Implications of Basel Framework on Trade Finance

No one can ever underestimate the importance of trade finance, especially under current severe economic situation. The success of a nation’s export program and even economic recovery, to some significant extent, relies upon the availability of trade finance, which facilitates the transfer of commodities and manufactured good between countries.

Trade finance covers a spectrum of payments 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. According to IMF estimate, by 2008 the global merchandise trade reached some 16 trillion USD. International Chamber of Commerce (ICC) banking commission believes that almost 90% of the world merchandise trade is supported by trade finance.

The Basel Committee on Banking Supervision (BCBS, or Basel Committee) is an institution created by the central bank Governors of the Group of Ten nations in 1974, and now comprise of 27 members from both developed and emerging economies. The BCBS is mandated with issuing supervisory standards and guidelines and recommending statements of best practice in banking supervision, with the aim to encourage global convergence toward common approaches and standards. The Basel Committee along with its sister organizations, the International Organization of Securities Commissions (IOSCO) and International Association of Insurance Supervisors (IAIS) together make up the joint fora of international financial regulators.

The most influential publications by the BCBS are Basel Accords (the initial version was issued in 1988, undated in 2004 and 2010 respectively). The key part of Basel Accords, or Basel framework as commonly referred to, guides banking industry how to calculate risk-weighted assets (RWA) and capital requirements, and the Basel Committee has just finished the final text 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. As requested by the G20 Leaders, the Basel Committee, in a press release issued on Dec 1st 2010, will evaluate the impact of the regulatory regime on trade finance in the context of low income countries.

The focus of this paper is on short-term trade finance arrangements in which the banking system provides lending, insurance against nonpayment, or other support to help international trade. For example, the importer’s bank may provide a letter of credit to the exporter (or the exporter’s bank) providing for payment upon presentation of certain documents, such as a bill of lading. Or the exporter’s bank may make a pre-shipment loan (by advancing funds) to the exporter on the basis of the export contract or the letter of credit, etc.

Part I. Definition and functions

There is no universal definition about trade finance, and people may use the same term for different things. According to LEE Yow Jinn from International Trade Institute of Singapore, trade finance refers to the institutions, laws, regulations and other systems related to the following three activities: 1. provision of capital to firms that are engaging in international trade transactions, 2. provision of support services to manage the risk involved in these transactions, and 3. provision of international payment mechanisms.

The Basel Committee does not define trade finance itself. However in June 2004 when the BCBS issued International Convergence of Capital Measurement and Capital Standards: a Revised Framework (Basel II), it defines commodities finance as one of the five-subclass specialized lending. According to Basel II paragraph 223, commodities finance refers to structured short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the exposure. It is believed that commodity finance covers on-balance-sheet part of trade finance.

Basel II also stipulates the way to handle with off-balance-sheet (OBS) items. OBS items under the standardized approach as well as in foundational internal ratings- based (FIRB) approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF).  A 50% CCF will be used for certain transaction-related contingencies (e.g. performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions), and a 20% CCF will be used for  short-term, self-liquidating trade-related contingent liabilities arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipments). Under the advanced internal ratings- based approach (AIRB), banks will be allowed to use their own internal estimates of CCFs across different product types, provided they meet the minimum requirements.

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.

Letters of credit allow the issuing banks to substitute their creditworthiness for that of their customers. At an importer’s request, the issuing bank pays stated sums of money to sellers of goods against stipulated documents transferring ownership of the goods. Through L/Cs, exporters can be assured about the payment from the importer and mitigate commercial risks by gaining assurance from the importer’s bank.

Under a pre-shipping financing, a bank may grant short-term loans, discount L/Cs or provide advance payment bonds for the exporter, to ensure that the company has sufficient working capital for the period before shipment of the goods. An exporting company can get post-shipping financing to bridge the period between shipping the goods and receiving payment from the importer.  

Collection is a very important form of trade finance to facilitate the payment. Basically, there are two types of collections: clean (financial document alone) and documentary (commercial documents with or without a financial document). A financial document is a check or a draft; a commercial document is a bill of lading or other shipping document. A clean collection involves drafts and checks presented for collection to banks by their foreign correspondents. In a documentary collection, the exporter draws a draft or bill of exchange directly on the importer and presents this draft, with shipping documents attached, to the bank for collection. In collection and letter of credit transactions, the bank takes a very active role in the exchange of documents between buyer and seller.

With further development of trade, there come into existence new forms of trade finance. For example, factoring gains momentum in emerging markets recently. This involves the sale at a discount of accounts receivable or other debt assets on a daily, weekly or monthly basis in exchange for immediate cash. The debt assets are sold by the exporter at a discount to a factoring house, which will assume all commercial and political risks of the account receivable. In the absence of private sector players, governments can facilitate the establishment of a state-owned factor or a joint venture set-up with several banks and trading enterprises.

Part II. Roles in promoting economic recovery

 

It is recognized that world trade is essential to the economic recovery and that the availability of trade finance is key to the smooth functioning of trade flows. Any disruption in the ability of the financial sector to provide working capital, export finance, issue or endorse letters of credit or deliver export credit insurance, is likely to create a contraction in trade and output.  Trade finance is particularly vital to emerging markets and least-developed countries.

More than ever, the level of activity in trade finance markets is crucial to global economic recovery. Limited access to trade finance significantly curbs import/export activity, one of the principal drivers of economic growth. With the global integration of supply chains, trade had become proportionally more responsive to output changes. Historical data shows that the elasticity of global trade volumes to real world GDP has increased gradually from around 2 in the 1960s to above 3 in recent years, driven by production-sharing networks and the proliferation of global supply chains[1]. The higher elasticity means that trade declines faster than in the past as output drops, but it also suggests that a more rapid recovery will take place as the recession ends.

The World Trade Organization (WTO) pointed out that the global trade volume dropped by 12% in 2009, the greatest decrease since World War II[2]. The World Bank estimates that 85-90% of the fall in world trade since the second half of 2008 is due to falling international demand, and 10-15% is attributable to a fall in the supply of trade finance. The potential damage is enormous to the real economy from shrinking trade finance. More important, small and medium-sized enterprises (MSEs) rely on a high level of trust and confidence in global suppliers that they will deliver their share of the value-added, and need financial means to produce and export it in a timely manner.[3]

Responding to ongoing financial crisis, governments and enterprises all over the world, with their deep awareness of the importance of trade finance, have paid more and more attention to the unique role of trade finance. The London G20 Summit held in April 2009 contended that the recovery of international trade and investment was the key to the global economic growth. Thus the summit put forth several important measures such as providing 250 billion US dollars for trade finance through multilateral banking mechanism and export credit agencies to facilitate the resurrection of international trade and bail out the world economy.

Part III. Risks and Features

 

The risks associated with trade finance are credit, transportation and political risks, amongst others. The credit risk is by far the most severe threat essentially from the inability of one of the parties involved to carry out its obligations. For example, an exporter is not able to secure payment from his merchandise in case of rejection from the importer for improper quality or in case of insolvency or bankruptcy of the importer. Alternatively, the importer may suffer from a delayed or false delivery of goods from the part of the exporter.

However in trade finance, many transactions are short-term credit and self-liquidating, and most credits are supported by L/Cs and letters of guarantee (L/Gs) from banks, some collateralized by the underlying shipments of goods. ICC banking commission claims that default rate of trade finance is very low, and trade finance is a very safe asset on banks’ balance sheets. 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. [4]

Trade finance is a well-established industry practice. With regard to trade finance and guarantee conducted against the real trading background, there are international standardized and mature rules and practice as business guidelines recognized within the industry and as authoritative evidence to resolve disputes and conflicts in a just and reasonable manner.

According to OCC handbook, upon reviewing the history and performance of trade finance credit, the Interagency Country Exposure Review Committee (ICERC) usually concludes that trade finance credits granted by US banks to entities in foreign countries have a low risk of default. The low default risk is due, in part, to the importance that countries assign to maintaining access to trade credits. In a currency crisis, central banks may require all foreign currency inflows to be turned over to the central bank. The central bank would then prioritize foreign currency payments. Trade liabilities would be more likely to be designated for repayment than most other types of credits. For this reason, trade finance is viewed as having less transfer risk than other types of debt.[5]

One more factor helps to account for low credit risk for trade finance. Even in times of severe difficulty, companies will generally try to avoid defaulting on trade obligations, as continuing access to trade finance is a lifeline for most firms. In a similar vein, it should also be noted that trade-related instruments are generally the last forms of credit to be cut, and the first to be established, in debt-distressed economies.

That safe nature of trade finance is well recognized by the BCBS. When the committee published (and later updated) International Convergence of Capital Measurement and Capital Standards (Basel I), a preferential 20% CCF was assigned to short-term, self-liquidating trade-related contingent liabilities arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipments).

Part IV. Basel Regulations’ Likely Impact

 

As said above, trade finance received a favorable regulatory treatment under Basel I (20% CCF value). The basic text and CCF value for trade finance is largely unchanged under Basel II, however, as the banking and regulatory communities are moving toward internal ratings-based (IRB) methodology, a number of concerns emerged with respect to the treatment of trade assets, particularly in periods of economic crisis. As the official sector has just published the final text of Basel III[6] by imposing more stringent capital requirement, tougher liquidity ratios as well as an un-weighted leverage ratio, people are more and more concerned that the Basel III proposals might have adverse consequences on trade finance, particularly for SMEs and counterparties in emerging markets.

1. Basel II 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 and less robust legal system, and 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.

Financial Stability Institute (FSI) in last August published 2010 Survey on the Implementation of the New Capital Adequacy Framework: Summary of Responses to the Basel II Implementation Survey.[7] According to this survey, more than one third of respondent banks would prefer to use standardized approach to implement Basel II. Considering those respondents are more likely international active banks, the percentage of banking employing standardized approach, particularly from emerging markets, will be much higher.

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 what 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 plays 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. [8]

2. One year maturity floor should be waived for trade finance

Basel II paragraph 320 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 OBS items 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% 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.[9].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 should not Cover Trade Finance

 

Basel III capital standards paragraph 102 prescribes that a multiplier of 1.25 is applied to the correlation parameter of all exposures to those financial institutions with assets of $100 billion or unregulated financial institutions. Under the rule, asset value correlation (AVC) of financial institutions employs a multiplier of 1.25 in the framework of IRB. Although it will definitely strengthen the capability of financial institutions to prevent systematic risk, the proposed AVC is nearly two times that of the present one in Basel II.

The rule will increase the cost of the providing credit to trade finance, thus potentially inhibiting the flow of trade. The implementation of this rule may incentivize banks to lend more to financial institutions which are some (less than $100 billion in assets) and thereby taking risks which they would have otherwise not taken. In addition, the rule will also potentially impact the AVC for risk participations, which could limit a bank’s ability to use risk participation, thus increasing a bank’s exposure to underlying risk in a transaction. Therefore trade assets should not be included in the financial institutions assets calculation when determining the AVC should be applied.

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.

Part V    Recommended Solutions

The implementation of Basel framework will undoubted strengthen the resilience of international banking industry, however the official sector as well as the private should work closely to avoid any potential unintended consequences.  Given the importance of trade finance to economy recovery and its primary characteristic of low default risk, some corrective proposals should be raised to facilitate its smooth development.

1. Adjust Default Data Calculation Requirements. Most financial institutions lack historical performance data of trade finance (usually with short term in tenor). Current Basel default data calculation requirements may disadvantage trade finance focused banks. Banks should be allowed to enhance their current default data calculations using available industry data, such as the ICC Trade Finance Default once it improves its data quality.

2. Leverage ratio should give preferential treatment to trade finance. Trade-related OBS item business is generally considered a routine operation, providing liquidity and security to the movement of goods and services, but it is regulated by leverage ratio in the Basel III this time. It is inappropriate for the Basel Committee to give the equal treatment to trade-related OBS item as derivatives which are the real source of excessive leverage in the banking system and the real cause of financial crisis. Historically, a very small portion of letters of credit, trade guarantees, and trade standby letters of credit (SBLC) convert into on-balance sheet exposures. The BCBS should develop a more adequate treatment of trade finance for leverage purposes ,which takes into account the fact that a very small portion of these off-balance sheet exposures convert into on-balance sheet exposures, even in stress scenarios.

3. Create separate AVC for trade finance. Trade exposures which are diverse in nature, smaller in value, shorter in tenor and self-liquidating in nature and which exhibit different behavior and payment patterns from other corporate banking products, may warrant a separate AVC.

4. One-Year maturity floor should be abolished. The Basel Committee allows national regulators to waive the one-year maturity floor for trade finance. However, most of the national regulators have not executed their discretion. Even in countries where this is waived, it is waived only for a limited list of trade finance products. The Basel Committee should move forward to encourage national supervisors to waive one-year maturity floor.

5. Preferential run-off rate should be given to trade-related OBS items. The national discretion of giving preferential run-off rate, such as 5% or 10%, should be pushed, just as the one-year maturity floor above.

6. It might be timely to set up a BCBS Working Group on Trade Finance. The Basel Committee will evaluate the impact of the regulatory regime on trade finance in the context of low income countries, as requested by the G20. Given the broader concerns surrounding the (unintentional) impact of Basel framework on trade finance, it may be timely for the Basel Committee to establish a specialist trade finance working group. Such a group would be well placed to examine the specific characteristics of trade finance products, the issues that arise when applying the existing regulatory framework to trade facilities, as well as the trade related aspects of the Basel Committee’s current proposals.


[1] The Trade Response to Global Downturns: Historical Evidence, abstract, by Caroline Freund, The World Bank Development Research Group Trade and Integration Team, August 2009,WPS5015

[3] Boosting the availability of trade finance in the current crisis: Background analysis for a substantial G20 package, by Marc Auboin, WTO Secretariat, Center of Economic Policy Research, Policy Insight 35, June 2009

[4] ICC: Report on findings of ICC-ADB Register on Trade & Finance Statistical analysis of risk profile of trade finance products, page 6.

[5] OCC: Comptroller’s Handbook: Trade Finance, Page 3, November 1998

[6] There are 2 parts, one is Basel III: A global regulatory framework for more resilient banks and banking system, and the other is Basel III: Basel III: International framework for liquidity risk measurement, standards and monitoring.

[8] One further point. The Basel Committee provides that the counterparty cannot be rated higher than the country risk. This provision does not conform to the basic philosophy that capital adequacy assessment should be aligned more closely with the key elements of risk. The mere location may not necessarily be a good indicator of a bank’s creditworthiness. Besides, any deterioration of the country risk during period of recession will automatically and negatively affect the counterparty risk regardless of the underlying creditworthiness of that counterparty

[9] ICC: Register on Trade & Finance:  Statistical analysis of risk profile of trade finance, Products

Document No. 470/1147 (Rev) – 21 September 2010, page 5/6.

About wilbertouyang

I am a Chinese, just moved from China to the States. I am now working for the banking compliance field, especially keen on new basel accord, liquidity risk, corporate governance, etc.
This entry was posted in Banks, Basel Accord, Regulations. Bookmark the permalink.

3 Responses to Implications of Basel Framework on Trade Finance

  1. Erigro says:

    very interesting. Do you have a PhD in Economics or finance?

  2. I have read so many posts on the topic of the blogger lovers but this piece
    of writing is genuinely a pleasant piece of writing, keep it up.

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