Basel III – Future Impact of Trade Finance

The Basel Committee on Banking Supervision (BCBS, or Basel Committee) is an institution created by the central bank Governors of 27 members from both developed and emerging economies. The most influential publications by the BCBS are Basel Accords. The key part of  Basel framework as commonly referred to, guides banking industry how to calculate risk-weighted assets (RWA) and capital requirements. The Basel Committee gave its  final text of Basel III on Dec 2010 of details of updated global regulatory standards on bank capital adequacy and liquidity, which was agreed by the Governors and Heads of Supervision, and endorsed by the G20 Leaders at their November 2010 Seoul summit.

Implementation in India From: January 012013. The Basel capital ratio will be fully implemented as on March 31, 2018

Impact on Buyers Credit

  • LOU costing will go up
  • LOU issuing bank would prefer their branches / subsidiaries for arranging funds because of the provisioning norms. Thus would reduce options to their customers.

Trade Finance

Trade finance covers a spectrum of payment arrangements between importers and exporters. While a seller (the exporter) would like to ask the purchaser (the importer) to prepay for goods to be shipped, the purchaser (importer) may wish to reduce risk by requiring the seller to document the goods that have been shipped. Banks may assist by providing support in various forms. International Chamber of Commerce (ICC) banking commission believes that almost 90% of the world merchandise trade is supported by trade finance.

With trade finance, exporters and importers can achieve four broad functions, i.e., arrange for payment, raising fund, mitigating risks and costs, and access of credit information. Trade finance transactions can be structured in a number of ways. The structure used in a specific transaction reflects the relationship between participants, countries involved, and competition in the market.  So far, letter of credit (L/C) transactions are the norm in sales associated with emerging market countries. Collections, especially documentary collections are also important in bank trade finance.

Basel III:  Trade Finance Regulations’ Likely Impact on Banks

1. Basel III framework is biased against banks in emerging markets.

The minimum standards set for the IRB approach even at the foundational level are complex and beyond the reach of many banks. Emerging markets would face serious implementation challenges with their low technical skills, structural rigidities, less robust legal system, shortage of experienced talents, etc. The complexity and sophistication of the proposals makes its application in emerging markets highly unlikely, where the banks continue to be the major segment in financial intermediation and would be facing considerable challenges in adopting all the proposals.

Under Basel II, for banks with good quality assets, the risk weighted assets (RWA) under IRB approach will be significantly lower than under standardized approach, and that is what exactly the Basel Committee intends to encourage banks to migrate from standardized approach. It is felt that the proposals will disadvantage banks in emerging markets. Those banks play pivotal roles in extending trade finance to local traders, with those banks’ cutting finance support, the trade development for emerging market will be adversely impacted.

2. One year maturity floor  for trade finance

Basel III prescribes one-year maturity floor to the maturity of lending facilities despite of the fact that the maturity of trade finance products is usually shorter than 180 days. Since capital requirements (naturally) increase with maturity length, the capital costs of trade finance are artificially inflated as a result. Such measurement does not precisely reflect the short-term and low-risk nature of trade finance and expands the occupation of risk capital of banks, which is not conducive to the development of trade finance business.

Basel II paragraph 321 stipulates that the one-year floor does not apply to certain short-term exposures, as defined by each supervisor on a national basis. In other words, the Basel Committee permits that all national regulators have the discretion to waive this floor,  however many regulatory authorities are still reluctant to exercise this discretion, even after UK FSA waived the one-year maturity floor at the end of 2008.

3. Lack of Specific Data Puts Trade Finance in an Unfavorable Situation

Banks are allowed to use either the standardized approach or the IRB approach to measure RWA in terms of credit risk. The fundamental difference between IRB and standardized approach lies in that banks would adopt their own models to estimate parameters required for calculating RWA. The low-risk nature of trade-related Off-Balance Sheet items (OBS) should lead to low values when calculating risk parameters and demonstrate the advantage of saving risk capital compared with other lending facilities. Nevertheless, IRB requires that banks accumulate relevant historical data for at least 5 years when calculating probability of default (PD) and the calculation of loss given default (LGD) and exposure at default (EAD) be based on data even longer.

The majority of banks in the world do not have sufficient historical performance data for trade-related OBS items. The factors causing this are wide and varied, but particular problems include: (a) migration of facilities (i.e. when a trade loss results in an exposure on another facility, such as an overdraft); (b) customer-centric data collection practices; and (c) inherent biases in the data collected. Due to the common shortage of relevant record of historical performance data of trade-related OBS items, the low-risk nature is not given a full play from the values of risk components devised by Basel II. When calculating the occupation of risk capital, banks have to adopt 20% or 50% Credit Conversion Factor (CCF) made by the regulatory rules and it gives rise to the excessive occupation of risk capital as far as trade-related OBS items are concerned.

The ICC, with Asia Development Bank (ADB), decided to establish a pooled performance database for trade finance products, which is called Register on Trade & Finance (the Register). By September 2010, altogether nine banks provided portfolio-level data comprising 5,223,357 transactions worth of USD2.5 trillion, with a total throughput between 2005 and 2009. The initial finding is encouraging. Only 1,140 defaults have been reported within the full data set of 5,223,357 transactions. More important, reported default rates for off-balance sheet trade products are especially low. The Basel RWA methodology are more concerned with issues of counterparty instead of facility issues, therefore it is somewhat difficult to build that some type of facility is low in credit default. However, the ICC is determined to further their efforts to meet regulatory requirements for data collection, and the ICC will work to enhance and expand the data collected.

4. Basel III 100% CCF for Leverage Ratio Proposal Poses Threat to Trade Finance

Basel III capital standards paragraph 163 provides that the Basel Committee recognizes that OBS items are a source of potentially significant leverage; therefore banks should calculate the above OBS items for the purposes of the leverage ratio by applying a uniform 100% credit conversion factor (CCF). Increasing the CCF to 100% for trade-related contingencies for the purposes of calculating a leverage ratio could significantly disadvantage trade finance-focused banks.

When the leverage ratio becomes compulsory, a bank may choose to increase the cost of providing trade products or selectively offer these products to customers, which will undoubtedly impact the perspectives of trade finance. It is not appropriate to apply 100% CCF to trade-related OBS items such as L/Cs and L/Gs in calculation of leverage ratio under Basel III. This calculating method fails to differentiate trade finance products from other OBS fictitious financial instruments. Trade finance products are often of the short-term and self-liquidating nature and closely related to the activities of real economy with actual trade background of goods and services. In other words, this sort of transaction is based on the real-economy need of customers and totally satisfies the demand of customers for credit enhancing, settlement and financing in the trade of goods and services. Compared with OBS synthetic financial instruments, it cannot increase market risk. Consequently, it is not justified to treat trade-related OBS items as the significant source of excessive leverage and to adopt 100% CCF to restrain them.

If the risk difference of distinct OBS assets is ignored, it might encourage banks to retain high-risk and high-profit asset businesses like derivatives driven by the motive to gain more profits when stepping into the precautionary area of leverage ratio supervision, thus deviating from the original intention of leverage ratio supervision.

5. Asset Value Correlation Cover Trade Finance 

Under Basel II, there are separate Asset Value Correlations (AVC) for retail mortgage, credit cards and other retail exposures. The correlations for these products are different due to the fact that they have different tenors, behavioural and payment patterns, and influencing macroeconomic factors. For corporate banking, there is only one AVC for all corporate products, including trade finance. Trade finance exposures are diverse in nature, smaller in value, shorter in tenor, self-liquidating and exhibit different behaviour and payment patterns from other longer term corporate lending products. Defaults on trade finance obligations are generally minimal, even during stress situations. This is supported by industry data from the International Chamber of Commerce (ICC) – Asian Development Bank (ADB) Trade Finance Default Register study. The study, covering 5.2 million trade finance transactions over a period of 5 years, confirms that trade finance has historically had low default rates, even during the financial crisis. Additionally, in the rare occasions when trade loans default, loss recoveries are high. The AVC proposals recommended by the Basel Committee could increase the cost of providing credit for trade transactions and limit their availability, particularly in emerging markets that rely on sustained and affordable access to trade finance to support commercial activities.

6. Likely Implementation Issue under Basel Liquidity Standards

On top of the aforementioned capital standards in the new Basel III regime, there are new liquidity ratios that firms are forced to adhere to.  Both the short-term Liquidity Coverage Ratio and long-term Net Stable Funding Ratio allow national discretion on all other contingent funding liabilities such as trade finance and L/Cs when calculating the amount of liquid assets and stable funding required to match the potential liabilities. As with the one- year floor issue above, it is likely that some national supervisors will use this discretion to implement onerous liquidity requirements, which, when added on to other aspects of Basel III, will restrict the availability of trade credit even further.  These rules should be harmonized to avoid having irregular national rules for global business.

Basel III:  Trade Finance Regulations’ Likely Impact on Companies.

  1. Increase in cost of trade finance. According to few bankers, trade finance will becoming 15 to 37 percent more expensive.
  2. Reduced number of banks providing trade finance. Trade finance is low margin business.  As capital requirement going up, bank would prefer to increase their exposure on asset which with more earning.
  3. In order to avoid higher capital requirement, banks may start insisting customer to take funding from their overseas branches for products like buyers credit instead of other banks. Reason : Under letter of undertaking provisioning norm would be at 100% where as incase of letter of comfort it would be zero.

Related Articles

  1. Treatment of Trade Finance under Basel Capital Framework : October 2011
  2. RBI Circular: Implementation of Basel III Capital Regulations in India – Final Guidelines : May 2012
  3. Report on Findings of ICC-ADB Register on Trade & Finance : September 2010
  4. Basel III : A global regulatory framework for more resilient banks and banking system: Revised Version : July 2011
  5. Basel III: International Framework for liquidity risk measurement, standards and monitoring: December 2010

Note: Purpose of putting this article is to explain the importance of Basel III and impacts that Basel III will have on Trade finance product like Buyers Credit. This article is summary of various articles available on Basel III. Please refer to subject matter expert before using the article.

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