Trade finance fears remain despite Basel shift

Rebecca Brace
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The move to soften the liquidity coverage ratio will have little impact on boosting trade finance, as the industry’s chief concerns – capital ratio hikes and the incoming leverage ratio – still weigh heavy. The hope is that the Basel Committee’s recent flexibility sets a positive precedent.

The Basel Committee’s announcement on January 6 that Basel III’s liquidity rules are to be less onerous than expected comes as a relief to many in the industry. However, the relaxation does not resolve all of the concerns around the new regulation, particularly those concerning trade finance.

What has changed?

Basel III, developed by the Basel Committee on Banking Supervision in response to the financial crisis, is an international regulatory framework due to be implemented between 2013 and 2019. The new regulation – building on the capital adequacy requirements of its predecessors, Basel I and Basel II – also includes new liquidity and leverage requirements.

The recent amendments focus on Basel III’s liquidity coverage ratio (LCR), which requires banks to hold enough high-quality assets to cover cash outflows during a 30-day stress period. Broadly, amendments have been made in the following four areas:

The range of assets defined as high-quality liquid assets (HQLA) has been expanded while the assumed cash inflow and outflow rates during times of stress have been modified;

  • The LCR will still be introduced on January 1, 2015, as planned but its requirements will be phased in gradually. The minimum LCR will be 60% in 2015 and will reach 100% in January 1, 2019;

    Banks will be able to use their stock of HQLA during periods of stress;

  • The Basel Committee will continue to work on the interaction between the LCR and the provision of central bank facilities.
  • The Basel Committee’s changes come as welcome news to many in the industry. “The changes are basically about three things: clarification, further definitions and timing,” says Martin Knott, head of trade, GTS EMEA at Bank of America Merrill Lynch (BAML).

“Overall, it is a positive story, with the potential to have a short-term impact following the change in timing to meet the LCR 100% ratio.”

Impact on trade finance

However, the changes should not be seen as the cure to all of the industry’s concerns regarding Basel III.

Trade finance is one of the areas in which Basel III has been particularly controversial. Concerns have been raised that Basel III does not take into account the characteristics of trade finance instruments, treating them as riskier than they really are. As a result, the price of trade finance is likely to increase under Basel III.

“The recent announcement only concerns the liquidity coverage ratio element of Basel III, which actually was likely to have been limited on trade finance anyway,” says Mike Regan, head of regulatory developments, international banking at RBS.

Martin Knott, head of trade, GTS EMEA, BAML
“Certainly, the push back from banks and others in relation to trade and the Basel requirements has been more focused on the capital requirements and the leverage requirements.”

However, the revisions to the LCR do have some implications for trade finance. “Prior to the announcement, the Basel Committee left it to national regulators to determine the appropriate treatment for trade finance under the liquidity coverage ratio,” says Regan. “This left a lot of room for interpretation and different treatment from different regulators.”

The recent changes include amendments to the way in which hypothetical outflows during a liquidity stress scenario are calculated. Whereas national regulators had previously been free to decide upon the appropriate outflow rate for trade finance instruments, the new LCR text states: “In the case of contingent funding obligations stemming from trade finance instruments, national authorities can apply a relatively low run-off rate [eg 5% or less].”

The wording implies that the specified range of 0% to 5% is not set in stone. “They are not committing regulators to work within that range,” says Regan. “However, it is positive that they have given guidance which both highlights the fact that they consider trade to be low risk in the context of this requirement, and also limits the ability of different regulators to take materially different positions.”

Unresolved issues

The changes to the LCR do include some good news for trade finance, but concerns remain around the regulation’s leverage and capital requirements – and these have not yet been addressed.

“The bigger issue around Basel III that will impact trade finance relates to the leverage ratio,” says Ruth Wandhöfer, head of regulatory and market strategy, transaction services at Citi. “The leverage ratio is intended to bring about a limitation of growth, whereby banks will not be able to leverage their balance sheets as much as in the past.

“However, as it stands, the leverage ratio applies to all off-balance sheet items without distinguishing between less risky items such as trade finance and risky ones such as mortgage loans. Change will only come about if the Basel Committee formally reviews or clarifies the leverage ratio.”

In addition to the leverage ratio, trade finance will also be affected by the capital regime. “The regulators clearly want people to hold more capital,” says Wandhöfer. “Trade finance is a lending activity which has direct implications on the bank’s capital ratios. Of course, when the capital requirements are increased it will get more expensive, which has other knock-on effects.”

Future steps

“A lot of good work has been done since the Basel III framework was announced in terms of the collation of data to support the stance that trade is a relatively low-risk asset class with comparatively low levels of default and loss,” says BAML’s Knott. “For me, it is really about continuing to build that database and progressing the dialogue.”

Nevertheless, concerns remain around the treatment of trade finance under Basel III. “I am hoping that the EU adopts the changes that we proposed in CRD IV [the Capital Requirements Directive which implements Basel III’s requirements in Europe] where we are saying that trade finance assets are very particular as a class and should not be treated in 100% way under the leverage ratio,” says Wandhöfer.

“Therefore, you should not be restrained as much in your leverage around trade finance because there are predictable financial returns and flows that are backed by real economic activity. If this is achieved, the Basel Committee will look at this – as will the US regulators.”

The latest announcement might not have addressed all of the concerns the industry has around trade finance under Basel III – but as the changes to the LCR show, it is not too late for further tweaks to be made.