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Amid the chaos engulfing the rest of the financial world, the trade finance market may have just been thrown a life ring, writes Rebecca Spong.

The foundations of the global economy are being battered once more. Eurozone leaders continue to grapple with their worsening debt crisis, banks are facing rising cost of funds and a drying up of US dollar liquidity, and across the globe people are railing against proposed cuts to public sector spending while the “Occupy” protests are attacking the very concept of capitalism.

In recent months, even those working in the relatively safe and stable trade finance markets have voiced concerns that they are unable to close as many deals as quickly as they may like due to the escalating cost of funds.

Trade finance did enjoy a renaissance of a kind during and after the 2008-09 crisis; with traditional relatively low-risk trade finance products rising in popularity among banks.

Yet 2011 has not been as successful a year for trade finance as one might hope.

Dealogic tables for the first nine months of 2011 reveal that global trade finance volumes reached US$114bn, which is down 6% from the US$121.1bn recorded in the same period in 2010.

The drop in trade finance activity was particularly acute in the third quarter of this year, where volumes reached US$40.4bn, a 29% fall from the third quarter of 2010.

A proportion of this drop could be put down to a variety of factors; the deteriorating eurozone crisis, the Arab Spring, and the slowdown in economic growth across the globe.

Yet many market observers agree that the biggest threat to the long-term future of trade finance is the proposed Basel III regulations. The regulators intend to stabilise the banking system and avoid another financial crisis, but it is thought that the regulations will have unintended consequences by demanding that disproportionate amounts of capital be put aside against trade finance assets such as letters of credit. It is argued that such a requirement would make trade finance a more expensive and less competitive product.

A Breakthrough

Yet, as GTR goes to press, thee have been some significant breakthroughs in terms of the negotiations with the Basel Committee and getting the correct capital treatment for trade finance.

In late October, the Basel regulators announced that they would adjust some of the means in which the new Basel III capital requirments are calculatd, although they have completed rejected other requests put forward by industry bodies. The committee has agreed to waive the one-year maturity floor for certain trade finance instruments such as for issued and confirmed letters of credit under the advanced international ratings-based approach (AIRB) for credit risk. Under current AIRB rules, capital requirements for credit exposures are subject to a minimum maturity requirement of one year while the average tenor of a trade finance transaction is far lower than one year.

Waiving this maturity floor of issued and confirmed letters of credit would help reduce capital requirements for banks engaged in trade finance using the AIRB method. The Basel Committee also believes that the waiver of the one-year maturity floor should be a rule, rather than something left up to the discretion of national regulators. It furthermore decided to waive the sovereign floor for certain trade finance-related claims on banks using the standardised approach for credit risk.

This means that in the case of a low-income country importing goods, the issuing bank will be based in the importer’s country, and this bank is likely to not have an external credit rating. Under the regulatory capital framework, where risk weights are based on the external ratings of bank counterparties, claims on an unrated bank are subject to a risk weighting of 50%, or in the case of short-term claims, 20%.

However, the risk weighting applied to a bank exposure cannot be lower than the risk weighting of the sovereign in which the issuing bank is incorporated. In the case of low-income countries, this is typically 100%.

The Basel Committee getting rid of this sovereign floor for short-term self-liquidating letters of credit means that banks can now take advantage of the reduced risk weightings of 50% or 20% rather
than 100%.

This move is intended to reduce banks’ capital requirements for trade finance and help support the import of goods for low-income countries.

Drawbacks

Nevertheless, the Basel Committee has refused requests to make trade finance partly or fully exempted from the leverage ratio.
Under the new Basel regulations, it has been proposed that a 100% credit conversion factor (CCF) would be used in calculating the leverage ratio for contingent trade finance exposures, such as confirmed letters of credit.

After considering the arguments of industry bodies such as the WTO and the International Chamber of Commerce (ICC), the Basel Committee stated in a report issued at the end of October that it will not change this ratio, arguing that: “Changing the CCF for trade finance under the leverage ratio would be inconsistent with the core financial stability objectives of the capital framework.”

Industry bodies also argued for a reduction in the 20% CCF (20% CCF is a ratio set out in Basel II) under the risk-based standardised and foundation internal ratings-based approaches.

Again, the Basel Committee considered the arguments as well as analysing a credit register compiled by the ICC and recording trade debt data. Yet the committee drew the conclusion that the credit register did not provide “sufficient analytical evidence for reducing the CCF in the risk-based approach below the currently applied 20%”.

Industry reaction

Reaction to the Basel Committee’s decision has been mixed. The International Chamber of Commerce (ICC) has said that although it is “pleased” that the Basel Committee has announced measures that reflect the low risk nature of trade finance, it argues that there is still opportunity to “refine” the rules. “It is crucial that the cost of capital between a low-risk low margin activity like trade finance is differentiated from higher risk higher margin activity,” notes the ICC Banking Commission chair, Tan Kah Chye.

“We have narrowed the gap today and there is an opportunity for us to do more through continuing dialogue. We believe that banks and Basel have a responsibility to develop a robust banking environment to create jobs through trade.”

The World Trade Organisation’s (WTO) director-general Pascal Lamy and the bank’s president Robert Zoellick have welcomed the changes to the trade finance regulatory regime, commenting that, “this is a useful step that will help promote with low income countries”.

They also hint that further negotiations are needed to more effectively communicate the message that trade finance is a low-risk asset class.

“We look forward to continuing consultations with the committee. While necessary, the strengthening of prudential standards for the financial industry needs to take account of the low risk nature and the pro-development impact of trade finance,” they stated.

The industry will no doubt be pleased that some breakthroughs have been made; adjustments that will help the trade finance market stay temporarily buoyant. But there is still much work to be done to keep the industry from slipping into a long-term downward spiral. GTR