Collateral counts

Reinhard Uhl, global head of trade finance at Deutsche Bank in Frankfurt, describes how traders are doing their bit to aid risk engagement by banks and investors.

At a time when borrowing costs are low, banks are liquid and investors are going through a periodic soft spot for the emerging markets, the last thing on anyone’s mind would be a credit squeeze in structured trade. Commodities traders should be roaming the world in search of untapped pastures to bring to market, safe in the knowledge that receivables or pre-export finance can be sourced at the drop of a hat.

Yet many of the farthest-sighted market participants are now becoming convinced that their credit lines will soon be under threat. How come?

The reasons can be traced back to the new risk culture that is permeating the financial sector, and banking in particular. Indeed, although it is easier to associate the new Basel II accord with risk assessment on long-term corporate debt, trade finance is also squarely in the sights of the Basel Committee (even if it does lie buried within the specialised lending protocol). Where trade financiers have been used to rating risk via what the Basel Committee would term ‘expert judgement’ – ie, relying on innate knowledge of their markets and past experience of their counterparties – the demands of compliance are causing a shift to more quantitative methods.

Such transparency is necessary not only to aid syndication between banks using different ratings systems, but also to keep the secondary market liquid and continue growing the investor base for structured-trade transactions.

This means building a greater degree of default protection into the facilities themselves, which in practice translates into traders once again offering genuine physical collateral over the underlying goods. And collateralisation is naturally likely to favour commodities, which are transparently priced, over manufactured goods, for which both the pricing and the liquidity of collateral is more challenging. Such collateralisation is a necessary piece of the jigsaw that will allow counterparties with good credit histories to be rewarded with cheaper credit under Basel II.

After years of traders steadily moving away from offering collateral, this may seem like cutting off your nose to spite your face, but when compared with some of the disparities caused by inappropriate past use of risk-adjusted return on capital or RAROC models for rating trade-finance risk, it is well worth it.

Trade finance has historically suffered from RAROC treatment. RAROC models were developed to help spot default risk in the bond market, rather than taking into account the much lower risk profile in the market for trade receivables. Trade finance is almost by definition a ‘repeat business’, meaning that counterparties are more careful because they will need the same transaction next week, next month and probably next year (especially with commodities). And trade counterparties do not become more risky with longer tenors – if anything, a maturing trading relationship should mean the reverse – although that is nonetheless the basis on which RAROC models tend to multiply risk. It is also well known that trade credit is prioritised in the event of default, including sovereign defaults. And, most importantly, trade creditors have recourse to the assets in question, which means they can sidestep queuing up with other creditors for a share of the security remaining in an insolvent company.

Taking collateral over the underlying assets is therefore the most direct means of offsetting risk for investors in trade receivables, and one that remains effective throughout an instrument’s lifecycle in the secondary market. But at origination stage, it also provides a key determinant of pricing under the advanced internal-ratings-based (A-IRB) component of Basel II.

A-IRB systems calculate risk weights according to three primary parameters – probability of default (PD), exposure at default (EAD) and loss given default (LGD). It is in the first of these fields that counterparties with good credit histories stand to be rewarded by their banks. Whereas under the current accord, many banks assign risk weights in line with public bond ratings – or according to a relatively crude scale for non-rated entities – Basel II will allow IRB banks to award their own risk weights. This means that counterparties with a good track record can be rewarded with lower PDs, resulting in a marginally lower risk weighting for the exposure as a whole.

But a good track record from the counterparty cannot reduce the bank’s calculation of EAD and LGD, given that these two remaining parameters measure the risk once a default has taken place. Only the availability of collateral on the contract can reduce these risk measures, bringing down the overall risk weighting assigned to the exposure. And given that lower risk weights demand less regulatory capital, this is a primary means of achieving cheaper credit from A-IRB banks.

Giving collateral over the goods is therefore likely to become a fact of life for borrowers sourcing finance on the structured-trade-finance markets. And with many borrowers already worried by a polarisation between large banks heading for investment-bank status and smaller niche providers, now is the time to make the concessions necessary for full Basel II implementation in 2008 by making collateral more readily available.