The prudential treatment of trade finance under Basel III: For a fair treatment

Marc Auboin, 7 March 2010

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There was a time when trade finance received favourable regulatory treatment. It was viewed as one of the safest, most collateralised, and self-liquidating forms of finance. This was reflected in the moderate of capitalisation for cross-border trade credit in the form of letters of credit and similar securitised instruments under the Basel I regulatory framework put in place in the late 1980s and early 1990s. The Basel I text indicates that "Short-Term self-liquidating trade-related contingencies (such as documentary credits collateralised by the underlying shipments)" would be subject to a credit conversion factor equal or superior to 20% under the standard approach. This meant that for unrated trade credit of $1,000,000 to a corporation carrying a normal risk-weight of 100% and hence a capital requirement of 8%, the application of a credit conversion factor of 20% would "cost" the bank $16,000 in capital.

The basic text and credit conversion factor value for trade finance was kept largely unchanged under the Basel II framework. But issues of pro-cyclicality, maturity structure and credit risk have arisen under the Basel II framework. In an internal-rating based and risk-weighted assets system, the amount of capitalisation to back-up lending depends on the estimated risk at a particular point in time and for a particular borrower. Trade-related lending is disadvantaged in low cycles because the risk-weighting of end borrowers is subordinated to that of the country risk, because of the high concentration of lending on small- and medium-sized enterprises, and because of the de facto one year maturity-floor applied to trade credits (while most of such credit is revolving every 90 to 180 days). In effect, as indicated by the International Chamber of Commerce (2009), "the capital intensity of lending to mid-market companies under Basel II is four to five times higher than for equivalent transactions under Basel I". To alleviate some of the biases of Basel II on trade finance, a sentence made its headway into the communiqué of G20 Leaders in London in April 2009, inviting regulators to exercise some flexibility in the application of these rules, in support of trade finance. That has not been the case yet, and remains an issue for the G20 to consider.

Basel III proposals

Notwithstanding the treatment of trade finance in the Basel II framework, on 10 January 2010 new proposals were made by the Basel Committee on Banking Supervision to the Committee of Governors of Central Banks and Heads of Supervision of the BIS. These proposals, contained in a Consultative Document ("Strengthening the Resilience of the Banking Sector"), are open for public comments through the spring of 2010. Under the new proposals, it seems that trade finance is facing another hurdle.

One of the key measures proposed by the Basel Committee to reduce systemic risk is to supplement risk-based capital requirements with a leverage ratio, to reduce incentives for "leveraging". The intention of reducing such incentives is relatively consensual, and has been shared by economists, regulators, and bankers. The idea, under Paragraph 24 to 27 of the BIS draft proposals, is to impose such a "leverage" ratio, in the form of a flat 100% credit conversion factor to certain off-balance sheet items.

However, under paragraph 232 of the Basel proposal, this would include "unconditionally cancellable commitments, direct credit substitutes, acceptances, standby letters of credit, trade letters of credit, failed transactions and unsettled securities." This provision is fuelling the highest fears in the trade finance industry regarding its future. While the in-balance sheet treatment of trade credit seems not to have changed capital-wise, the credit conversion factor for off-balance sheet operations records a five time increase relative to the 20% credit conversion factor used under Basel II for stand-by letters of credit and similar trade bills – as for other any other kind of off-balance sheet assets.

While there is logic in tightening the treatment of some toxic off-balance-sheet financial instruments, there is less sense in stricter regulation of letters of credit and similar trade bills. There is no evidence historically – or recently – that these exposures have ever been used as “a source of leverage”, in particular given that they are supported by an underlying transaction that involves either movement of goods or the provision of a service.

The question of why off-balance sheet trade exposures are not being automatically incorporated into the balance sheet (to avoid the leverage ratio) is one of process. The processing of letters of credit, which are highly documented for the financial transactions' own security, involve off-balance sheet treatment at least until such time as the verification of the documentation is finalised – a process that has been existing for a long time. The financial crisis has even resulted in greater scrutiny of such documentation. The rigor of the process of document verification is at the very heart of what a letter of credit is, and it concurs to its safety.

Given the high rejection rate of poorly documented letters of credit (up to 75% for first submissions), and the fact that, if definitively rejected, the letter of credit might not even enter the balance sheet, it is argued that the off-balance sheet management of these exposures is necessary and in most cases only a temporary treatment of what would eventually become an on balance-sheet commitment.

The five-fold increase of capital requirements for off-balance-sheet letters of credit would increase the cost of banks in offering such risk mitigation products. Either that cost will be passed on customers, hence making even more difficult to smaller businesses to trade internationally, or, in the absence of incentives to issue letters of credit, customers may simply choose to use on-balance sheet products such as overdrafts to import goods (as these carry less stringent documentary requirements) that prove to be potentially far more risky for the banking sector in general. Finally, the issue has some importance for developing countries' trade. Unlike developed countries, open account financing is not appreciated by developing countries. Traditional letters of credit bring more security and are more appreciated. Given that word trade is likely to be driven by South-South trade in the future, the prudential treatment (and cost) of letters of credit is critical for developing and emerging market economies.

Conclusion

In the economics of regulation, there can be doubts about the ability of public authorities to adopt fully independent points of view. A recent paper by Ranjit Lall (2009) argues that the Basel II framework did not fail because it was too ambitious, rather on the contrary because creators fell short of their aim of improving the safety of the international banking system. Intense and successful lobbying by the banking sector was, according to the paper, largely responsible for the failure of regulators and supervisors to impose sufficiently stringent standards. For the same reason, Lall believes that recent proposals to re-regulate the international banking system are likely to meet a similar fate. Drawing on recent work on global regulatory capture, the paper presents an interesting theoretical framework emphasising the importance of timing and sequencing in determining the outcome of rule making for international finance.

The matters involved in financial regulation are inherently complex and require the understanding of all sides. In matters that are at the cross-roads of trade and financial regulation, there should be a thorough examination of both cultures and instruments. Having this in mind, there should certainly be some middle ground in attempting, on the one hand, to prevent toxic assets to spread out through the financial system and harm its transparency through off-balance sheet vehicles, and on the other hand seriously disrupting a process for securing trade credit instruments that has long been used.

For this reason, the trade finance and the regulatory communities should understand one another’s processes and objectives – they are not necessarily at odds with one another. The trade finance community believes that it promotes a cautious model of banking that has clearly been financing the sustained expansion of international trade without major hurdles until the recent crisis. The two communities should be encouraged to develop a mutual understanding and to meet regularly during the comment period with a view to reaching a consensus on processes and hence on a new regulatory framework that can be both right and fair.

References

Auboin, Marc (2009), "Boosting the availability of trade finance in the current crisis: background analysis for a substantial G20 package", CEPR Policy Insight no.35

Auboin, Marc (2010), "International Regulation and Treatment of Trade Finance: What Are the Issues", WTO Working Paper ERSD-2010-09.

Bank of International Settlements (2010), "Strengthening the Resilience of the Banking Sector", Consultative Document.

BAFT Trade Finance Survey (2009), Survey Among Banks Assessing Current Trade Finance Environment, and updates.

ICC Banking Commission (2009), "Recommendations on the Impact of Basel II on Trade Finance", Document 470/1119, Paris.

Lall, Ranjit (2009), "Why Basel II Failed and Why Any Basel III is Doomed", Global Economic Governance Programme, GEC Working Paper 2009/52, Oxford University.

Reuters (2010), "Banks to show regulators trade credit less risky", by Jonathan Lynn, Geneva, 14 January.

Topics: International trade
Tags: Basel II, global crisis, Trade finance

Counsellor in the Economic Research and Statistics Division, WTO

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