With Basel III requirements barely nearing implementation, the Basel Committee on Banking Supervision is already preparing what has been dubbed ‘Basel IV’ in the banking sector. What will the proposed changes mean for trade finance?
Since late 2014, the Basel Committee has published a number of consultation papers proposing a significant revision of the Basel capital rules for banks. While regulators call this process the “finalisation of the Basel III reform package” – rejecting the terminology Basel IV – the industry has coined the term to underline the far-reaching impact of the proposed changes.
What the final amendments to Basel III will involve is yet to be finalised, and the negotiations are dragging out. But the new regulatory agenda will undoubtedly be felt by all banks, including in the trade finance space, as it will affect credit risk exposures.
While Basel IV may be keeping some bankers awake at night, there are also a range of changes that could be favourable, explains Tan Kah Chye, chairman at Singapore-based Capital & Credit Risk Manager (CCRM).
One of the main proposals is that banks will have to scrap their own internal models to calculate capital requirements for big corporates, and follow the ‘standardised approach’. It will mean more standardised pricing for loans for larger companies, while creating more price competition for SMEs.
“For larger companies, banks will have less flexibility when it comes to the amount of capital they need to provide for the money they lend. It’s not necessarily a bad thing, because it means more consistent pricing,” Tan tells GTR. “For SMEs, the banks will have a lot of pricing flexibility. Whether that’s a good thing or not is yet to be seen, but it means that banks have more opportunity to compete.”
The biggest impact, Tan adds, will likely be the proposed requirement for banks to provide capital for credit limits that are not utilised. “Pricing will have to go up; capital charge will have to go up. Banks will need to develop new capabilities to sell down credit limits that are generally not sold today.”
GTR asked three law firms to elaborate on some of the key proposals of the Basel Committee and the potential impact on the trade finance industry.
Trade finance and Basel IV: a missed opportunity?
Sam Fowler-Holmes, associate, Sullivan & Worcester UK
The proposed package of reforms has been met with much concern about the further regulatory burden it will impose and the consequences for many banks in complying with the likely higher capital adequacy requirements. Of particular note are the proposed changes to the risk-weighted asset framework, which will impose restrictions on the ability of banks to use an internal model for calculating regulatory capital in favour of a standardised approach. While these changes are intended to reduce differences in the way in which the internal ratings-based model is applied by banks and to reduce regulatory complexity, these do not appear to have been welcomed by market participants. However, these changes may have some effect in levelling the playing field between those banks that are subject to the standardised approach and those that are subject to the internal ratings-based (IRB) approach.
The proposed reforms under Basel IV do not relate specifically to trade finance nor do they address one of the biggest shortcomings of Basel III (as implemented in the EU by the Capital Requirements Regulation (CRR) and the Capital Requirements Directive) for certain trade finance banks. The issue in question is the restriction on the types of asset that banks adopting the standardised approach can use as credit risk mitigation under Articles 194 to 217 of the CRR.
In particular, these banks cannot use either receivables or physical collateral as eligible credit risk mitigants as these are expressly reserved for banks operating under the IRB approach. This is a significant restriction given that many trade finance structures involve taking security over physical goods that are being financed and/or security over receivables generated by the sale of such goods. The broad brush approach taken to credit risk mitigation under the CRR fails to recognise the significant knowledge and expertise that many smaller trade finance institutions have and places them in a disadvantageous position compared to their counterparts who operate under the IRB approach.
However, the reality is that any proposed measures under Basel IV are going to take time to be finalised by the Basel Committee and then additional time to be implemented at EU level. With Brexit looming large, it is unclear how such measures will be adopted in the UK and this may well open the door for trade finance banks to lobby the authorities (particularly in the UK) for further changes to address the imbalances created by Basel III.
What might Basel IV mean for banks involved in trade finance?
Steven McEwan, partner, and Will Hardisty, associate, Hogan Lovells
We identify five key developments which banks involved in trade finance will need to look out for:
- Floors applied to internal model approaches: The internal ratings-based and advanced approaches first allowed by Basel II offered banks the ability to calculate risk-weighted assets on the basis of their own credit analysis and data. This is now under threat, as the Basel Committee thinks there is “excessive variability in risk-weighted assets”, and wants to impose capital floors based on the standardised approach. However, expect resistance from the EU and Japan, both of which take a more favourable view of internal models.
- Changes to credit conversion factors: Off-balance sheet exposures such as revolving facilities and letters of credit are multiplied by both a risk weight and a credit conversion factor (CCF). If the CCF is less than 100% then it reduces the corresponding capital requirement. Currently, the undrawn part of a facility which can be unconditionally cancelled at any time without notice attracts a mere 0% CCF. The Basel Committee is proposing to increase this to 10%. In addition, the CCF for a revolving facility of 364-day or less currently has a 20% CCF, and a longer-term facility has a 50% CCF. The Basel Committee proposes that both should be increased to somewhere in the range of 50% to 75%, imposing a significant capital charge on banks engaging in short-term lending.
- Exposures to other banks: Trade finance banks traditionally rely on unfunded risk participations by other banks, in order to reduce their risk-weighted assets. Going forward, these participations will be caught by the Basel Committee’s proposals for a more risk-sensitive approach to exposures to other banks. For rated exposures, additional due diligence on the participant will be required, which may increase the risk weight. Unrated exposures, and exposures in jurisdictions where ratings are not allowed to be used, will be risk-weighted according to how well the participant is performing under applicable bank capital rules.
- Currency mismatch add-on: The Basel Committee is proposing a 50% capital add-on to address the increased credit risk that arises where a loan made by the bank is in a different currency from the borrower’s main source of income. This will apply unless the borrower has a natural or financial hedge against the foreign exchange risk arising from the mismatch.
- Exposures to sovereigns and multilateral development banks: The Basel Committee has said that it is reviewing whether exposures to sovereigns and multilateral development banks (MDBs) should be subject to a higher risk weight than the current 0%. If a higher risk weight were to be applied to these exposures then the benefit that trade finance banks can obtain from risk participations and guarantees provided by governments and MDBs will be correspondingly reduced.
Basel IV: Shaping the future of trade finance
Omar Al-Ali, partner, Simmons & Simmons
For the EU, Basel IV is an opportunity to shore up any remaining weaknesses in the financial services regulatory system; whereas for banks, including those offering trade finance, it is the final opportunity to correct perceived errors in the manner in which certain products have been treated by that regulatory system.
Over the past two years, institutions offering trade finance and industry bodies have submitted numerous responses to the Basel Committee’s proposals. Some of the key changes being sought in relation to trade finance products are:
- a reduction to 0% in the CCF (credit conversion factor) for uncommitted trade facilities – the current proposal to increase the CCF in relation to unutilised “commitments” that are unconditionally cancellable fails to recognise that unlike in other areas of finance, banks would typically be able to unconditionally refuse to make advances and/or issuances under uncommitted trade facilities,
- a lower risk weight than 120% for commodity trade finance – the current proposal to take a borrower-specific approach to this area of trade finance fails to recognise its structured nature and the fact that the bank’s exposure will typically be at least 100% collateralised,
- an exemption from the leverage ratio calculation from the ECA-backed portion of any transaction – this has already been accepted by the Basel Committee in part (which is encouraging), but currently only if the exposure is in the ECA’s domestic currency. The Committee could go further and apply this to exposures in any currency.
The Committee continues to face a huge challenge in trying to produce a set of rules that treats all institutions and the multitude of products in the market fairly. It is therefore hardly surprising that this has been a lengthy and iterative process. However, if this is indeed the last chance that the trade finance industry has to persuade the Committee to “get it right”, then it is important that these and other changes proposed by the trade finance community are addressed. If not, then there is a real risk that the cost to banks of offering these products will lead to one or more of the following:
- banks being driven away from offering certain trade finance products;
- an increase in financing costs for borrowers; and
- certain borrowers (especially SMEs) being refused access to trade finance,
all of which would be an unfortunate and, one would hope, an unintended consequence for what is a statistically low-risk asset class. On the other hand, if these issues are addressed, it should serve to make these products cheaper to offer and thus more attractive to banks, resulting in easier access for borrowers.