Oil on less troubled waters: trade prognosis under Basel III more optimistic

Feature | 30 April 2013

RUTH WANDHOFER provides an update on the evolution of Basel III and its treatment of trade finance and finds the outlook a lot less bleak than it was a year ago

With 11 countries allegedly having implemented Basel III on the deadline of the 1 January 2013, the much-discussed reform of international prudential bank regulation is arguably already a reality.

A close examination of global trade reveals a massive retreat of eurozone banks in financing those flows over the last four years. Challenged by the financial crisis, the eurozone crisis and the advent of Basel III minimum tier one common equity capital requirements, the answer for many European banks meant retreat from international financing of trade and deleveraging of the balance sheet. This then triggered more consolidation - the opposite of what the regulator's intentions were - as well as leading to overall reductions in lending - again, not helpful in an era where the developed world is struggling to grow at all.

In this article I will examine the recent developments in the area of trade finance, in particular the evolution of Basel III applicability in the context of trade finance, the efforts of the industry and the very recent glimpse of hope for a business that is intrinsically focused on helping the global world to grow and prosper.

How the trade finance landscape continues to change

Trade flows are traditionally financed in US dollars (US$). Statistics from end 2011 estimate around 67% of US$ trade finance flows globally. Despite the increase in using renminbi (RMB) to denominate contracts, the US dollar will continue to play a significant role in this space going forward.

Historically large global trade banks provide US$ funding to emerging market banks, which in turn use US$ to fund their client's US$ trade flows. Global trade banks also provide US$ deposits, payments and letter of credit (LC) relay/re-issuance and confirmation services in order to enhance returns on capital from trade advances. The role of European banks in this space has traditionally been that of a net funder to the world. This has continued to diminish in the context of multiple pressures, ranging from the EU requirement to ensure 9% capital ratios in 2012 in line with the European Banking Authority requirements, to the ongoing eurozone crisis and its consequences as well as the upcoming Basel III implementation, which collectively trigger a number of consequences.

When we look at the various elements of Basel III the cumulative impact is expected to increase the cost of supporting the current global trade model.

1. Globally significant banks

The Basel regime foresees extra capital charges for so-called globally significant banks (G-SIBs). Given the fact that the majority of global trade banks are G-SIBs, this means that higher capital requirement will have to translate into a higher cost base for the entire trade finance chain. Arguably this is fair enough as the cost that needs to be paid in order to make the financial system more safe and sound.

2. Asset value correlation

Turning to inter-bank exposures, the Basel Committee proposes the application of a 1.25 asset value correlation (AVC) multiplier with regard to exposures to large financial institutions (banks over US$100bn assets or unregulated financial institutions). This multiplier would need to be applied across the board, including transactions such as trade advances and LC confirmations. When looking at this concept in more detail with regard to trade, we can observe that this multiplier is not correlated with the actual risk of advising/confirming LCs. Trade is now given the same treatment as longer-term loans without specific collateral. The new AVC also does not distinguish amongst different FI exposure types. Altogether, this will constitute another new component of cost in the trade finance space.

3. Liquidity ratios

The liquidity ratios stipulated by Basel significantly reduce (even remove to a certain extent) the value of financial institution deposits. By way of example 100% of non-operating deposits from financial institutions are assumed to run-off within the 30-day stress period as defined under the liquidity coverage ratio (LCR). At the same time financial institution deposits cannot be used as stable funding under the net stable funding ratio (NSFR) regime. This creates a general strain on inter-bank business.

4. Cost of US$ funding for large European banks

And finally, the continued eurocrisis also continues to impact the cost of US$ funding for large European banks, which has knock-on impacts on those bank's ability to serve the international trade finance markets.

As a consequence of the above four factors, banks will:

  • continue to divest minority interest and non-strategic assets;
  • have to constrain lending;
  • be more critical in making portfolio decisions including clients, sectors, geographies and product choices; and
  • continue to re-evaluate pricing and funding models.

In the space of trade finance, as much as in other areas of banking - given the plethora of regulatory change and the challenge of increased local fragmentation of rules - this is starting to trigger consolidation.

Basel III progress: revision of the LCR and a new consultation

The key momentum on the Basel III front so far this year has been the publication of the revised liquidity coverage ratio (LCR) in early January.4 The LCR is a minimum standard to ensure that financial institutions have the necessary assets on hand to handle short-term liquidity disruptions. Banks are required to hold an amount of highly liquid assets equal to or greater than their net cash over a 30-day period of stress. In terms of the calculation it helps to understand that the numerator of the LCR is the stock of high-quality liquid assets (HQLA), while the denominator in the LCR formula is the total net cash outflow, in other words the total expected cash outflow minus the total expected cash inflow, within the 30-calendar day stress scenario.

The key change in the LCR calibration that refers specifically to trade finance relates to the above mentioned run-off rate in the case of contingent funding obligations stemming from trade finance instruments where national authorities can apply a low rate of 0-5%. Given the definition of trade finance instruments this change results in a 0 -5% outflow calculation for contingent liabilities, not maturing trade finance loans. Such a low proposed outflow rate constitutes and improvement on the national discretion provision in the original LCR proposal, which left the percentage up to national regulator decision.

However, this amendment does not address the issues for trade finance in the inflows calculation. For wholesale inflows the Basel Committee assumes that banks will receive all payments (including interest payments and instalments) from wholesale customers that are fully performing and contractually due within the 30-day horizon. In addition banks are assumed to continue to extend loans to wholesale clients at a rate of 0% of inflows for financial institutions and central banks and 50% for all others including non-financial corporates, sovereigns, multilateral development banks and public sector entities.

This will result in an inflow percentage calculation of 50% for corporate trade finance maturities and 100% for bank trade finance maturities. The industry however, had generally requested a 100% inflow calculation for all trade finance related activities, which has clearly not been granted in this recalibrated LCR regime. For now there appears to be little room for change and actual implementation and live data may be required to re-open some of these arguments.

Basel III in Europe: a best practice approach for trade finance

On a more positive note, the European Union has very recently endorsed its own legislation that will implement Basel III requirements - as well as a plethora of other additional elements such as remuneration regulation and corporate governance.

The EU version of Basel, the so-called Credit Requirement Directive IV + Regulation, in short CRD IV, has very positively taken into account the industry's concerns in relation to the unintended consequences of the proposed regime on trade finance.

Key changes in support of trade finance include the following:

  • usage of actual maturity floor for short term trade finance as well as incorporation of the sovereign floor waiver for trade according to the 2011 Basel Committee revision;
  • LCR liquidity inflows from trade finance shall be taken into account in full and for outflows the 0-5% rate applies according to the revised LCR; and
  • in terms of the leverage ratio, reduction of the credit conversion cactor for short-term self-liquidating trade finance transactions to 20% and 50% depending on the level or risk, from the initially proposed 100%.

This list of changes is considered best practice amongst trade finance professionals and at a global industry level BAFT-IFSA is advocating with the Basel Committee and the G-20 for a revision of the Basel III recommendations in relation to trade finance that is broadly in line with the EU's approach. 

Recent developments: a welcome BIS consultation

And there is another glimpse of hope! On 25 March the Basel Committee released a consultation on the 'Supervisory framework for measuring and controlling large exposures' (comments deadline 28 June).

Under the sub-heading 'Banking book "traditional" off balance sheet commitments: calculation of CCFs' (chapter III, part B), it is for the first time expressly mentioned by the Basel Committee that applying a 100% CCF in the context of trade finance activities "is likely to have a material adverse impact on an essential form of financing in some countries, in particular, in emerging markets."

This leaves us with an implicit message that says, it would be better to apply the CCF used under the standardised approach in such cases for large exposures purposes, i.e. "a 20% CCF for short-term, self-liquidating letters of credit arising from the movements of goods, which will apply to both issuing and confirming banks; and a 50% CCF for other transaction-related contingent items related to particular transactions."

The consultation therefore carries a lot of significance for the global trade finance market and it is hoped that the committee will take further formal steps in relation to amending the application of the leverage ratio to trade finance transactions, just like Europe has done.

Basel III and trade: still like oil and water?

Although we can successfully note key improvements in the Basel III implementing legislation in the EU and while the Basel Committee for Banking Supervision has quite clearly hinted at a potentially softer treatment of trade finance under the leverage ratio in the recently published consultation, the largest challenges that remains is of course inconsistent implementation of the regime by countries around the world.

Despite the fact we have eleven countries that announced Basel III readiness for January 2013, there is still ambiguity in the detail. Clearly most countries will have focused on their increased capital requirements primarily while the liquidity and leverage regimes are planned for a later date. At the same time key jurisdictions like the US, which is still expected to process its rules by mid 2013, are quite obviously delayed and other countries have advanced very little altogether.

If a number of economically important countries and regions were to delay implementation of Basel III or significantly alter the proposed framework, this could trigger capital arbitrage across the banking spectrum - an outcome that is hugely undesirable.

Next steps

In terms of next steps, industry efforts, for example under the umbrella of BAFT-IFSA, will continue to underline the need for a formal revision of the Basel III recommendations in relation to the treatment of trade finance under the leverage ratio. This revision should take into account the changes applied by the European Union in their Basel III implementing rules. Furthermore, positive momentum for such a potential step is reflected in the approach to CCF for trade finance transactions reflected in the recently issued Basel Committee consultation on large exposures.

In addition, the International Chamber of Commerce (ICC) continues its work on data gathering in the area of trade finance, which already clearly demonstrated the very low risk and short-term nature of this type of financial transaction two years ago. The latest 2013 report has just been released (see note 1).

Fingers crossed and the treatment of trade finance under Basel III will soon be less problematic - albeit still onerous. Longer-term impacts and consequences on global trade will only become visible over time. But for now the situation looks much less bleak than a year ago.

Ruth Wandhofer is global head of regulatory and market strategy at Citi Transaction Services

Box-out 2

Box-out 3

<p class="para_Box_out_header"/>

Box-out 4

<p class="para_Box_out_header"/>

 1. An overview of Basel capital standards can be found on pages 36 to 62 of the ICC Banking Commission's Global Risks Trade Finance Report 2013, available at www.iccwbo.org/products-and-services/trade-facilitation/icc-trade-register

2. This article updates 'Oil and water' in TFR, May 2012, at www.tfreview.com/node/7766

3. Source: CIRA "Banking on Trade", published October 2011

4. See also: 'Group one banks getting there but trade position still unhelpful', TFR, 5 May 2013 at www.tfreview.com/node/8840

5. For BAFT-IFSA's comments on EU amendments see www.tfreview.com/node/8913

6. www.bis.org/publ/bcbs246.htm

Already registered? Login to access premium content

Give Feedback