Basel III will be here within two years and trade finance bankers are preparing themselves for a fight to stop the industry from changing for the worse. Michael Turner reports.

The proposed new framework for banking supervision, otherwise known as Basel III, is set to radically alter the way in which banks can offer trade finance. Most notable amongst the incoming changes, due to be implemented from 2013, are the leverage ratios and the maturity floor; both of which look set to place large obstacles in the path of trade finance.

It is important to get the balance of prudent regulation and commercial business sense.”

Under Basel II, leverage ratios sat at 20% for trade-related contingencies, such as letters of credit and shipping guarantees, and 50% for transaction-related contingencies, including performance guarantees.

But the Basel committee has stated that the implementation of Basel III will see the credit conversion factors of all off-balance sheet exposures increased five-fold to 100%. This one-size-fits-all approach lumps the historically low-risk trade finance product in with high-risk items such as credit default swaps.

A survey by the International Chamber of Commerce (ICC) called ‘Rethinking Trade and Finance’ discovered that there is also a possible inconsistency within the Basel III wording which differentiates between unconditionally cancellable commitments, such as letters of credit and standby letters of credit, and conditional cancellable commitments like off-balance sheet credit card commitments.

If the discrepancy were to be passed into regulation, the leverage ratio for credit card commitments would be 10%, meaning that as far as the regulators are concerned, trade finance is 90% more risky and likely to face default than credit cards.

The maturity floor

For the Basel committee to consider trade finance as risky as credit default swaps and less risky than off-balance sheet credit card commitments indicates that the trade finance community has so far failed to get the message across that the product is low risk.

This disconnect is also apparent in the maturity floor rule that is being carried over from Basel II, which again shows a conflict between the regulations and the way that the majority of trade financing is carried out.

The ICC survey highlights that the average maturity of a letter of credit is 90 days, and rarely goes above 180 days. The Basel II framework applies a one-year maturity floor to all lending facilities.

Some banks will take advantage of their national regulators not implementing Basel rules as quickly as others.”

“Since capital requirements (naturally) increase with maturity length, the capital costs of trade financing are artificially inflated as a result… Consequently, obliging financial institutions to back a self-liquidating asset for a full year is a considerable waste of capital resources at a time when these are scarce,” the report says, making clear the specific difficulties that trade financers will face if the one-year floor is left in place.

Regulators do have the chance to waive this maturity floor on a national level, and so far Germany, Hong Kong and the UK have done so. While this is a clear advantage for the banks based in these countries, it is also a clear disadvantage for banks based in countries that have not waived the maturity floor.

“It is probably true that some banks will take advantage of their national regulators not implementing Basel rules as quickly as others, but this is a competitive industry and of course banks will use advantages where they can,” says Tan Kah Chye, ICC banking commission chair and new global head of trade at Barclays.

“However, the national regulators, and not necessary just from the OECD, have to realise that trade finance is a very porous business. If it is more expensive in one country it will just move to another. It is important to get the balance of prudent regulation and commercial business sense.”

Fighting the corner

With regulations seemingly stacking up against the industry, the ICC banking commission is fighting the trade finance corner.
“The ICC welcomes regulation, as obviously no one wants to see a repeat of the global financial crisis. However, the market works in such a way whereby the market economics will automatically correct any market imbalances created by market rules,” Tan explains.

“The danger that we have is that if the new Basel III regulations proceed with the current capital requirements, then banks will find it cheaper to sell their trade finance portfolios to the hedge funds. This is a very small part of the business at the moment, but this will move trade finance into an unregulated area and result in the kind of activity that the banks and regulators are trying to avoid.”

The ICC is lobbying the Basel committee on behalf of the industry, but has yet to receive any conclusive responses.

“We have had an excellent working relationship with the banking commission,” confirms Dan Taylor, vice-chairman on the ICC’s banking techniques and practice commission. “We have had several meetings with the people from the Basel committee. The meetings were very open and [there was] a good dialogue about the crisis.”

We have had an excellent working relationship with the banking commission.”

A significant portion of the ICC’s lobbying comes from a joint project with the Asian Development Bank. The two groups created a quantitative report, named the ‘Trade Finance Default Register’, which contains data from the trade transactions of nine international banks over five years. Of the 5.2 million transactions recorded, there was a default rate for letters of credit of just 0.058%.

The ICC is in the process of undertaking the second phase of the register, this time involving 16 banks. Steven Beck, head of trade finance at ADB, tells GTR that the development bank is bowing out of the initiative now to let “the ICC and commercial banks take full ownership of the register”. Beck adds that the ICC has struck a deal with Harvard Business School to draft future reports and provide further analysis.

Trial and error

While statistics for the first phase of the register have now been presented, the Basel committee is keeping quiet about their reaction to the results, and refusing to be drawn into any answers before it presents its proposals at the next G-20 summit in France in November 2011.

The committee has, however, stated on numerous occasions that it is intending to implement a trial-and-error approach to applying the new regulations.

In an April 6, 2011 speech at a Financial Stability Institute conference, Basel committee secretary general Stefan Walter said: “The committee will use the observation period [between 2013 and 2018] to review the implications of the standards for individual banks, the banking sector and financial markets, addressing any unintended consequences as necessary.”

This implies that the Basel committee is willing to allow would-be issues to become highlighted in the field before action is taken to counteract the problem. In the world of trade finance, where relationships between bankers and clients are paramount, this could have an irrevocable effect as banks are no longer able to oblige customer requests.

The effect on clients

So far, the industry is largely holding back from passing on information about how Basel III will affect clients’ balance sheets due in part to the hope that the rules will be changed before the proposals become regulation.

There is also a concern that the rules as they stand are too complicated, and that clients will not care about the specifics of how a bank has to change its business, only about the outcome in terms of price hikes and trade finance availability.

“The regulation is complicated. Many chief executive officers have got to the situation where they do not know there is possibly an impact on their balance sheet,” Tan explains further.

This runs directly counter to a speech given by Nout Wellink, chairman of the Basel committee, in Cape Town at the end of January 2011.

“In my view, Basel III is not overly complex nor is it an overhaul of Basel II. And this is another misconception; that Basel III somehow replaces Basel II or Basel I. Basel III complements the Basel II and Basel I frameworks,” Wellink said.

Again, this shows a disparity between the Basel committee and the trade finance industry. The disconnect of information between the two communities has been raised as a concern by many, and it still remains the job of the trade finance market to present enough information to the committee to try to ensure that regulators understand how the business works, and subsequently get preferential treatment in the final rules.

“The good news is that dialogue is happening. We are happy to tell you that there is a very active dialogue between the ICC and the Basel committee,” Tan reiterates, providing hope that trade financers’ worries might be heard by the regulators. GTR

ICC survey shows emerging markets priced out

High pricing is pushing traders in many low-income countries away from being able to afford trade finance, according to a new survey by the ICC.

The ICC Trade and Finance Global Survey 2011 found that the price of import finance is particularly prohibitive for low-income countries.

However, the report did find that the average price for letters of credit in large emerging economies dropped from 150-250 basis points in the 2010 survey to 70-150 basis points in this year’s study.

Latin America and large sections of Asia and Africa continued to pay high prices for trade finance.

“What is needed now is a more targeted use of resources, focusing on the poorer countries and small and medium-sized enterprises around the world,” says Pascal Lamy, director-general of the World Trade Organisation.

Development banks have stepped in to fill much of the gap in emerging economies and as yet have not had to face a single loss as a result of non-payment or default.

“The development banks have been particularly important because they help build relationships with banks in emerging market which cannot get off the blocks in the international markets,” Vincent O’Brien, chair of the ICC market intelligence advisory group, explains to GTR.

On the positive side, the survey confirmed the rebound of trade flows globally, driven by increased trade in North America and Europe.

In these developed economies, liquidity and trade finance availability is returning to normalised pre-crisis levels, as is the pricing and risk appetite.

Messaging firm Swift has also provided the ICC with the volume of messages sent and received throughout all regions.

Africa showed the highest growth of import messages between 2009 and 2010, at 21.2%, followed by Asia Pacific with 10.1% and Latin America with 9.7%.