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Asia-PacificMarch 1 2013

Basel III reshapes trade finance

As Basel III regulations come into play, banks looking for a quick fix to bulky balance sheets are divesting their trade finance assets, creating a gap in the market that investor groups and other alternative financiers are keen to fill.
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Basel III reshapes trade finance

The updates to Basel III earlier in 2013 provide little relief from the headache the regulation is causing commercial banks involved in trade finance, but a remedy may not be far off.

With the anticipated rise in the cost of capital under the key ratios of Basel III, banks are being compelled to shrink their balance sheets, with trade finance taking the hit. But as banks shed their trade finance assets, liquidity-rich, risk-averse investors looking to invest in asset classes that are relatively immune to market instability are paying close attention, as are alternative financiers. This reshuffle of the trade finance market is causing some anxiety about shadow banking, but also cautious optimism that the market may adapt to a new normal structure from which banks, investors and corporates can benefit.

New asset class

Bruce Proctor, head of global trade and supply chain finance at Bank of America-Merrill Lynch (BAML), says there are a number of investor groups, such as hedge funds and sovereign wealth funds, for instance, that are looking to invest in new assets that are not impacted by interest rate or stock market volatility.

“They may consider trade finance to be an asset class they can balance against a fixed-income or equities portfolio, or other types of investments. It may be a good complement to investment portfolios that previously have been weighted toward the longer term,” says Mr Proctor.

For Tod Burwell, chief executive of international transaction banking trade body BAFT-IFSA, there is “definitely a possibility” of using trade assets as a balance to long-term asset portfolios. BAFT-IFSA, through its Global Trade Industry Council, is working to define individual trade products as their own asset class to find consistency in the product definition, risk parameters, documentation, types and behaviour of the assets.

Why trade finance?

Trade finance in particular has been a casualty of the unintended consequences of Basel III at some banks. This asset class tends to be more short term compared with other lending activities. The average tenor of trade finance is between 80 days and 147 days, according to the International Chamber of Commerce. For capital-constrained banks, shrinking the size of their balance sheet by divesting short-term commitments is one of the easiest ways to downsize, says Mr Burwell. 

Even if a bank is not capital constrained, it still needs to decide how to best deploy its capital under Basel III.

Off-balance-sheet trade finance, along with other off-balance-sheet items, will have to be incorporated into the calculations of the leverage ratio, and thus are assigned a 100% credit conversion factor. As trade is considered low risk, the returns, compared with other business lines, are also smaller and the margins thinner. Capital costs for banks in trade finance are expected to increase by 18% to 40%, according to BAFT-IFSA.

“So if the capital that is being applied to the activity of trade is the same as for any other type of lending that generates a higher return on the same capital, then banks may choose to deploy their capital for those types of assets and not so much for trade finance,” says Mr Burwell.

Banks will either have to reconstruct their business models, or some of the costs will be passed on to businesses, especially small and medium-sized enterprises (SMEs), and emerging market financial institutions – “the parts of the market that depend most heavily on trade finance and also the ones driving economic growth”, says Mr Burwell.

Run-off rate

The latest update to the Basel III regulation in January 2013 already acknowledges to some extent the individuality of trade finance assets. In particular, the liquidity coverage ratio (LCR) requires banks to assume certain levels of outflows or drawdowns on lending facilities – the run-off rate – in a liquidity stress scenario. The assumed run-off rate for conventional lending to non-financial corporates is 30%. But the suggested assumption for trade finance is very different.

According to the update, “in the case of contingent funding obligations stemming from trade finance instruments, national authorities can apply a relatively low run-off rate (for example, 5% or less)”. This appears to give national regulators a great deal of discretion, potentially even to assume no run-off rate on trade finance at all.

However, the Basel Committee also says that “lending commitments, such as direct import or export financing for non-financial corporates, are excluded”. This means that direct corporate lending not using trade finance structures with underlying physical receivables would be subject to the 30% assumption, even if the loan was intended to finance trading activity.

Mr Burwell say the EU is considering a solution to the unintended consequences of Basel III under its region-specific customisation of the rules, the Capital Requirements Directive IV. This would appear to make sense due to the fact that fewer than 3000 defaults in 11.4 million transactions happened between 2009 and 2011, according to the International Chamber of Commerce. In this period, “default rates for off-balance-sheet trade products were especially low, with only 947 defaults in a sample of 5.2 million,” it stated in a report published in 2011.

This explains the frustration market participants feel as many questions remain unanswered with regards to off-balance-sheet items. Christophe Salmon, chief financial officer for Europe, the Middle East and Africa at commodities trading and logistics group Trafigura, says that the minimum capital requirement based on a minimum one-year tenor is a burden to trade finance activity as its turnover rate is considerably faster.

Commodity trade finance, which has been under pressure with the recoil of large commercial banks, followed by an influx of new entrants in recent years, could see some damage due to shortcomings under Basel III, warns Mr Salmon.

“Letters of credits, stand-by letters of credits and letters of indemnity are very common in commodity trade finance. If they need to be included in the Basel III ratios [the liquidity coverage ratio and the overall leverage ratio], it could negatively impact trade finance activity,” he says.

Time for a makeover?

BAFT-IFSA is now working with the banking community to define asset classes in a “consistent fashion” to provide a clear overview to potential investors and to make it easier for banks to expand their investor base, according to Mr Burwell.

“The banking industry is asking how it can make trade finance for non-bank investors more attractive to unlock additional liquidity because there is a growing concern that banks alone may not be able to meet the demand of a growing global trade market,” he says.

“For many years, banks have been doing secondary market sales of assets that they originate to continue to provide liquidity to the market without doubling or tripling their balance sheet. That is usually with other financial institutions. Now they are looking at other potential sources of liquidity but we need to determine the terms and conditions.” 

One possibility could be to tap into capital markets, says Mr Burwell, although the discussions are still in the early stages, looking at matching the potential investor base and its needs with the characteristics of the trade assets themselves.

BAML, for instance, has recently become involved in distributing longer term loans backed by export credit agencies into the capital markets. These credits usually last between 10 and 12 years, sometimes longer. This is an alternative to keeping long-term assets on the books, according to Mr Proctor. Those credits can then be re-issued as bonds or longer term notes, or as other instruments to a broader investor base – an “interesting development”, as Mr Proctor describes it.

This would not only allow non-banks to be active on the origination side, but borrowers would be able to access a deeper pool of funds. The capital markets units of most banks already have this capability, so marrying a traditional bank product with a more flexible capital markets approach is a change that will benefit many clients at a time when it is difficult to find a broad number of banks willing to take on long-term assets, according to Mr Proctor. As the credit guarantee is backed by a sovereign borrower, the credit risk that underlies those transactions should be relatively manageable.

“This type of export credit agency financing has been around for a long time, but has been really based on a ‘book and hold’ approach among commercial banks. The ability to direct these deals into capital markets structures is fairly recent and will help to broaden the potential investor base for these credits,” says Mr Proctor.

Export intermediary

Export credit agencies have become increasingly involved in trade finance in the past three to five years, according to Mr Burwell. As data from Dealogic shows, trade finance deals backed by export credit agencies soared by 96% to $78.4bn during the first nine months of 2012 compared with the corresponding period a year ago. This contrasted with the overall slump in global trade finance, which in the first three-quarters of 2012 declined in value by 8% to $123.9bn compared with the same period in 2011. But in a trade forecast from February 2012, HSBC predicted world trade would soar by 86% in the next 15 years to $53,800bn.

It is clear and understandable, therefore, that where traditional providers retreat, alternative providers are quick and keen to step in.

The shrinking balance sheets among many banks has given rise to activity in export trade finance among organisations such as the World Bank’s International Finance Corporation (IFC), which has a particular focus on relations between banks in emerging economies that require financing for their corporate clients’ trading activity and lenders who want the deals to be backed by the security that IFC offers. Others examples are the trade facilitation programme by the European Bank for Reconstruction and Development, which has been available since 1999, and the Export-Import Bank of the United States, with which BAFT-IFSA works closely.

“[Export-Import Bank of the United States] has seen three years of consecutive growth in its participation in export finance deals and has even extended to SMEs – a departure from historical use of export finance products, such as for aircraft deals or capital goods,” says Mr Burwell. But he expects a limit to how much capital those organisations can contribute to growing global trade, which is why a clear definition of trade finance assets may help in the future to tap into new investor bases.

Commodity trade finance

On the other side of the trade finance spectrum, commodities finance, especially for large trading houses such as Glencore, has been making the news in recent years. First, Crédit Agricole announced it would cut lending in the commodity trade finance market as US dollar liquidity became scarce. The other few European banks that led the market followed suit, becoming more selective in the type of clients they wanted to finance, according to an industry expert.

“At the same time [as the big banks’ retreat], there have been newcomers to the sector, which are much more regional; banks in the Gulf, Latin America, south-east Asia, for instance, that can accommodate the flows. But these banks have not got the expertise, so they tend to partner with more traditional commodities banks,” says the expert. Such examples are banks from Qatar, Bahrain, Jordan, Saudi Arabia, the United Arab Emirates, as well as some lenders that have a strong presence in Asia, such as Standard Chartered and DBS.

There also has been a comeback of large institutions from the US. “Historically, they were the active banks in trade finance, but not so much on commodities. There has been a big push now,” says the expert, who adds that his firm has noticed more and more syndicated facilities whereby the expert commodity banks, often based in the Netherlands, UK or France, syndicate a facility to a regional bank.

Europe’s drastic change

Although the main eurozone banks active in commodity finance returned to the market earlier this year, the fast changes in the market highlight its attraction to new entrants. As trade is essential to many clients, growing emerging market banks and alternative providers are keen to offer this service to build their client base.

Trade finance is also an attractive asset class because its default rates are low, according to Mr Salmon. Even developing countries tend to prioritise their payment obligation for commodity flows, such as oil, because a default will put them on a blacklist, but even in the case of defaults, there are high recovery rates, he says. Trafigura sees more institutional investors interested in this asset class and is at advanced stages to structure some commodity repos (instruments used to raise short-term capital), that would be financed by institutional investors.

“The challenge is that there is an obvious mismatch of maturities – investors want to invest their money on a long-term basis [three to five years]. The inventory flows that are underlying materials are much shorter term, turnover is every 60 to 90 days. So we need to size these structured repos adequately to make sure we can replenish the materials going out from our structure,” says Mr Salmon.

Although the maturity mismatch cannot be remedied, it is an issue for Trafigura, not the investors, says Mr Salmon. “We just need to make sure we constantly have enough material to put into the repo structure, otherwise you pay for nothing.”

The banks, Mr Salmon adds, still play a role in these new trade finance structures. “They can manage the collateral [the inventory] for the benefit of the investor, or wrap up the risk by partially or totally guaranteeing the structure in case of a liquidation scenario,” he says.

However, Kamel Alzarka, chairman of alternative financier Falcon Group, says that if the likes of pension funds and insurance companies ever decided to lend to corporates directly, they might eventually disintermediate banks – although he too emphasises that this is not the intention of alternative financiers and that banks will continue to have a role in the market. He says that alternative financiers could complement bank offerings. For him, alternative financiers are the new normal of trade finance. Indeed, both Falcon Group and Trafigura have been approached by banks to partner up, and Mr Alzarka says this is something the group may consider in the future “when it makes sense for us to do [so]”.

For now, Falcon Group seems to be fine on its own feet. The first 10 years were a challenge after forming in 1994, when its balance sheet was understandably smaller than that of traditional trade finance providers. But the past five to six years have been especially fruitful as the financier has benefited from the shrinking balance sheets of larger and traditional trade finance providers.

Today, it has the mass to fund directly: Falcon Group’s current book value stands at $1.7bn and it has 800 transactions on its books. Its clientele includes small companies with more than $100m in turnover, as well as publicly listed companies with market caps of $3bn or more, and it has been catering more and more towards medium to large companies. The Middle East accounts for 40% of its business, while business in Asia has been increasing in the past five to six years. It is also seeing “significant” growth in the Americas and southern Europe, especially Ecuador, Mexico, Germany and Spain.

Rising in the shadows

The rise of such alternative financiers – often referred to as shadow banks as they do not need to adhere to the same regulations that apply to commercial banks, such as Know Your Customer and Anti-Money Laundering standards – remains a worry for some in the industry, says Mr Burwell. But in the case of Falcon Group, for instance, the organisation decided to comply with the Dubai Financial Services Authority stipulations to be prepared for potential regulation later. In practice, few significant financial institutions would risk the potential penalties of ignoring Anti-Money Laundering standards. The more sustained advantage for alternative providers will be in their exemption from Basel capital and liquidity requirements.

Mr Proctor highlights that investment banks Goldman Sachs and Morgan Stanley obtained commercial banking licences in 2008, allowing them to provide trade finance services. Such alternative providers may not necessarily be cause for concern, it seems. “This may result in some new instruments and types of financing that are provided. If this helps expand the market, bring new offerings and give rise to new technologies, it will be a positive consequence. I do believe that trade as an asset class would be attractive to investors, but traditionally, they did not have access to it. [Now] it would be a win for clients, banks and certainly to investors.”

Mr Burwell “cautiously” agrees, but emphasises that the industry remains concerned about regulation and deglobalisation of regulation. “If regulations vary from jurisdiction to jurisdiction, there will be an unlevel playing field for global trade finance providers. This means there will be an unlevel playing field and deviation from risk mitigation for some types of deals. That ultimately can hurt the industry and change the overall low risk profile of trade finance,” he warns.

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