Keeping trade finance flowing: Turning the wheels of Trade

One of the unfortunate consequences of the subprime crisis is that some banks have had to curtail their trade finance activities. This has left others who navigated the crisis unscathed to contend with an increasing level of trade financing expectation from existing and new clients. This second group of banks is having to explore new strategies and partnerships that will free up sufficient balance sheet capacity to meet this demand.

 Unfortunately, regulatory factors do not exactly facilitate this process. Basel II has heavily increased the emphasis on the credit profile of the client via two important regulatory capital concepts:

 - Probability of default, which is closely linked with the client's credit profile;

 - Loss given default, which varies according to the financing instrument used.

 In the case of trade finance, the loss given default is low. However, Basel II is weighted so that greater emphasis is placed on the client's probability of default. As a result, regulatory capital requirements for trade finance are intrinsically slightly disadvantageous.

 In addition, the transition from Basel I to Basel II is something of a minefield for banks when it comes to modelling and data. For example, data on historic trade finance defaults is seldom available in sufficient quantity and granularity to fully support modelling assumptions under the Basel II Advanced Internal Ratings Based (IRB) approach. The net effect is that for a given amount of space on the balance sheet, a reduced amount of trade finance business can be written under Basel II when compared with Basel I.

Possible solutions

 Ways to address these challenges include:

 Constructing a portfolio of counterparties with strong credit ratings: This is theoretically possible, but difficult to achieve in practice, because much of the demand for trade finance comes from smaller corporations that are either modestly rated or not rated at all. Furthermore, in emerging markets (where trade instruments predominate), local banks tend to have lower credit ratings than their Organisation for Economic Co-operation and Development counterparts and therefore intrinsically higher capital requirements.

 Collateral: Under Basel I, the provision of collateral by clients did not reduce the financing bank's capital requirements. By contrast, under Basel II's IRB approach, any collateral provided is deemed to reduce the overall risk. This allows the release of additional balance sheet capacity that can be deployed to write additional trade finance business with the client.

 Risk participation: Sharing the risk of client trade finance deals with third parties such as insurance companies or multilateral organisations, such as the International Finance Corporation (IFC), is another way of freeing up balance sheet capacity. And other banks that are comfortable with a particular client's risk but lack the network or capability to originate trade business directly are often active in the secondary market. This type of risk participation creates balance sheet headroom that allows more business to be written. It also creates client-specific incremental credit appetite because the headroom is created by sharing the client's credit risk with other entities, allowing further business to be conducted with that client without increasing the specific credit risk.

Liquidity Matters

 In addition to balance sheet capacity, liquidity is still an issue for some banks. There are a couple of possible remedies for this:

 Acquiring client operating accounts: If the bank can obtain a client's cash management and transaction banking business, then on a portfolio basis this provides a stable source of liquidity, particularly in comparison with the interbank market.

 Funded risk participation: In addition to vanilla risk participation, some third-party organisations are prepared to provide liquidity-related risk participation, thereby freeing up the bank's balance sheet through risk participation while easing its liquidity position.

The bigger risk picture

 While these various techniques clearly have their merits, they need to be deployed intelligently in the context of the overall risk picture. In the current economic climate, corporate balance sheets are under stress because of depressed sales activity, so from a bank perspective they represent a higher risk. Therefore, banks need to work closely with their clients to gain a deeper understanding of their business models and their financial flows.

 Fortunately, the risk profile of trade finance assists here. As it is self-liquidating and typically short term, both bank credit departments and regulators regard it more favourably than less structured forms of financing, such as overdrafts.

 Appealing as trade finance is in this respect, there is a further opportunity. Much demand emanates from smaller corporations that are more modestly rated or unrated, which increases the overall risk. Therefore, anything that banks can do to coax as many of these trade transactions into the framework of a supply chain finance structure anchored by a robust credit pays dividends from a risk-reduction perspective.

New class of investor

 A further opportunity to increase total trade finance capacity is to expand the demographic of participating investors. Traditionally, the secondary market for risk on trade transactions has been primarily interbank. However, other categories of participant have started to take an interest; for example, Standard Chartered has recently conducted trade finance-related deals with hedge funds and pension funds.

 These new investors either already understand the risks involved or are keen to comprehend them. Companies are reluctant to default on trade obligations because doing so effectively halts their entire operating cycle, therefore one advantage of an investment in trade finance is that it has a lower probability of default than vanilla bank lending, such as bank loans.

 Various vehicles are available for sharing trade finance risk, including collateralised loan obligations, securitisations, credit default swaps and conventional funded risk participation. They can be packaged in a size sufficient to interest large institutional investors - Standard Chartered's $3bn Sealane in 2007 was the first substantial synthetic securitisation of trade finance loans.

 However, products such as securitisations are only viable if the originating bank has a large trade portfolio with a broad geographic spread and industry mix, otherwise investors will have concentration risk concerns. In practice, few banks will have trade portfolios meeting these criteria and those that do will find it challenging to gather all the data from the various countries and provide it to the investors on a regular basis.

 Apart from investors, there is also a need for banks to re-engage with multilateral organisations and export credit agencies (ECAs). In the previously relaxed credit and liquidity conditions, these organisations had taken a back seat because of lack of demand, particularly with respect to short-term trade finance. There was a resulting outflow of short-term trade expertise, so it is difficult to fulfil this business now that there is an appetite for it again as most of the available proficiency is longer term. Fortunately, this situation is starting to improve - for example, Standard Chartered signed a memorandum of understanding with the IFC at this year's G-20 summit for a $1.25bn programme that will generate $5bn-worth of trade flows. Nevertheless, there is still a need for banks in general to be more proactive in this space.

 Another area where ECAs can add substantial value is in collaboration with credit insurers. The credit insurance market is under strain - underlying factors include increasing delays and defaults, and reduced capacity caused by insurers cutting lines or withdrawing from the market altogether. This has had a strong knock-on effect because companies that previously used credit insurance as part of their factoring process have found it difficult to obtain cover and therefore also difficult to obtain liquidity.

 Collaboration between ECAs and credit insurers could remedy this. For instance, ECAs could provide top-up policies to credit insurers so that every dollar of risk approved by insurers would be matched by ECAs.

 The market is looking to banks to provide sufficient trade finance capacity so that global trade can again flow unimpeded. The two most important qualities required to deliver this are collaboration and innovation. Whether it is with new categories of investor, ECAs, credit insurers or multilateral organisations, banks will need to collaborate in order to free up balance sheet capacity for new trade finance origination.

 However, these partnerships will only yield their full potential if supported by innovation, such as the development of new securitisation structures, the fostering of new insurance strategies between credit insurers and ECAs, or the leveraging of supply chain relationships to achieve greater capital efficiency. Banks will only be able to deliver the level of trade finance capacity that their clients require if they can demonstrate such collaboration and innovation.

 This article was contributed by Standard Chartered Bank