Joshua Cohen, managing director, transaction banking and global head of liability and RWA management at Standard Chartered provides an update on regulatory issues affecting trade.

Trade gets paid – that’s the old adage and the reason why trade finance is so beloved of old-school bankers.

In periods of economic boom, trade finance gets left behind; the forgotten foundations on which merchant banks and then investment banks were built.  But in times of more moderate growth or financial stress, the banking community looks to its roots, to transactional products that provide stability and safety; low risk income and steady growth, savings accounts, mortgages, cash management, custody, trade finance.

It is estimated that 80% of global trade is supported by trade finance and there are suggestions that the cost of regulations may push up trade finance prices by 300%.  This bad news for all of us as consumers, not just exporters.

Stability and safety are core to the new sets of regulations born in Basel and rapidly spreading across the globe.  The impact of all of these new rules (2010’s publication known as Basel III) is itself causing instability by threatening the main reason for a bank’s existence – returns to its stakeholders; be they shareholders, employees, clients or the public in its social goals of promoting economic growth and prosperity.

Central to Basel III’s capital guidance is the need for banks to have a higher capital base, greater liquidity and to use less leverage.

This article will focus on capital for which regulators have created a measure: Risk Weighted Assets (RWA).  This is the most recent derivation of a measure for capital – akin to risk adjusted capital.

Banks that have adopted RWA measure their profitability as the Return on RWA (RoRWA).  If a bank uses less RWA to produce the same revenue, it will become more profitable.

Some RWA guidelines appear inappropriate when applied rigidly across all segments and products.  Over time inappropriate regulation will need to be adapted, and a more pragmatic structure will evolve.  One particular unintended regulatory consequence; the one-size-fits-all application of the Asset Value Correlation (AVC) to wholesale banking businesses is considered here.

The details

Recent changes at BCBS and new proposals awaiting adoption in Europe will help in a small way to lift the burden of the capital allocation for some types of trade finance.  While there are many contributing factors, the AVC still remains a key determinant of capital requirements.

AVC is the measure of how closely the defaults of asset classes mimic changes in economic activity.  If trade finance is less risky, more stable and less likely to experience losses in stress periods, the AVC, and hence the regulatory capital should reflect this.  Unfortunately, they don’t.

The AVC applied to discounting a 180-day invoice exposure to a large commodity trader (the obligor) to finance its purchase of grain that it will shortly sell on to a third party will be the same as 6-month general purpose loan for the same obligor.

Why is the AVC the same across all wholesale banking product disciplines?   Trade usually gets paid so the the argument flows that trade finance should be viewed with a separate AVC.

The Message

Why is trade finance more stable and reliable than other forms of commercial lending?  Here are the answers:

Trade finance is short term

Much of trade finance is employed in commodity transactions (oil, metals, minerals, foodstuffs) and necessary goods (clothing, electronics, FMCGs).  Exposures typically are limited to under 180 days; the time needed by the buyer to convert the raw material or inputs into its end product for on-sale, or the time a trading company needs to negotiate with, deliver the shipment to and receive payment from a third party.  Such short term exposure means that there is a temporal seniority to other debt of the same obligor – in other words, you will see your money back in your account before the bond holder sees its money return to its account.

Trade finance gets repaid from an identifiable revenue source
Put another way, trade finance is self-liquidating.  As a lender, you are not wholly reliant on the strength of the obligor’s balance sheet to repay the debt, rather you are also looking at its ability to convert and on-sell.  Trade finance looks beyond the obligor and focuses on its ability to perform its duties under a supply contract and the buyer’s ability to honour its debt.

Obligors would prefer to keep their trade commitments up to date to ensure continuity of supply of inputs.  This is critical to the performance of trade debts.  Chapter 11 insolvency protection in the United States recognises how important it is to maintain the operations of an organisation experiencing stress – keep the operation viable, and the creditors may still see their money back.  In times of poor cash flow, a corporate will behave similarly, treating trade finance with preference.

Sovereigns prefer to meet external trade obligations over other debt obligations in times of stress.  This is the sovereign analogy to the previous point.  A sovereign entity will keep its trade obligations current in order to protect its supply of essential goods, raw materials, and other products.

Sovereign workouts tend to give preferential treatment to trade creditors.  Developing countries’ external sovereign debt restructurings are generally driven by Paris Club debt renegotiations.  To protect trade finance from defaulting, Paris Club debt restructurings often exclude short term debt; in its words “as their restructuring can create a significant disruption of the capacity of the debtor country to participate in international trade”.  In other words, the Paris Club recognizes the importance of not allowing external trade debts to become overdue.

Moreover, central banks are often keen to register all external trade debts in order to manage foreign exchange positions and for these debts to be easily identified and kept current in a situation where foreign exchange is tight. These registers make it easy to identify trade debts and ensures their prompt settlement.  Countries demonstrably treat trade finance with special care and its creditors with preference.

Trade Finance is often fully or partially collateralised either through explicit legal title to goods achieved through documentation, or else with implied constructive possession over the goods being transacted.  Having explicit or implicit control over the goods creates a security that can ensure that the finance extended by a bank will get paid either by the obligor, the end user, or through recovery processes, by another buyer.

The evidence

In October 2011 the International Chamber of Commerce (ICC) published a report on trade finance. The report included reference to a trade register on the performance of trade finance transactions from 14 contributing international banks.  The data covers over 11 million transactions.  The report examines the three-year period from 2008 to 2010 capturing the worst of the recent economic crisis.  The loss rate experienced on trade obligations ranges between 0.0007% and 0.07% depending on the trade finance product employed.

Compare this to the loss ratios of corporate loans which are between 2.9 and 286 times those experienced with trade debts.

Trade finance demonstrated its low correlation credentials.  Losses on trade finance were consistently low in good times and in bad.

A high AVC which lifts the capital allocation for trade finance is inappropriate.

What next?

Hopefully, these arguments are sufficient to persuade the reader that under stress, trade debts are more likely to be honoured in a timely fashion than other obligations of the same debtor.

We know that most corporate and bank risks share a generic AVC under Basel II and III.  What we are asking policymakers to support is a separate Trade AVC.

Why do we advocate this?  Because trade finance is a less risky lending activity, and should be recognised as such.  And importantly, trade is fundamental to the world’s economic prosperity.  If financial institutions are discouraged from extending finance to support trade, economic growth will suffer, jobs will disappear, protectionism, tariffs, quotas appear, trade conflicts develop, and political accords will be stretched.  None of this is good.

What We Need

The data compiled for the ICC register is based on three years of history.  What we need from the trade finance industry is commitment to support further data collection, and to explain to stakeholders what we are trying to achieve.

What we need from policymakers is a go-ahead to gather and present data that supports a separate trade finance AVC and their commitment to introducing it.

What can we all do?  Speak with industry groups that are working on regulatory advocacy in trade finance.

We need to impress upon the BCBS that this small change is for the good.  Good for economic growth, good for jobs, good for SMEs, good for emerging markets.  And that the proposals will not jeopardize the soundness of the banking sector.

The AVC has been around since the consultative document was published in 1999 and its implementation under Basel II in 2005.  These were times of easy money, easy credit and strong revenues.  But today, many of the banks which support trade are struggling with liquidity, capital and profitability.

In Europe the central bank has provided term liquidity to ease the situation, but it’s not a sustainable solution – in three years’ time someone else will need to offer refinancing.

Returns on equity in the banking sector are below the cost of equity.  A McKinsey report published last September suggests estimated western banks’ return on equity is below 10% while the cost of equity for banks globally is at 12%.  So banks have to continue to deleverage, cut costs (and jobs), or dramatically improve profitability to meet shareholder expectations.

Inappropriate regulation should not dissuade banks from extending finance – or to increase the cost of the finance – unnecessarily, especially where the asset class is demonstrably less risky, and should therefore employ less capital to support it.  The sooner we can fix this, the better.

Ultimately, banks need to get back to business, and back to the right kind of business.