Industry experts are concerned that impending regulation will obstruct the route to global recovery unless it is modified to make allowances for trade financing. Writer John Beck

In the immediate aftermath of the financial crisis, international trade suffered enormously. Even some of the biggest corporations could not obtain letters of credit for simple cross-border transactions, and exports were driven down by more than 10% in volume terms - the biggest contraction of its kind since the Second World War.

Much of the blame for this precipitous drop can be apportioned to broader economic woes, but the World Bank estimates that 10% to 15% was caused by a lack of available trade finance, which is behind as much as 90% of world trade. Despite the massive contraction in the need for trade finance, its availability retreated even further due to banks exiting the market as short-term trade obligations were liquidated in an effort to reduce their balance sheets. This shortfall reached between $100bn and $300bn in March 2009, according to World Trade Organisation (WTO) and World Bank estimates.

Things have improved dramatically since then and world trade has been staging a vigorous recovery of late. But it has yet to regain its former heights, and upward movement slowed significantly in the second half of 2010. Banks, businesses and industry bodies are now concerned that if impending regulation is not modified to make allowances for trade financing, international business - vital to securing a return to global growth - will once again be stymied by a lack of available funding.

Specifically, the proposed third iteration of the Basel Committee on Banking Supervision's Basel Accords has raised fears among bankers that trade financing could become prohibitively expensive. And the impact on the global economy could be massive - as much as a $270bn (1.8%) reduction in international trade flows and 0.5% reduction in global gross domestic product (GDP), according to estimates from Standard Chartered.

As recent headlines attest, bankers and trade bodies alike are concerned about stringent new capital requirements and planned global standards for leverage and liquidity proposed under Basel III, which, they claim, will increase the amount of capital banks have to set aside for trade finance, making it a far less attractive business proposition.

At no point are we saying Basel III is bard for trade per se, or has done something bad to or singled out trade... The point is it is not favouring trade

Stuart Nivison

As a result, larger banks may cut back trade finance operations, and smaller banks could be forced out of the market entirely, warns Bruce Proctor, global supply chain and trade executive with Bank of America Merrill Lynch. "If Basel III is implemented as proposed, then with the cost of compliance and regulation added in, pricing is going to rise. Capital will become more important as a factor across the board, so it's a matter of where best to deploy it based on returns, and trade financing may not be the best place to do so for many banks."

Capital needs

Under the new rules a leverage conversion factor of 100% is assumed, meaning banks would be required to hold capital against the entire value of a trade finance lending commitment, up from the current prerequisite of 20% under Basel II - itself an increase of 10% from Basel I. Bankers argue, however, that holding adequate capital reserves to cover every trade obligation is not necessary when the probability of having a default is much less.

The principle is that off-balance-sheet (OBS) instruments could be a significant source of leverage for banks, and should be considered in an institution's overall list of obligations and limited. But planned leverage ratios will not account for the risk profile of a loan, so lower risk trade obligations - such as bonding or letters of credit - may be caught up with other, riskier, OBS instruments.

If implemented as it currently stands, Standard Chartered's managing director and global head of trade product management, Ashutosh Kumar, predicts Basel III could lead to a 6% reduction in global trade finance capacity, as well as an increase in pricing of as much as 40%. And the true damage could be even worse because demand will continue to increase, says Mr Kumar. "While supply will go down by 6%, demand will go up by much more, so the real impact will be much higher."

The financial industry is nothing if not resourceful, however, and should this happen, Mr Proctor suggests that because the regulations will only apply to banks, other providers in the market who would not fall under the same regulations might provide financial support for trade activities.

Paul Simpson, global head, treasury and trade solutions with global transaction services at Citi, suggests instead that national agencies would have to step in to provide help. "We'd probably look to use government-related programmes a lot more if life were to evolve to that place. You would see governments step in and probably even provide larger-scale programmes much more frequently, simply because they'd have to."

Collateral damage

This would hardly be an ideal solution for the market and, in any case, the aims of Basel III are to safeguard against another financial crisis by making sure institutions fully account for the capital and costs associated with all the lines of business they are engaged in, not to penalise trade financing. But the danger is that such operations are caught up in regulation that was never intended to encompass them. "At no point are we saying Basel III is bad for trade per se, or has done something bad to trade or singled out trade," says Stuart Nivison, head of trade and supply chain for Europe at HSBC. "The point is it is not favouring trade."

As a result, major trade finance providers, including HSBC, Standard Chartered and Citi, are lobbying to secure less stringent capital rules and specific provisions for trade finance.

"We are active in talking to all the relevant parties," says Mr Nivison's colleague Alan Keir, group general manager and global co-head of HSBC's commercial banking division. "We believe it is important to encourage international trade. We believe that letters of credit and most forms of trade finance are a productive tool underlying economic transactions, and that is something that we want to see encouraged and recognised."

Mr Simpson adds that Citi is engaging with relevant regulatory bodies and has been providing extensive feedback on Basel III in an attempt to highlight the dangers to world trade. "There is a real need to educate, but we've had a good hearing… We will continue to provide feedback, real live transaction details and client-to-client details, so everyone is completely operating from the same base," he says.

In unison

The banking industry does appear to have pulled together on the issue, along with organisations such as the WTO. The International Chamber of Commerce (ICC) together with the Asian Development Bank, for example, has created a register of 5.22 million trade finance transactions conducted around the world by nine international banks over the past five years. For the first time, the industry has empirical data to present to regulators on the average duration (115 days) of a trade finance deal and on total default rates (which amounted to just 1140).

Mr Simpson adds that Basel III is not due to be implemented until 2019 in some cases and is already very different from initial proposals. Banks are at pains to point out that a two-way dialogue with the Basel Committee for Banking Supervision is taking place.

And the committee is taking note, says its secretary-general Stefan Walter. "The Basel Committee is assessing the treatment of trade finance with a particular focus on access for low-income countries, while at the same time ensuring the integrity of the broader financial stability agenda agreed by the Basel Committee and endorsed by the G-20."

Emerging issues

The issue may well be less of a danger than the disquieting statistics suggest. However, it is not just the potential future shape of Basel regulation that is causing concern in the world of trade finance. For some, the existing iteration poses problems of its own.

The Basel Committee is assessing the treatment of trade finance with a particular focus on access for low-income countries, while at the same time ensuring the integrity of the broader financial stability agenda agreed by the Basel Committee and endorsed by the G-20.

Stefan Walker

The balance of power in the trade landscape is shifting drastically with Asian trade booming and emerging markets - pinpointed as vital for global recovery - growing in importance. And it is not only the usual suspects of China and India; a whole swath of emerging market economies are appearing, for which trade finance is going to play an increasingly prominent role, says Mr Keir. He points to markets such as Turkey, Vietnam, Egypt and South Africa, where businesses are increasingly looking to take advantage of growing trade connections. Even in eastern Europe, countries such as Poland and the Czech Republic have doubled their share of trade over the past decade.

However, trade-flows towards these developing economies have already suffered under the existing Basel II regime, thanks to risk-weighting rules, says Marc Auboin, economic counsellor with the WTO, who was not speaking in his official capacity.

This is partly due to the relationship between country risk and counterparty risk under Basel II's harmonised approach, which essentially ensures a counterparty cannot be better rated than the sovereign, he says. Arguably, such a framework does not always make financial sense. Pakistan, for example, has defaulted on its sovereign obligations many times since gaining independence, while the major Pakistani banks are much less likely to default. Despite this, however, a bank cannot be rated higher than its parent country. "You have countries which have been suffering sovereign defaults, creating a sovereign debt overhang, and that has an impact on the cost of financing for counterparty banks in these countries. They have jumped into global supply chain financing and then seem to have lost access to it, and that's something which worries us," says Mr Auboin. "Whether it is completely linked to regulation is open to question, but because of that, firms may have less interest in doing finance in Africa, say, where the cost of capital is higher because the sovereign rating is lower."

Moreover, for larger banks with a model of accessing risk that allows them to circumvent rating agencies, a one-year maturity floor is required when providing capital on short-term trade finance bills such as letters of credit. When ICC data points to the average letter of credit as having a duration of 115 days, there is arguably as much as a threefold over-capitalisation by large banks of trade bills, says Mr Auboin. And customers will bear the brunt of corresponding price increases.

Continuing difficulties

While many argue that liquidity has returned to the roots of international trade, small and medium enterprises in some countries still have great difficulty in accessing trade finance at a reasonable price, and developing and emerging markets are certainly suffering despite recent progress, treasurers say. "I can see that the situation is stabilising and we have enough access to financial sources when it comes to quantity. The price is another question," says Jiri Kovar, CEO and general director with Czech industrial automation firm UNIS. "It is expensive and that could be dangerous. Compared to the Eastern market, it's acceptable, but it's difficult to approach Africa or the Middle East with the price of money in this area. [Banks are] giving money out now much better and we can get financing easier, but the high interest rates and any other fees relating to financing are not going down quickly enough. There was a very good case to increase all these costs in the first place, but all banks are now reluctant to reduce prices again."

The overall mood may be positive, but much is still to be done if trade is to be safeguarded across the world. Striking a balance will be tough, however. Regulators and banks must work together closely to develop the right reflection of risk in a transparent manner and produce guidelines for holding the right amount of capital on balance sheets against that risk. At the same time they must safeguard transactions such as trade finance, which contribute so much to underlying economic activity.

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