Planned changes to UK capital requirements rules would significantly increase costs for some trade finance instruments and exacerbate the trade finance gap, a global coalition of banking industry associations has warned.

The UK’s Prudential Regulation Authority (PRA) last year published its plans for implementing capital requirements standards formulated by the Basel Committee, including new treatment of guarantees, letters of credit and purchased receivables.

The regulator’s proposals go further than what is likely to be implemented by the European Union and in some respects would make the UK an outlier, the industry groups warn in a joint submission to the PRA’s consultation.

The PRA has said it intends to lift the conversion factor (CF) for performance guarantees and “guarantees not having the characteristics of direct credit substitutes” to 50%, up from 20% under the UK’s current capital requirements regulations, which are derived from the EU’s Capital Requirements Directive. The conversion factor calculates the risk that a bank will have to pay out under a commitment such as a guarantee or letter of credit.

The lobby groups – including the International Chamber of Commerce (ICC), International Trade and Forfaiting Association (ITFA), Bankers’ Association for Finance and Trade (Baft) and UK Finance – warn such an approach would lead to a 150% jump in capital costs.

Banks will pass those costs onto users of guarantees, with the per annum price of a £10mn performance guarantee climbing from £120,000 to £300,000 if the plans go ahead, the groups’ submission says.

The Basel committee’s 50% CF figure was arrived at in the 1980s, the groups say, and more recent data shows that the current level of 20% sufficiently accounts for the actual risk profile of performance and financial guarantees.

A recent updated study by the ICC and the Global Credit Data, which includes data from 17 mainly European lenders, shows that between 2016 and 2020 only 0.2% of performance guarantees were ultimately paid out by their issuers. The figure for financial guarantees fluctuated between 1.2% and 2.7% over the same period.

The submission argues that if implemented, the PRA’s reforms could exacerbate firms’ difficulty in accessing trade finance. “Capital constraints are a contributor to the existence of the trade finance gap, which also links to a widely acknowledged financing gap for small and medium enterprises,” the submission says.

The most recent estimate of the global shortfall in trade finance supply compared to demand was US$1.7tn.

Scott Stevenson, Baft’s senior vice-president for trade, says in a separate response to the PRA consultation that some of the regulator’s plans “will lead to higher capital usage, and therefore will lead to an increase in pricing to a bank’s clients including corporates and SMEs”.

“Of particular concern is the potential negative impact on the competitive position of UK exporters due to their extensive use of export letters of credit,” he writes.

The European Commission also proposed a similar hike to capital requirements for guarantees and other trade finance instruments in 2021, but a concerted ICC-led lobbying campaign convinced member states to maintain current levels, with the bloc’s parliament set to follow suit. The Commission has since indicated it will not oppose the reversal.


Going beyond Basel

Debate over the implementation of the Basel standards in the EU has largely been divided between countries which are prepared to consider deviations from the committee’s formulations, and those which insist on strict compliance.

Pan-EU regulators such as the European Banking Authority and the European Central Bank have criticised indications that EU law making bodies are planning to carve out exceptions to the standards, such as on trade finance.

Mirroring arguments deployed in EU lobbying, the industry associations say that the features of trade finance require deviations from the Basel text.

Their submission argues: “While it is acknowledged that it is difficult for authorities to bestow differentiated regulatory treatments to a large number of financial sector products or lines of business, we believe that the unique characteristics of trade finance have been well and objectively demonstrated in the research, analytics and advocacy work conducted over the last several years.”

One area where the Basel framework allows national governments to use their discretion is an exemption which permits lenders to apply a zero risk weighting to off-balance sheet commitments involving some corporates and SMEs, effectively meaning that no capital has to be held in reserve.

The PRA explained in its consultation that it does not intend to take advantage of that discretion because “it considers that there is still a possibility of arrangements becoming on-balance sheet exposures where a contractual relationship exists” and applying zero risk weighting “would be inconsistent with the risk and could result in imprudent outcomes”.

The industry groups say that view puts the UK at odds with other national regulators, will lead to higher risk weights across trade finance, and hurt “market access to these products” and the “associated effects on economic and development activities they enable”.

The lobbying group’s submission also warns against the PRA’s plans to go beyond the Basel framework by placing a 50% CF for some financing commitments which are not unconditionally cancellable.

In that scenario the pricing on a 50% utilised £10mn 120-day trade loan, for example, would increase from £140,000 to £150,000, putting pressure on relatively thin trade finance margins. “When aggregated across a broad spectrum of trade finance products and banks, the market impact is likely to be significant,” the submission argues.

“UK banks and the UK companies they support will be placed at a competitive disadvantage,” the groups claim, because other regulators are choosing to align with the less onerous Basel standards.


Letters of credit and maturity

The PRA has opted to follow the Basel standards on self-liquidating letters of credit. It has posed a 20% CF for letters of credit with a maturity of less than one year, and 50% for those with a tenor of more than one year.

The groups say this runs counter to data from the ICC’s Trade Register, which it says shows that the current CF “is reflect[ive] of the true underlying risk” for letters of credit.

The Basel framework for trade finance “needs a relook based on up-to-date empirical data collected by the industry”, the submission says.

Among other concerns described in the submission, the industry associations also say that the PRA’s proposal to introduce a one-year effective maturity for purchased receivables – a significant extension of the current 90-day minimum – would “have an impact on pricing” and encourage a switch to less secure overdrafts.

The ICC’s Tomasch Kubiak tells GTR: “We believe the data presented from the ICC Trade Register establishes a compelling case for reconsidering the UK’s proposed treatment of trade assets. We look forward to further constructive dialogue on this agenda with the PRA.”

The PRA took into account the Trade Register data but not an April 2022 study on the credit risks of guarantees when drawing up its consultation on Basel, according to a Freedom of Information disclosure to GTR in January.

The PRA consultation closed in March but it is not yet known when the PRA intends to respond to the feedback it has received, although it is understood it will not publish the responses in full.

It has previously said that apart from measures covered by transition periods, the new rules will go into effect in 2025.