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Banks in the EU are gearing up for the implementation of new capital requirement rules when Basel 4 takes effect on January 1 next year, but doubts remain over the treatment of key trade finance products.

Even though the deadline is just days away, there are still differing interpretations of capital rules for medium- and long-term trade finance guarantees and concerns about the impact of the reforms on banks’ use of credit insurance.

Regulators require banks to put aside capital as a buffer against financial shocks, and Basel 4 is the latest set of regulations crafted by the Basel Committee on Banking Supervision, a group of global financial regulators, in the wake of the 2008 financial crisis. But the rules have an impact on the broader economy because banks prioritise lending toward products with lighter capital requirements.

Banks last year were spared what they said was a potentially significant blow to trade finance when the EU decided not to implement parts of the Basel framework that would have more than doubled capital treatment for off-balance sheet trade finance instruments.

The climbdown meant that capital requirements on common trade finance products, such as guarantees, warranties and standby letters of credit, will remain the same. But the release of the final text and a European Banking Authority (EBA) consultation this year have reopened parts of the debate.

These are the key sticking points.

 

Uncertainty over guarantees

Over the course of 2024, EU banks have become concerned that the wording of the regulations could force them to more than double the capital requirements on trade finance guarantees with tenors exceeding one year.

While the updated Capital Requirements Regulation (CRR3) includes guarantees among the products subject to current – and more favourable – capital ratios, it separately defines trade finance as “of fixed short-term maturity, generally of less than one year”.

This has prompted some banks to ask whether that means guarantees with a longer maturity should attract a higher credit conversion factor (CCF) of 50%, rather than the 20% applied to other off-balance sheet trade finance products. CCFs denote how much capital should be held in reserve for a particular exposure, so a US$10mn guarantee with a 50% CCF would attract US$5mn in reserve capital.

A jump to 50% would have the effect of more than doubling the amount of capital banks need to put aside when issuing guarantees for customers.

Guarantees are particularly important tools for banks that support exports related to large overseas projects or supply contracts and are widely issued by lenders in countries such as France, Germany and the Nordics.

Several Nordic lenders have interpreted CRR3 as requiring a 50% CCF for guarantees with a duration of more than a year, market sources say, but most are waiting until next year to determine whether or when they will need to pass on the greater capital cost to their customers.

Asked during a panel discussion at GTR Nordics in November whether Basel will prompt banks to raise prices on guarantees they have already issued, Handelsbanken’s head of trade finance in Sweden Stefan Carleke said it was unlikely.

“That is not so prudent. That, I think, will be very, very difficult, and it will affect the relationship [with the client] for sure,” he said, but acknowledged that potential pricing hikes due to Basel is “a hot topic”.

Most banks elsewhere in the EU are set to continue applying a 20% CCF to all trade finance guarantees unless regulators say otherwise, according to International Chamber of Commerce (ICC) policy manager Tomasch Kubiak.

 

Banks awaiting answers from regulators

Industry efforts have been underway during the year to get the European Commission or European Banking Authority to clarify what capital requirements medium- and long-term guarantees should attract, and to persuade them that guarantees should be considered trade finance instruments no matter their maturity.

A Commission spokesperson tells GTR it “is aware of the issue, which is being discussed in the context of implementation work by the [EBA]. We do not have further comments at this stage.”

As part of the advocacy push, the ICC Banking Commission in September published a “definition of trade finance” that says “guarantees are considered as trade finance instruments… regardless of maturity” if they involve an underlying trade transaction.

The ICC, which is comprised chiefly of banks, says its Banking Commission’s steering committee had noted that “there is no consensual agreement on the definition of ‘trade finance’ by regulators on a global basis”.

“The concern is that a misleading and oversimplified definition of trade finance may result in unintended negative consequences for the business. For instance, tenor, maturity, and destination of goods are not elements to define what is trade finance.”

The ICC’s Kubiak tells GTR that the ICC “is hopeful that this message has been heard” and that “there’s going to be some kind of clarification coming from either [the Commission] or the EBA, or that would… avoid this blurry question mark that some have”.

 

An EBA document caused confusion

Despite banks avoiding the proposed spikes to off-balance sheet instruments initially proposed by the EU, a consultation issued by the EBA in March this year led to new debates with the regulator over capital treatment for specific trade products.

The EBA’s draft regulatory technical standards on off-balance sheet instruments, which is designed to help banks follow CRR3, included proposals for the classification of some trade finance items that drew criticism from trade lenders.

Among other things, the provisional guidance says that to continue benefitting from current capital rules, documentary credits must be collateralised by shipping documents. But respondents, including banking associations from France and Italy, argue that the wording of CRR3 does not stipulate collateralisation.

The ICC argued that the EBA had exceeded its mandate. “There is a risk… that some aspects of the draft [regulatory technical standards] are fundamentally changing the current allocation of off-balance sheet items in a way that was not intended by the Basel Committee” and the EU, it said in a consultation response.

Sweden’s banking association simply argued “that all trade finance off-balance sheet items shall be allocated to [20% CCF] since this is the intention of the CRR3 level 1 text”.

The EBA has until June to release a final version of the standards, and a spokesperson says it expects to meet the deadline.

 

Impact on corporate lending and credit insurance

Capital requirements on lending to unrated corporates will increase for many banks under the new rules.

In a possible harbinger for what EU financial institutions may face, several sources have told GTR that after Japan implemented Basel 4 in 2023, Japanese banks struggled to compete with foreign peers on some corporate lending products.

But the impact on EU banks will also depend on whether banks used internal models, which are being heavily curtailed under Basel 4, to calculate their capital needs, as well as their business models and what types of lending they provide.

Martin Neisen, a partner and global Basel 4 leader at PwC, says the consulting firm’s analysis suggests the impact on banks could vary as widely as a 15% decrease in capital requirements all the way to a 25-30% jump in risk weighted assets.

As a result, banks are exploring ways to shrink their capital burden. “We have never seen such an active syndicated loan market as in the last two years, and securitisations are back on top of the agenda,” Neisen tells GTR, “and that is because banks start to prepare for Basel 4”.

Banks’ use of credit insurance may also be dampened by the new rules, which end their ability to model the credit risk posed by exposures to insurers, including through insurance policies.

An EBA report in September suggested credit insurance policies should attract higher capital requirements, a position also taken by the UK, which experts say would make the product less effective at reducing capital requirements on lending and potentially lead to higher prices for borrowers. A Commission spokesperson told GTR in November it was still assessing the topic.