Bridging the gap

Feature | 30 January 2017

Correspondent banking lines have shrivelled up as global banks retreat from markets deemed too expensive in compliance checks. The TFR editorial board gathered at the close of 2016 to review the trade finance gap and identify what can be done to reduce it

Clarissa Dann: It's been a strange old year hasn't it! Trade has slowed, moved from global to local, we've had the Donald and Brexit, but what has been your experience of trade finance this year?

Rudolf Putz: Our experience is not typical of the commercial banking market. For my business it has been a record year for two reasons. We have had high risk in several of our countries of operation and many commercial banks have been cautious in taking risk there. This has contributed to record results in terms of EBRD activity volumes. Margins have fallen dramatically in countries with good risk such as Turkey Romania and Poland, but there is currently less new business in CIS countries such as Ukraine and Azerbaijan. In Egypt there is less enthusiasm for longer tenor deals. We have seen economic slowdown in many of our countries so there is less trade. Most of our transactions and also what we have seen from commercial banks is short term business. Anything with a high risk means they have to allocated higher amounts of capital, and increased operations and compliance costs has led to a reduction in the number of counterparties with the effect that the banks of smaller businesses cannot access credit lines at all. In some countries there is only lending to the top three banks.

Markus Wohlgeschaffen: I think this needs to be discussed in more detail. Rudolf has raised a series of very important points.

Celia Gardiner: I was pleasantly surprised by levels of activity we have seen this year, it has been a very busy year for us - but not for conventional banking facilities. I am seeing the high-risk end where trading companies and development finance institutions are getting together to finance high-risk producers. I don't think parochialism is reducing trade: trade in commodities is always necessary, but significant geopolitical events can affect demand, particularly in industrial commodities like oil and steel. In softs (foodstuffs) we are seeing a lot of small deals

Katharine Morton: To what extent does the EBRD have a responsibility for maintaining the smaller correspondent relationships and supporting the smaller importers and exporters?

Rudolf Putz: This is our major task. We concentrate on a high number of transactions that are just too small for commercial banks and export credit agencies.

Sean Edwards: Coming back to parochialism, what I find is a slight paradox is that you hear supply chains are contracting because China is doing more onshore sourcing. But there is a big gap for some of the more niche markets. Take the garment industry where there is an increase in demand for sourcing garments and raw materials for garments from some countries such as Vietnam and Bangladesh which are very underbanked. Those supply chains still exist and are growing but they are very underserved. Traders are working with DFIs and ECAs here, but it's an area commercial banks do want to get into but struggle because of capital and compliance costs although they have plenty of liquidity. These countries are not very transparent and it's an opportunity that needs to be worked on. There some fintechs moving into this space but they have limited liquidity.

Clarissa Dann: So do the Chinese banks but they just don't tell you very much about their transactions.

Jean-François Lambert: We all know the fundamentals - protectionist measures are taking over in many countries and there is a sluggish economic environment. In such context, banks would have to play their role as enablers i.e. keep supporting the economy for higher pricing. This is not happening for all the reasons we discussed - cost, compliance and shrinking of credit appetite. Basel is pro-cyclical - when risks are not improving, banks lend little and when you have new capital requirements on top they lend less again. So there are many supply chains in many parts of the world that simply cannot be supported. As banks are no longer doing their job, trade is not growing as much as it could and has very little chance of grow faster than the world GDP over the next few years. Fintechs are active but they are all about systems and payment flexibility, not risk. So, who is going to take the risk?

Paul Coles: There are so many different layers of risk for banks to focus on. It's not just commercial default risk; for example, 2016 was a year full of political risk. Reputational risk is also an important area - you don't want to be making inappropriate transactions. This means you need to concentrate on client and deal selection that deliver the returns which make sense to your business. Banks are there to facilitate transactions and to support corporates but it can be very difficult to achieve this and still meet all the internal requirements.

Jean-François Lambert: Banks are worried about doing wrong, so they don't do what is right for the economy.

Clarissa Dann: We hear a lot about the trade finance gap and the cost of onboarding a new client of being around US$50,000 to US$75,000, and the excess liquidity that is not being lent being deposited with central banks at very low rates of interest which has hardly profitable for a bank's shareholders. So is there a solution on the horizon at all?

Dominic Broom: You were at the ICC UK trade finance conference where we heard very eloquently from a banker in Benin who said he was struggling to find a correspondent. Many financial institutions have cut back their correspondent relationships because the cost of maintaining them, particularly in high risk jurisdictions, is extremely high. The banker in Benin said he had one French bank correspondent. It could well be that that French bank in turn has a US dollar correspondent bearing in mind that 80% of LCs are undertaken on dollar terms. If that banker in Benin was looking to LCs to facilitate short term trade he is going to want his correspondent to pass on the payments associated with those transactions to their dollar correspondent. Five years ago no problem, but these days you have got to have direct account relationships. The whole nested correspondent structure has gone out of the window and the new model has exposed huge challenges for small scale and regional banks, in terms of getting access to global correspondent networks. The resulting 'trade finance gap' needs to be addressed by a call for assistance from the end users of the services. Regulators, with a few exceptions such as the HKMA and the MAS, are thus far not directly addressing the problem.

Geoff Wynne: What I find fascinating in the discussion is the whole doom and gloom on an annual basis we write off trade and trade finance for the next and preceding year. There is a fair bit of trade being done, but as Celia pointed out it is being done differently. The space vacated by the large banks is being taken up by smaller banks and non-bank financial institutions and by funds and what they all demonstrate is that the overburdensome compliance requirements make it very difficult for the larger banks. I think from 2018 onwards we will see a much lighter touch from the regulators for quite a lot of trade. We should not write trade off.

Sean Edwards: I agree with Geoff's timeline. And the Financial Action Task Force that set the standards for a lot of KYC said in its last report on correspondent banking that regulation has been overdone and KYCC should not be happening. The noises are coming in the right direction. I come back to the fact that the supply chain areas are not undiscovered countries and once the regulatory burden is lifted, there is a lot of business waiting to be done and many banks would like to do this directly if they could.

Paul Coles: The regulation is an application of common sense as some banks were not being sufficiently prudent in the past and the regulation had to rein that in. It is still for the banks to decide what the thresholds are that make sense to them. We can all point at reasons why we think we're unable to do as much business as we would like to, but the truth is that we are still able to justify why we should be doing trade finance and we continue to close the right deals when we need to as well. For the untapped supply chain market the big banks will always follow the big names internationally. The smaller companies are more likely to be funded by the smaller fintechs, platforms and people with more flexible funds. They don't need to rely on the big banks because their transactions are smaller in the first place. The models should all support each other and work together.

Sean Edwards: The point of supply chain finance, or reverse factoring, was the idea was that the big buyers should be able to support the small suppliers. That is not happening because of onboarding issues. Once you reduce the cost of regulation, vanilla business with suppliers in those countries become possible. That is what a lot of those countries are lacking. You can do that through lending to local banks.

Peter Mulroy: If you look at the volumes in the factoring industry, the growth has been across the board but the real growth has been the past three years cross border. Last year the domestic side reduced by 1%, cross-border grew by 8% on the back of 20% growth from 2009 to 2014, so it's slowing down. But this year the brakes started. We had 15 years of phenomenal growth out of China. There were a number of fraud cases and bankruptcies but they did not hit until this year. There are around 400 cases of factoring in the lower courts and they cannot answer the cases as they don't know what factoring is. They have not adopted any kind of model law and there are three different versions of legal precedent. The Supreme Court has not issued any type of proclamation. Because of these cases everything stopped.

Clarissa Dann: How are things in the funds space?

Suresh Advani: The funds space remains regulated so they have the same issues and challenges on a KYC/counterparty appraisal sense in terms of ensuring their investor clients that when they deploy money their investors expect them to invest in things appropriately KYC'd and that the counterparties are acceptable. The space has different regulatory constituencies but it is there.

Clarissa Dann: A lot of FIs were complaining it was quite hard to keep their vehicles topped up with enough transactions. Is that still a problem?

Suresh Advani: The alternative space remains subscale compared with the banking sector and highly fragmented. It remains a niche provider of credit for trade finance.

Rudolf Putz: Non-banking financial institutions and traders are taking the gap left by banks but in my countries of operation this is only in commodity trade finance. But economies have other trade flows but no traders have taken significant amounts on smaller transactions outside of commodities. High margin commodity deals with lower tenors secured by offtake contracts are of interest but nothing outside this.

Markus Wohlgeschaffen: So what is next, what should we do? Should we all give up?

Clarissa Dann: How is insurance helping deal flow?

Andrew van den Born: We continue to follow the fortunes of the banks. We are still busy and are seeing a relatively decent deal flow but some of those structures are increasingly challenging. However, we are seeing a significant uptick in restructurings and claims notifications. While not at 2008 levels there are some big numbers out there. While some are commodity related and may have dollar issues - say in Ghana, Angola and Nigeria, we are also seeing losses in China and Latin America. We are also seeing a number of sovereign defaults. The market is robust enough to absorb these but it is challenging.

Jean-François Lambert: Was the business originated with banks or trading houses?

Andrew van den Born: Primarily banks. But yes, trading houses have to shadow bankers and have been very active this year and have filled some of the gaps.

Clarissa Dann: So there are lots of losses out there stacking up.

Rudolf Putz: If you have insurance cover, the insured has to take some risk themselves. But if a bank won't take any risk it does not work.

Andrew van den Born: Insurers require banks to have some level of skin in the game.

Markus Wohlgeschaffen: Let us suppose banks could assume the 20% or so not covered by insurance. When I was in banking we would have had a problem because we usually did not have the first demand mechanism. This means banks have to obtain credit approval and necessary data to perform a proper credit assessment. Banks in general would have serious problems even if there was increased insurance capacity.

Jean-François Lambert: The capital requirements for a bank does not fit the insurance model properly otherwise it would be very complimentary. Demand guarantees are not available in the insurance market. Insurance is insurance and not a guarantee.

Suresh Advani: The advent of the Basel III compliant policy of insurance markets has provided banks a very stable form of investment grade capital substitution. So it is a valuable tool for the banking market. Obviously the US banks have their own issues, but large European banks, and Asian banks use insurance - particularly second tier banks.

Paul Coles: You said you were seeing a lot more defaults. In which markets?

Andrew van den Born: Mainly emerging markets.

Paul Coles: That comes back to what we have been talking about. The banking and finance sector works well when it is dealing with well-rated risks but when we go into the lower end of the spectrum we often struggle to manage these risks. It is not yet clear what the solution is.

Celia Gardiner: The problem with the risk assessment is you have to predict the future. And something always goes wrong somewhere and this sends a ripple through the market. This was what happened after Qingdao. There are more defaulted facilities now than I have seen for the past few years. None have any pattern. Each time you are involved in one of them your whole risk assessment of the entire market shifts.

Paul Coles: This takes us back to the old forfaiting days where everyone relied on their relationship networks with local knowledge. The smaller forfaiting houses would exploit these pools of knowledge to deliver solutions that would work rather than rely on big banks trying to do everything from start to finish.

Celia Gardiner: I have seen other non-bank institutions doing exactly that, saying the banks won't touch that but we can take this risk because we understand this market.

Jean-François Lambert: The dream of the big international trade banks is over. The perfect model is the one you describe, I take the risk I understand, you take the risk you understand and then we work together. This works well. But we now have the problem of the correspondent banking system that is disrupted for the reasons we know so if you want a solution, this is where the problem lies. A global bank could not take the whole supply chain risks before, and much less so now. So the question is: how do we weave this network of banks so that it works together to foster trade?

Dominic Broom: I could not agree more. At the heart of it you have got a stressed correspondent banking model. We lived through a 20-year period from the late 1980s to mid-noughties where global supply chains were dominated by and large by global corporations; which suited the global banks that serviced those corporations. Technology has since facilitated a change in global supply chains, where SMEs are now dealing more remotely in terms of geographic distance. The best entity to judge and assume these local risks, is a local financial institution, which underpins a layering of risk through the correspondent banking network. The best person to judge Benin risk (per my earlier example) is a specialist bank in that small West African country. In turn they need to plug in to a correspondent network that understands the fundamentals of the global correspondent banking network. From an institutional and technology perspective we have the solutions, but until we can get back to a point where a banker's word on KYC checking is his bond, and can rely on that, then the traditional correspondent banking set up will be strained.

Clarissa Dann: Can we now look at what potential solutions there are in place such as KYC utilities and the data issues arising, and what the fintech industry is doing.

Andre Casterman: We have often talked about the benefits of digitisation but what we have seen in the news recently is the impact on banking jobs. ING let go 7,000 people because of digitisation and announced €80m in digital services investment, UniCredit has announced 14,000 job losses. There is a growing focus of the top management on the efficiency impact of digitisation over the next five to 10 years.

Dominic Broom: I was recently in our global processing centre in upstate New York. There we have set up a digitisation team in our innovation centre, one of eight such centres we have around the world, this one being tasked with bringing digital application into transaction processing. In the innovation centre, teams are using robotics to do payments and compliance checks, and tests indicate they are able to do this eight times faster than a human. Digitisation is potentially a saviour for institutions who have had to ramp up on back office costs to remain compliant to the point it is becoming unsustainable. To rein in those costs, we are looking to harness technology.

Paul Coles: Technology does drive efficiencies but you ideally need to rethink the underlying processes from scratch.

Clarissa Dann: There is lots of noise about digitisation but what is the message to the ICC and SWIFT about a utility that you will all use and trust and that will reduce KYC costs?

Suresh Advani: You are concluding that the best solution is going to be a single monolithic understood thing but you have an integration of different technologies and different very entrepreneurial entities approaching this technology and looking at it in very creative ways. Large institutions try to create this entrepreneurial creative aspect within their organisations but outside they have to deal with the fact nobody can predict what shape or form all this tremendous change will take. One of the more dynamic things about all these alternative providers is there are lots of them, with lots of enthusiastic smart ideas. Some will succeed, some will fail, many will consolidate, all of which will create a wave of change over time.

Andre Casterman: It might be too early to identify common layers or foundations that could be owned by SWIFT or ICC. It is better to leave these initiatives to go as far as possible in their creativity. Blockchain enabled cross-border payments will impact trade flows - so that you could instantly credit an account anywhere in the world through a correspondent bank without a vostro or nostro account. Ripple has said banks should invest in this.

Jean-François Lambert: But you need to bring the regulators somewhere in the picture because the way banks are dealing with trade and payments, simplifying processes and streaming back offices is changing. Regulators have to understand that.

Andre Casterman: Ripple is doing this already on their own but outside established consortiums such as R3. They are educating the regulators, and you can see various papers written by the Fed on how distributed ledger technology can be applied in domestic or cross-border real time payments.

Geoff Wynne: The problem I have been discussing is that some of the legal problems arising from fintech participation have not been addressed, and may not be until something goes badly wrong. We are talking about emerging market trade - is someone growing crops for sale going to be interested in this?

Celia Gardiner: There is a particular issue in that the law is dependent upon nation states. You cannot always choose the legal system which deals with a particular problem: will it be the English High Court or will it be, say a local court in the Ukraine? The outcome may well be different. As technology changes the world will adapt and new legal principles will evolve but there are pitfalls on the way. For example, the movement from paper rights (like bills of lading) to electronic rights involves changing an asset from a physical asset to an intangible: which means a completely different set of legal principles will be applicable: we will all have to adapt to this.

Peter Mulroy: Looking in the future as relates to e-commerce, most sovereign procurement will be done on e-invoicing. In our world of factoring, you have to know if that invoice is assigned, has it followed the legal obligations. There are so many questions.

Dominic Broom: The millennial entrepreneurs run their lives from their gadgets and don't understand why the stodgy old world of trade finance is so technologically backward. SMEs are crying out for simpler ways of doing business.

Sean Edwards: Alibaba and Amazon are integrating vertically and can finance suppliers through existing technology. They have competitive advantage and have the cash to do it. They are not regulated and are huge in scale. When you look at SME financing a lot of suppliers will find their finance there. They are a huge investor - more than fintechs.

Dominic Broom: Across so many elements the technology is there. I am a big believer in that the forces already at work in the retail context will push up into corporate segments; essentially reversing a flow of business adoption that for years has worked the other way around in the financial world. I got a message this morning from an online order allowing me to track a parcel delivery. That technology can be applied in a corporate context: i.e. you can track an oil cargo. Our comfort level as retail consumers with online transactions is underpinned by legislation and the insurance market that wraps around that whole area. Those are the elements we need to move up from the retail into corporate space.

Suresh Advani: This is the concept of a trusted network that banks provide for documentary cash flows. With fragmentation, banks are no longer the custodians of this.

Clarissa Dann: What are you closing thoughts about how you see 2017 and the next three years unfolding? How will some of the issues we have discussed pan out?

Jean-François Lambert: On the commodity side, the good news is that prices are rising, metals and oil are up. This has not yet translated into bank business but it is starting. From a pure revenue perspective the beginning of 2017 should be better than the beginning of 2016. Will the Trump factor boost infrastructure spending? It might. China is on steroids with its economy artificially maintained so we don't know the real picture but they are pushing out infrastructure projects too.

Sean Edwards: If Russia opens up it may take more than a year to remove the sanctions, and the big trade finance deals may come back. This is really important for banks.

Dominic Broom: We now have a businessman in Number 11 Downing Street who understands that the economy cannot grow unless we fix our infrastructure. Mr Trump has come to the same conclusion in the US. They realise the key to a lot of success in Asian economies in the past decades has been fantastically efficient infrastructure. And Gulf economies are ramping up theirs in preparation for when the black stuff has run dry.

The TFR annual review of the year roundtable was held on 14 December 2016 at Dentons' London offices

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