Basel III: What more is to come for trade finance?

Caroline Maginn, Trade Partner at Cash Management Matters (CMM) comments on a very positive ICC Banking Commission initiative that galvanised a group of leading trade finance banks to work together to give qualified input to Basel III. This should support the industry as a whole to engage in the on-going provision of trade finance liquidity in support of the real economy

 Trade loans to corporates and banks carry a very low loss history and defaults do not necessarily result in write-offs. Although the data collected for this report would support a lower risk-based capital weighting, the Basel II Risk-Based Capital Credit Conversion Factors are more than sufficient and should be maintained.” – So concludes the recent report from the International Chamber of Commerce’s Banking Commission, “Global Risks –Trade Finance 2011”.

 In 2009, as Mr Kay Chye Tan, chairman of the commission, states in the preface to the report, the ICC and the Asian Development Bank decided to establish the ICC Trade Finance Register; to collect performance data on trade finance products to substantiate the argument that trade finance was, relatively speaking, a low-risk form of financing.  In so doing the intention was to provide the much-needed empirical basis for discussions regarding the treatment of trade financing.

The latter includes, very importantly, the dialogue with the Basel Committee on its policy making with regard to trade finance. The register provides compelling favourable evidence for banks and policy makers to bear in mind when approving trade finance related credit lines and when determining the appropriate levels of capital to be put aside by banks for trade facilities.

 A healthy quorum of significant trade banks contributed to this initiative by way of support or sponsorship:

• Bank of America Merrill Lynch
• Bank of China
• Barclays
• BNP Paribas
• Citibank
• Commerzbank
• Credit Agricole
• Credit Suisse
• Deutsche Bank
• HSBC
• ING
• J.P. Morgan Chase
• Royal Bank of Scotland
• Santander Global Banking
• Standard Chartered Bank
• Sumitomo Mitsui Banking Group
• UniCredit
• Wells Fargo

Source: Global Risks – Trade Finance 2011. An initiative of the ICC Banking Commission

The provisions contained in the current Basel II framework are: –
– Credit conversion factors of 50 per cent for transaction related contingent items (eg performance bonds, bid bonds, warranties and stand-by letters of credit related to particular transactions)
– Credit conversion factor of 20 per cent for short-term self-liquidating trade letters of credit arising from the movement of goods (eg documentary credits collateralised by the underlying shipment).

 Specific to trade finance related transactions

 Basel III, as currently drafted, increases the credit conversion factors further to 100 per cent.This directly impacts, and steps up, both the capital that banks will need to set aside for trade finance facilities provided to clients and the costs they will need to charge clients. It is to be hoped that initiatives such as this from the ICC will impact favourably on the discussions of policy makers to avoid potentially adverse effects on global trade and growth.

 At the heart of trade finance transactions are the ICC’s frameworks of rules for, inter alia, letters of credit, collections and demand guarantees, which are uniformly respected by and adhered to by banks engaged in trade finance internationally. As such, the ICC is uniquely well-placed to execute this initiative and create the Register.

 The key messages as set out in the report are:
– Trade finance, which supports USD 14-16 trillion in annual global commerce, is crucial for international trade
– The ICC Trade Finance Register bridged the information gap impeding the formulation of policies and has created a living database of the trade    finance market and helped to demonstrate the resilience of trade finance
– The ICC Trade Finance Register is the most comprehensive dataset now available on the market and has demonstrated the true nature of trade finance
– Data pooled within the register supports the view that trade finance is a low-risk asset class. The notable features are:
– The short tenor of trade transactions (average tenor of all products in the dataset is 147 days and off-balance-sheet products averaged less than 80 days)
– The low default and loss across all product types (fewer than 3,000 defaults were observed in the full dataset comprising 11.4 million transactions)
– The ICC concluded that trade finance was not the main driver behind the 2008 trade collapse.
– Based on the report’s key findings the ICC maintains that new Basel regulations should not constrain trade finance supply and that standards-setters and policy makers should study, carefully, the potential unforeseen impact of Basel III changes on trade
– In particular, the report’s 2011 data supports the view that the increase in the leverage ratio under the new regime would not reflect market realities and may significantly curtail banks’ ability to provide affordable financing to businesses in developing countries and to SMEs in developed countries

This very significant ICC initiative, to gather and publish factually based evidence of the risk mitigation inherent in trade finance, is to be wholly welcomed and endorsed. The report examined more than 11 million transactions, over a six year period from 2005 – 2010, provided by 14 major banks, on a trusted, confidential basis, with particular focus given to the period 2008 – 2010 to cover the effects of global financial crisis. For those three years, using a standard calculation, the ICC calculated the following average default rates within each product type:

Product Type                                                                  Default %                                        Loss %

Import L/Cs                                                                              0.067                                              0.006

Export Confirmed L/Cs                                                        0.09                                                 0.03

Standbys and Guarantees                                                    0.013                                              0.0007

Import Loans – Corporate Risk                                         0.06                                                 0.07

Import Loans – Bank Risk                                                    0.09                                                 0.05

Export Loans – Corporate Risk                                          0.29                                                 0.017

Export Loans – Bank Risk                                                     0.17                                                 0.01

 Source: Global Risks – Trade Finance 2011. An initiative of the ICC Banking Commission

 The Basel Committee on Banking Supervision has begun to take these report findings into account and, after consultation with the World Bank, the World Trade Organisation and the ICC, has evaluated the impact of Basel II and Basel III on trade finance in the context of low income countries. Two changes to the capital framework have been already agreed, namely to:
1.  Waive the one-year maturity floor for certain trade finance instruments under the advance internal ratings approach for credit risk
2.  Waive the so-called sovereign floor for certain trade-finance related claims on banks using the standardised approach to credit risk.

 The relevance of the initiative is of key importance to the GCC economy. Trade liquidity is of systemic importance and has been a core need of clients and products for banks throughout 2007-to-date as highlighted in CMM’s Tajara Research Reports covered in earlier editions of this magazine.

 The GCC have a key role to play in the Basel III deliberations as evidenced by the role of the KSA in the Basel Committee and the sheer size of trade assets booked by GCC banks. In the KSA, for example, as reported in an earlier edition of the magazine in an extract from the Tajara Monitor, the banks accounted for USD 86bn of trade related contingent items, outstanding as at the end of 2010.

Increased capital for trade finance facilities will increase the cost of providing those facilities to banks and potentially corporate clients with a resultant negative impact on global trade and the on-going provision of trade finance liquidity and cost viability particularly for SMEs.

 There is a strong argument that can only gather pace if more banks join the 14 major banks that have contributed data to the register.

 There should be no great difficulty for GCC banks active in trade finance to do this as they have been rigorously implementing and reporting on their compliance to the Basel I and II frameworks and have, accordingly, meticulously maintained their databases on default and loss for their overall portfolios. This has been overseen and prescribed by their local regulators, who have consistently ensured adequate capital provisioning and reporting and might reasonably recommend to GCC banks to join this important initiative. Any banks that subscribe to give input to the living register do so on a trusted, confidential basis, and only consolidated data pool results are published.

 The hoped for responses to the register and report are that:
– the Basel committee will continue to listen to this living database of the trade finance market and make less stringent provisions for trade finance, which is now demonstrably low-risk and of systemic importance to the functioning of the world economy; and
– More banks will join the 14 that initially subscribed to support it by providing the same data input on a confidential basis.

CMM will continue to monitor developments in this important area with interest .The full text of the report is available on the ICC website http://www.iccwbo.org  and should make interesting reading for all GCC trade finance practitioners. n

 Will any of the GCC Banks show their commitment to Trade finance by subscribing to this important ICC Trade Finance Register and adding their voice to that of the group of eighteen banks who have supported and or sponsored the initiative so far?