It is easy to forget about trade finance, what with the eurozone crisis and efforts to simultaneously rein in banks’ excesses while pushing them to lend more occupying the minds of politicians and central bankers worldwide.
Yet the impact of those challenges on this crucial component of the global financial system could be sufficient to undermine efforts to restore economic confidence.
World trade is under pressure. In September, the World Trade Organization downgraded its growth expectations for trade volumes for 2011 to 5.8%, with developed economies’ exports growing by 3.7% and shipments from developing economies increasing by 8.5%.
Downside risks to GDP have intensified in recent months, and where output goes, trade tends to follow. “This is the time to strengthen and preserve the global trading system, so it keeps performing this vital function,” says Pascal Lamy, director-general of the WTO.
The danger is that by focusing on the big picture of the eurozone debt crisis and enhancing the regulation of banks, the goal of strengthening and preserving the global trading system is being overlooked. At the least, the impact of Basle III on banks’ appetite for trade finance and the availability of US dollar liquidity to non-US banks are expected to shake up the business as never before, with big implications for trade and economic growth.
A year ago, many leaders in trade finance warned that the failure to exempt trade finance from some of the more onerous aspects of Basle III would have catastrophic consequences for world trade, and pledged to fight against them.
Objections centred on two main areas: the use of a standard-asset-value correlation (the value derived by analysing historical loss data for asset classes) for corporate banking, despite the short-term, low-risk nature of trade finance products; and the application of a 100% credit-conversion factor (the percentage used to convert off-balance-sheet items to credit-equivalent assets) for all off-balance sheet items, including trade finance, when calculating a leverage ratio.
On both issues, the trade finance lobby failed to overturn the Basle Committee on Banking Supervision’s existing decisions. Instead, the committee made a handful of small concessions, according to John Ahearn, global head of trade, global transaction services at Citi, which is ranked first globally in Euromoney’s trade finance survey. “The removal of the one-year floor for commercial letters of credit, for example, represents a small subset of the business,” he notes.
What happened? Ahearn says the banking industry did not succeed in making the Basle Committee understand the granularity of the trade business because of the backdrop of problems in the eurozone and the banking sector. In other words, the public mood made giving any concessions to banks, no matter how logical and important for global trade, politically difficult.
Markus Wohlgeschaffen, head of global trade finance and services at UniCredit (ranked fifth globally in the survey), adds that the banks’ lobbying effort was not as convincing as it needed to be. “Trade finance is crucial for world trade,” he says. “But in terms of outstanding exposure for big banks, it is a minor issue and there was a lack of focus to industry efforts to make a special case for trade finance.”
Separating the impact of Basle III from that of the eurozone crisis and general deleveraging by banks is difficult because they are occurring concurrently. However, while some banks’ difficulties in sourcing US dollar liquidity are undoubtedly primarily attributable to the eurozone crisis, they cannot be divorced from market perception of risk, which is being stoked by Basle III.
“A lot of banks initially thought that Basle III would have little impact until 2014/2015, but the reality is that most banks are now pushing to make a public statement of compliance in 2012,” says Ahearn. “This is putting the market under a lot of stress, as can be seen in the swaps market, where it has become extremely expensive to swap euros to dollars. Most swaps are for three to five years, and Basle III will come into effect over that time horizon.”
Euro-dollar swaps matter to European banks’ trade finance businesses. A report published in October by Ronit Ghose, head of the European banks equity research team at Citi, stated that two-thirds of international trade worldwide is priced and settled in US dollars; the figure is even higher in Asia. Moreover, international financial markets and operations are mainly conducted in US dollars. For example, 85% of FX transactions involve the US dollar as one side of the trade.
Ghose explained that the ability of an international bank to run a successful trade finance business is dependent on its ability to access US dollar funding. “For a US bank, or even a Hong Kong bank, this is less of an issue, given their access to US or HK dollar [pegged to the US dollar] deposits,” says Ghose. “However, European banks [rely] on short-term US dollar wholesale funding. This is becoming difficult to source from US money-market investors, and the alternative – swapping short-term euro funding for US dollar funding – is expensive.”
During the past three months, some trade finance players have been reducing their existing book, while activity in the secondary market has increased, according to Michael Spiegel, head of trade finance and cash management corporates, global transaction banking at Deutsche Bank, which is ranked third globally in the survey. “There is a correlation between those banks that are having difficulty raising US dollar liquidity and those reducing their books.”
Rakesh Bhatia, global head of trade and receivables finance at HSBC, ranked fourth globally in the 2012 survey, agrees: “It has impacted their ability to compete aggressively and there has been a softening in their participation in trade finance.”
Citi’s Ghose says French banks have been worst hit so far by US dollar liquidity problems, and while they will be able to manage an orderly reduction in their US dollar assets, they will inevitably “have to pull back from their international trade financing activities”.
Thierry Josz, head of trade finance at BNP Paribas, says only that the bank’s “goal, thanks to its solid foundation and large global network, is to meet the expectations of its clients – which we have consistently done”. BNP Paribas’s performance in the past year has been impressive and the bank is ranked second globally in Euromoney’s 2012 survey, but the majority of voting for the survey took place in the second week of September and it will be tough for the bank to replicate its success next year.
Josz declined to comment directly on the bank’s liquidity troubles. BNP Paribas has replaced bank operations in Greece and Israel with representative offices and while a decision on scaling back trade finance elsewhere has yet to be taken – so, theoretically, it could resurrect its business if liquidity returns – crunch time is imminent.
One might imagine that rival banks would welcome less competition, but Ahearn at Citi says the downsizing of some banks’ trade finance businesses could be dangerous for global trade. “Trade finance is not just a question of availability of funds,” he explains. “The French banks, for instance, are key players in the field of commodity finance. If they withdraw from the market, there could be huge increases in price and a loss of expertise. Banks can’t simply jump into that market, and as a result commodity markets could freeze up.”
The impact on pricing of some banks’ retreat from trade finance has been limited – in contrast to 2008. “Then, US banks were in a tight spot, and pricing in the market went up substantially as a result,” recalls Bhatia at HSBC. “Now, while there is less trade finance available given the predicament of European banks, the impact on pricing has been more limited – it has risen less sharply. US banks have not increased pricing aggressively because they are seeking market share. However, to succeed in trade finance, a bank needs not only funding but also access to potential customers, which is hard to achieve – especially among small and medium-sized enterprises – in a short period.”
The immediate problem of the availability of US dollar liquidity might affect European banks but Basle III has implications for all banks. “As Basle III stands, it will have a substantial negative impact on the trade finance business,” says Wohlgeschaffen at UniCredit. “Applying the asset valuation correlation multiple of 1.25, trade finance books would have to digest an increase of 25% to 30% of risk-weighted assets.”
He added that the failure to amend the credit conversion factor for off-balance-sheet trade assets – which will go from 25% to 50% presently to 100% under Basle III – will result in a further increase of risk-weighted assets. “At the same time, there have been changes to rules regarding collateral so that ECA [export credit agency]-backed assets no longer might qualify as collateral,” he notes.
Is all lost in the battle to protect trade finance under Basle III? One senior trade finance banker said there is no chance that rules on the treatment of trade finance assets under Basle III will be reconsidered. “There is a reluctance to acknowledge the mistake that had been made,” he says.
Others are less pessimistic. “We are seeing good dialogue between the industry and regulators, and we hope this engagement will result in processes that will allow and facilitate institutions to provide the necessary finance and tools for global trade,” says Ashutosh Kumar, global head of cash and trade at Standard Chartered, ranked sixth globally in the survey.
Certainly, Baft-Ifsa, the global financial services association, confidently restated its hopes for Basle III after the announcement of the limited changes to the regulatory treatment of trade finance in October by the Basle Committee. Moreover, UniCredit’s Wohlgeschaffen says the industry is now more focused on the challenges than it was a year ago. “Previously, banks were simply claiming trade finance was a robust business. Now the International Chamber of Commerce default register, which analyses default rates over five years, provides liquid proof of the low-risk characteristics of the industry. That register was not considered in the Basle Committee’s last statement. The Basle Committee recognised the initiative and will analyse the results.”
While further concessions – however small – on trade finance would no doubt be welcomed by the industry, the problem is less the specific treatment of trade finance under Basle III than that the more general provisions of it will weigh especially heavily on trade finance because of its characteristics.
“Basle III is not specifically anti-trade finance, but the risk is that, as banks adhere to Basle III, especially in current market conditions, they might have to deleverage,” says Bhatia. “Cutting back on trade finance is a quick and easy way to achieve that goal and improve a bank’s capital position, given that it is short term and self-liquidating.
“The environment is highly uncertain, and the enforcement of those requirements for higher capital, liquidity management and lower leverage will have an inevitable impact on lending when such lending is so critical to sustain economic growth. Pricing will go up and there could be an impact on trade and economic growth.”
Some European banks see Basle III as acting to cement the recent gains made by US banks at the expense of European banks – because US banks will not have to introduce it. “The US will not apply Basle III, as it did not apply Basle II, so unless European politicians wake up to this threat, they will be responsible for the demise of the European banking industry,” says a senior European trade finance banker.
However, Ahearn said that big US banks that compete globally are moving towards Basle III. “The argument that the US might not implement Basle III on the same timetable as Europe, and therefore give advantage to US banks in trade finance, is irrelevant,” he says.
The probability of a wholesale revision of Basle III that would limit the need for banks to deleverage, and therefore protect the provision of trade finance, is zero says Ahearn. “There is simply not enough data to be able to win an argument that Basle III will result in sufficient withdrawal of trade finance to plunge the world into a recession.” Nevertheless, even the most conservative trade finance bankers – for reasons that appear to stretch beyond self-interest – believe the impact of Basle III will dramatically decrease the provision of trade finance, undermining trade.
What could fill the gap and help protect world trade? “Counter-measures need to be urgently put in place to stop a negative cycle developing where growth slows further,” says HSBC’s Bhatia. “One answer is that the role of multilateral institutions will increase further to counter the large-scale withdrawal of trade finance, but we doubt this in itself would be sufficient.”
Instead, a more fundamental rethink of trade finance might be necessary. “The industry has to find new ways to create additional liquidity in trade finance,” says Spiegel at Deutsche Bank. “It is in the funded market where new investors are needed. There is a lot of liquidity to be deployed globally, and trade finance will have to become more capital markets-focused to tap this pool.”
Ahearn agrees: “As an industry, we are efficient at generating assets, but we can’t hold everything on our balance sheet. In the past, distribution was almost solely to other banks and efforts to find other investors were half-hearted. Now, as a priority, we need to focus on other types of institutions so we can churn our balance sheet.”
Axel-Peter Ohse, head of GTB Germany at UniCredit, said that non-banks are looking at trade finance because of its low-risk characteristics. Nevertheless, according to Spiegel, it will take time and much effort by the distribution and portfolio management units of banks to develop attractive market instruments, and collateral structures might need to be improved.
“It is important to consider where non-bank investors will enter the trade finance market,” says Ohse. “For example, hedge funds don’t traditionally target a transaction covered by an ECA but the uncovered portions that offer a better risk-return profile. Another example is the logistics industry, where there might be willingness to provide trade and inventory finance, but this is likely to be more focused on administration and process management rather than funding.”
To create a new market in trade finance assets, there are three prerequisites – none of which is impossible to achieve, says Ahearn. “Firstly, we must convince investors this is a good asset class. Secondly, there needs to be a breakthrough in how these assets are packaged. Thirdly, the returns have to be made palatable to these investors. A larger re-pricing is still to come in trade finance and that could be important in encouraging other potential investors.”
