a contagious banking crisis is a noble goal. But trade finance has been adversely affected by these new requirements too, despite acting as one of the most basic and reliable forms of lending.
Basel III’s impact on trade finance is particularly noticeable in three ways.
The first is the Basel Committee’s one-year maturity floor. This is a requirement for financial institutions to maintain capital for credit exposures on their balance sheet for a minimum maturity requirement of one year.
The average tenor of trade finance transactions varies but they are all well under a year, typically ranging from 90 days up to 150 days. 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.
“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,” says Ashutosh Kumar, global head of corporate cash and trade product management at Standard Chartered. “That will become a challenge for the capital side.”
Secondly, Basel III’s assessment of corporate risk is similar for all credit products within the wholesale banking group. In particular it standardises asset value correlation – which measures the correlation of assets to movements in economic data – for all asset classes.
This means trade finance is viewed on par with other larger, riskier, more correlated products in the wholesale banking group like syndicated loans and bonds; something that industry experts feel makes very little sense.
“Trade finance is low risk and it directly supports global economic growth; these alone are good enough reasons to support trade finance above other asset classes,” says Rakesh Bhatia, global head of trade and supply at HSBC.
“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,” adds Kumar. “All that doesn’t get captured in the ‘asset value correlation’… and trade gets deemed as a riskier product, thus 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.
Off the books
In addition to these two points, banks are concerned by Basel III’s newly introduced leverage ratio – which prevents them from building up excessive on- and off-balance sheet leverage.
Under the new rules a bank’s leverage ratio measures Tier I capital against the book value of assets that includes off-balance sheet items. It has been using 3% as a working figure.
This ratio poses a threat to trade finance because off-balance sheet funding is used to source a lot of deals. Particularly prominent are letters of credit, a contractual agreement between a buyer of goods to pay the seller upon delivery, using a bank as an intermediary and holder of the payment while the products are manufactured and delivered. Letters of credit are particularly relevant for low income countries that import and export goods.
“Even though [the leverage ratio] 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,” highlights 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.”
In other words banks have to keep 100% of an off balance sheet transaction’s value spare in capital. This was a whopping increase in the 20% that banks had to keep for letters of credit in the past, and makes such funding far less appealing.
“The industry was surprised that it came out so high,” says the head of Basel III implementation at a global corporate bank. “Traditionally trade finance and letters of credit specifically have always been simple and safe.”
Implementing a 100% conversion for off balance sheet trade financing is not realistic for trade finance as these transactions support world trade and cannot be greatly leveraged, adds Kumar.
Cost of capital
StanChart is extremely pessimistic about the impact of Basel III’s proposals on trade financing.
The emerging markets-focused bank believes the rules don’t distinguish trade finance enough from riskier forms of credit, and that lenders will be less willing to set aside funds for it as a result.
It thinks trade financing will fall, while its cost could surge up to 40% post-Basel III implementation. As a result global trade could drop by 2% in terms of volumes and 6% in terms of trade finance capacity available to clients as a result. That would cause global gross domestic product (GDP) to fall by 0.5%.
Another potential impact would be that banks under pressure to cut leverage and capital-intensive funding to meet Basel III chop into the most liquid parts of their asset pool, simply because it’s easier to do so. This could include trade finance.
“Trade finance becomes an obvious and easy area for banks to cut if they are trying to ensure they have the right capital ratios, because it’s liquid and you can get it off your books faster,” says Bhatia.
That risk is only raised by the fact that Basel III doesn’t view trade finance as superior to any other form of corporate lending in distressed situations, despite its extremely low default rate.
The new rules assume that banks will only receive around 50% of the money they have lent to corporates in a distressed scenario. This is way too pessimistic for trade finance.
Between 2008 and 2010 – the aftermath of the global financial crisis – the default rate for letters of credit was 0.077% while its rate of loss was 0.007%, the ICC told the ICC Banking Commission meeting in Beijing last October.
“At such low defaults, allowing 50% of inflows probably does not make economic sense; 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.”
By pressurising banks to cut risks yet not recognising the inherently less risky profile of trade finance, Basel III offering banks few reasons to hold such funding sacrosanct as they slim down.
“If trade finance doesn’t receive any progressive or favourable treatment because of its liquidity and low default rate, then there’s less incentive for a bank to keep it when cutting assets,” says Bhatia.
Assessment needed
The Basel committee is well aware of these criticisms, in large part because of a large lobbying effort by the banking community.
It led the committee to decide last October to completely waive the one-year maturity floor for issued and confirmed letters of credit.
However it remains uncertain whether all national regulators will implement the amendment, while some may choose to do so in a different manner to other states.
“One of challenges across the board today really is the implementation of Basel III. It isn’t going to get implemented globally; instead it will be done from national jurisdiction to national jurisdiction and that will create discrepancies,” says the head of Basel III implementation.
While the banks worry that the good intentions behind Basel III’s new strictures will damage trade flows, the committee itself appears willing to adopt a wait and see approach.
“The industry has done a lot of lobbying and met with the Basel III committee, but while they did make couple of changes they have largely said that they will continue to look at the issues,” says the Basel III implementation banker. “In other words they have left a small opening for change if it’s needed.”
“It’s difficult to say at this stage if we will get many changes,” adds Bhatia. “But if you see the linkage of the trade finance component of economic growth and a desire among regulators to make sure economic growth isn’t hindered, logically trade finance should be supported.”
Of course such consultation and reviews will time, during which the cost of trade funding looks likely to rise. StanChart’s views of a 40% increase in financing costs may be somewhat apocalyptic but an increase in the cost of letters of credit looks likely.
That could well force more companies to consider adopting more open account measures of trade financing. This would be good for banks and companies in many ways, making the facilitation of funds much easier via existing accounts.
However trade lending would still be regarded at the same level as other forms of funding from an asset value correlation perspective. Additionally increased open account trade financing could exacerbate the pricing disadvantages already experienced by emerging countries, which rely more on letters of credit and are less likely to adopt open account financing.
It could also force a greater amount of corporate to corporate funding, as larger companies help support the needs of their smaller suppliers.
Global trade is too big and important to be badly impacted by Basel III’s rules. But the new stipulations look certain to drive up costs for a form of funding that is unambiguously positive for growth.
“Basel III as a whole will have two effects across the industry,” says the Basel III implementation banker. “Prices will go up for a lot of things, not just trade, as banks have to raise capital which is expensive and difficult to raise. And if you cannot raise it you have to deleverage and reduce the size of your balance sheet. So there will either be an increase in prices, or a reduction in credit availability or a combination of the two.”
One of the safest forms of lending in the world looks set to get a lot more difficult.