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Citi’s John Ahearn speaks to Shannon Manders about how changes in the regulatory environment are forcing banks to rethink their business model.

The post-crisis environment, coupled with a new regulatory regime, is leading to a transformation of banks’ trade business.
One of the positive outcomes of the crisis is the fact that trade banks will get a much better understanding of their portfolios, says John Ahearn, Citi’s managing director and global head of trade, who notes that banks are currently in “growing up mode”.

With Basel III looming for the majority of global banks, and Basel II set to be implemented by US banks in April, the increased regulation will have an impact on how banks and their clients do business.

Faced with additional regulatory challenges, Ahearn believes that banks will begin to question their involvement in trade finance business. “What you’re going to see is an evolution of thinking with banks asking themselves: ‘How do we continue to give this product to our clients, but at the same time not impact the balance sheet?’”

“One thing that you will see across the board is that capital has to go up, and with that, the cost of capital is increasing at the same time,” says Ahearn. “Against that backdrop you have a declining corporate spread for borrowing. It’s just an unsustainable model.”

Ahearn explains that in some instances, cost of liquidity for corporates is cheaper than what it is for the banks they borrow from. This cheaper form of capital, coupled with the excess of liquidity in the market may discourage corporates from borrowing altogether. “Many corporates just do not have a need to borrow. They’ve got credit and receivables facilities in various parts of the world; and there’s no desire to sell these assets to generate more,” he says.

With the crisis successfully proving that trade is countercyclical, Ahearn believes that the next step would be to set up trade as “a separate product within the group” when it comes to capital allocation, loan loss revenues, and so forth, instead of simply making use of the plain vanilla working capital loan models that have been used in the past.
Problems for SMEs

The SME sector – and the banks that fund it – is likely to suffer considerably as a result of the new regulations. Most of the SME sector is served by second-tier banks, and as Ahearn explains, the trade business for these regional banks is not an especially profitable business, but rather a business that they have engaged in at the request of their clients.
With the proposed capital requirements under Basel II and III, these banks will now be expected to raise significant amounts of capital for business that is only marginally profitable.

“I think the conversation is going to be: ‘There’s only so much capital that we can raise. Is trade a core business?’ And then I think you’re going to see banks either exit the trade business or partner with other banks,” says Ahearn.

“If you look at Basel II and III, the SME sector is going to become the most expensive sector for us to support from a capital point of view,” Ahearn continues, adding that, with the new regulations, the sector will also pay the most expensive fees. “The exact sector that politicians are looking for banks to support is going to find themselves even more unbanked – at least when it comes to international trade.”

Dodd-Frank legislation

The Dodd-Frank Wall Street Reform and Consumer Protection Act, which becomes effective in July 2011, is another regulatory issue and a “good example of high-level legislation that may have a potentially negative impact”, says Ahearn, referring specifically to the act’s effect on master risk participation agreements (MRPAs).

Under the Dodd-Frank regulation, risk participation under London’s Loan Market Association (LMA) template used by Europe and Asia could be treated as both a mixed swap and a security-based swap.

One of the potential consequences of treating LMA-style participations as swaps is that trade would need to be made “on the public side” and impact the borrower’s ability to raise capital in the loan markets.

“There’s been a drive to set up MRPAs between banks because there is a large secondary market,” explains Ahearn. “If you go back to the height of the crisis, one of the things that was dramatically impacting trade at that point was the secondary market, which had closed down.”

“Under this regulation, what they’re saying is risk participation, depending on which structure you’re using, should be considered the equivalent of credit default swaps. And they’re starting to drive mark to market-type calculations against that.”

Many bankers believe that the Basel regulators lack a sound understanding of the true underpinnings of trade. Ahearn agrees and warns that if regulators continue to design the rules with such heavy-handedness, it could result in a reduction of trade finance availability or quite possibly a drop in international trade itself.

“It will be interesting to see how trade performs in a sovereign crisis,” says Ahearn, noting that with the high levels of stress in the system, the potential for a sovereign event is at its highest since the Latin American crisis.

“I think we are probably three or four years away from being able to say with incredible certainty that trade does perform better. We’re going to have the opportunity to prove that – both internally and to the regulators,” he adds. GTR

Basel III’s impact on trade

Basel II and III outline new regulations that may have a significant impact on trade finance and the amount of capital allocation required for short-term credit and trade.

The one-year maturity floor for short-term self-liquidating trade transactions does not reflect the majority of trade assets, which are typically 180 days or less.

The application of key risk attributes for trade finance assets do not reflect the industry’s expert judgement.

Basel III would change the credit conversion factor (CCF) for off-balance sheet operations from 20% to 100%.

Industry concern is that trade lending, especially for smaller firms, will be adversely affected by the regulatory proposals.

Citi Webinar

In March, GTR’s Shannon Manders and Citi’s John Ahearn, managing director and global head of trade, hosted an exclusive webinar to explore the worldwide impact on Basel II/III and other legislation on the trade services and finance business of banks.

John Ahearn provides answers to the questions submitted via instant message during Citi’s webinar.

Q: How confident are you that the industry will succeed in making the regulators understand the true nature of the trade business and correctly match the capital allocation requirements of banks?

Ahearn: I’m confident that we will get them to understand the connectivity; however, I’m not as confident that they will make the required changes. The overall drive of Basel III is to get banks to be better capitalised and I don’t know how accepting the regulators will be to making changes on a sub-product level.

Q: If the impact of Basel III is that there are less banks offering trade finance, does this mean there will be a greater degree of collaboration among these players and if so, how might this manifest itself?

Ahearn: Obviously if there are less banks, pricing will go up. You’re going to have to see a desire to get things off banks’ balance sheets. For example, Citi’s multi-bank trade programme is a collaboration among the industry players.

Q: Under Basel III, would the mark to market pricing reflecting unfunded sales reflect the risk associated with the obligor or the risk participant?

Ahearn: Yes, it affects both. Again, because of the short-term nature of trade it may not make sense. Trying to create all this infrastructure for short -term financing doesn’t make sense.

Q: How will Basel III impact the receivable securitisation market?

Ahearn: It’s not really a Basel issue but rather an FASB accounting rules issue. As FASB rules don’t necessarily support off-balance sheet activities and with the expected harmonisation between FASB and IFRS in the near future, even for non-FASB reporting entities, securitisation will not be as advantageous.

To replay the webinar, visit: http://digitalmedia1.citigroup.net/viewerportal/citimedia/player.do?eventContentId=34140