TWN Info Service on Finance and Development (Mar10/04)
Trade finance and
the implications of Basel-2
Geneva, 19 Mar (Chakravarthi Raghavan and Riaz K. Tayob) – National banking regulators and supervisors should exercise fully their discretion and flexibility in implementation provided for under Basel-2, paying special attention to the avoidance of the disruption of provision and pricing of lending and other financial services by banks including those related to trade finance, a leading financial market expert has suggested in a background paper for the UNCTAD Global Commodities Forum (22-23 March 2010).
The paper, "Basel-2
and the Availability and Terms of Trade Finance", is by Mr. Andrew
Cornford of the Observatoire de la Finance,
[The term Basel-2 is usually used for the framework of rules and standards for assessing the capital adequacy of banks and their exposures to risks through lending and other operations. The rules and standards have been formulated by the Basel Committee on Banking Supervision (BCBS).
[Based at the Bank for International Settlements, the BCBS initially set out these standards for the banks of the G-10 countries. The initial set of standards set in 1988 is known as Basel-1, but its inadequacies became clear quickly and the revision, involving very wide global consultations, resulted in Basel-2 (June 2006 text, "International Convergence of Capital Measurement and Capital Standards" - BCBS 2006). Of 111 countries surveyed in 2006, 95 indicated that they planned to introduce Basel-2.]
Cornford notes that since the advent of the current financial crisis in 2007, and in its wake the global economic recession, international trade has been severely affected, with trade volumes actually contracting by about 12% in 2009. Associated with this has been a contraction in volume and value of trade financing - reflecting partly the adverse macroeconomic conditions affecting world trade, but also a tightening in the availability and terms of trade financing. According to some recent estimates (by the OECD, World Bank and others), this tightening has made a significant contribution to the contraction of trade, especially during the early part of 2009.
Among the specific factors cited as contributing to the tightening of the availability and terms of trade finance, in addition to the contraction of international trade, are the increases in the capital adequacy requirements due to the introduction of Basel-2. This is cited in representations from bankers in two 2009 global surveys of trade finance, one by the International Chamber of Commerce (ICC) Banking Commission and another by the Bankers' Association for Finance and Trade (BAFT), and the IMF survey. These indicate the scale and geographical distribution of the contractions for major categories of trade finance and point to a widespread increase in its price.
According to the BAFT/IMF survey, there was a small increase of 4 % in the value of trade finance between the fourth quarters of 2007 and 2008 followed by a sharp fall of 11 % between the fourth quarter of 2008 and the second quarter of 2009. For six emerging-market regions (Emerging Europe, Southeast Europe and Central Asia, Developing Asia, Middle East and Maghreb, Emerging Asia and Sub-Sahara Arica), there were contractions in the value of trade finance for all but Middle East and Maghreb during the first period and for all except Emerging Asia (where there was no change) during the second period. There were also declines in both periods for major categories of trade finance, the value of letters of credit contracting 2 % in the first period and 8 % in the second.
The ICC Banking Commission survey, conducted in the winter of 2009 when the pressures on financial markets during the aftermath of the disappearance of Lehman Brothers were particularly acute, found not only that substantial proportions of responding institutions had recently decreased credit related to trade finance but also that there had been increases in the proportion of trade-finance transactions involving lower risk such as those supported by letters of credit and insurance or guarantees and a reduction in the proportion involving the simpler, cheaper but also potentially riskier open-account transactions.
Among banks covered by the BAFT/IMF survey which reported an increase in their capital requirements since the outbreak of the crisis, 43 % reported that Basel-2 had a negative impact on their capacity to provide trade finance, the paper states.
The Basel-2 standards are described by Cornford as "soft law" - rules and standards that are the subject of international consensus as to their intent but the details of whose national implementation provide room for flexibility.
Basel-2, Cornford notes,
has two methods for estimating regulatory capital requirements for
credit risk, the Standardised Approach and the Internal Ratings-based
Approach. Basel-2 contains a number of different options for estimating
regulatory capital requirements for credit risk. One of these options
is simple and follows lines similar to those contained in the previous
Basel Capital Accord of 1988 (
Since the outbreak of the credit crisis in mid-2007, many banks have faced serious difficulties in obtaining liquidity adequate for the ongoing funding of their operations. These difficulties have led to unprecedented levels of liquidity support from governments and central banks together with other official intervention such as the arrangement of mergers for weakened or failing institutions. Moreover, the experience of the crisis highlighted the close connections between banks' liquidity risks and threats to their solvency (the target of Basel-2), and have provided the impetus for new international initiatives on standards for banks' management of liquidity risk, i. e. the risk that a bank will not be able to meet its obligations as they fall due.
The proposals of these initiatives make explicit reference to instruments of trade finance as a subject to be taken into account as part of the management of liquidity risk.
Although management of liquidity risk is not formally part of Basel-2, acknowledgement of the connections between liquidity risk and threats to solvency is likely to mean that the new standards for liquidity risk will form an essential part of the package of revised regulatory standards for banks being developed by the BCBS to incorporate the lessons of the crisis. These proposals are still the subject of a consultation process, their effects in practice cannot yet be the subject of representations like those concerning the impact of Basel-2 on trade finance, Cornford points out.
Management of banks' balance sheets in accordance with the new standards for liquidity risk will involve estimates of expected net cash outflows and of required amounts of stable funding due to contingent liabilities linked to trade finance. The impact on trade finance will depend on the changes from existing practices which follow from eventual introduction of the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The details of the proposed changes are currently left by the Basel Committee to national supervisory discretion. This has the advantage of providing for flexibility which can take into account variations in national circumstances and in policy objectives.
The representations of bankers on the negative impact of Basel-2 on trade finance, the Cornford paper says, can be distilled under four headings.
First, the target is the emphasis of Basel-2 on counter-party rather than product or performance risk. This leads to the estimation of capital requirements as an increasing function of the probability of default and loss given default (both of which increase during downturns like the current one) and to the attribution of insufficient importance to the mitigating factors of the low risk of trade-finance instruments – a characteristic reflected in the self-liquidating character of many short-term trade-finance instruments.
The other three headings concern: (1) the application of the one-year floor to the effective maturity of exposures in estimating the determination of capital requirements for credit risk; (2) the minimum data requirements for estimating the probability of default and loss given default; and (3) the status of the United States Export-Import Bank as manifested in the risk weight for claims on or guaranteed by the institution.
A careful reading suggests that the substance of these representations reflects more the way in which Basel-2 is being implemented and applied than the rules themselves, Cornford notes. The focus of the representations is the Internal Ratings-Based Approach, that is more likely to be used by large banks, i. e. the banks which are the most important players in trade, rather than the Standardised Approach.
The paper quotes the Bankers' Association for Finance and Trade, "Most banks active in trade finance are likely to be core banks required to adopt the advanced approaches or opt-in banks that elect the advanced approaches".
Opt-in banks are presumably
United States Banks not required by regulators to adopt the Internal
Ratings-Based Approach but opting to use it anyway. Moreover, some
of the representations suggest that the implementation of Basel-2 in
Comments in the paper on the bankers' representations include:
-- Regarding the framework
of the Internal Ratings-Based Approach for estimating credit risk weights
and capital requirements for lending, including that for trade finance,
the paper recalls that under this framework, banks make their own estimates
within the guidelines set by Basel-2 and subject to their supervisors'
scrutiny. Lack of access to these estimates complicates assessment
of banks' representations concerning quantitative impact of the Basel-2
framework and comparison of this framework with
-- Eligibility under Basel-2 for adoption of the Advanced version of the Internal Ratings-Based Approach is conditional on the availability for a bank of five years of data for the probability of default, and seven years of data for loss given default and for exposure at default. Inability to meet these data requirements can mean that a bank must use a less advanced approach to estimating its capital requirements for credit risk. Meeting these requirements for trade finance according to the banks' representations is problematic, and the paper cites some reasons.
Regarding capital requirements, trade finance and banks in developing countries, the paper states that the BAFT/IMF survey covered 88 banks from 44 countries of which approximately one-half had headquarters in industrialized countries and the remainder in emerging-market countries. Twenty-eight percent of the banks had assets of at least $100 billion, 32 % assets in the range of $5 billion to $99.9 billion, and 40 % assets of less than $5 billion. The survey of the ICC Banking Commission also included a significant proportion of respondents from developing countries.
Of the banks in the BAFT/IMF survey which had increased their capital requirements, 43 % said that Basel-2 had a negative impact on their capacity to provide trade finance. However, banks with headquarters in industrialized countries were much more likely to cite these negative implications than those with headquarters elsewhere. This difference seems likely to be connected to the greater likelihood that the former group of banks would be using the advanced options of Basel-2 than those from elsewhere.
The effects of the
new capital requirements of Basel-2 on borrowing costs, and thus the
costs of trade finance, for developing-country entities are likely
to be mixed. In the case of the Standardised Approach, higher capital
requirements would apply only to borrowers with a credit rating below
B-minus (B-). For un-rated borrowers, the risk weight is 100 %, which
should lead to no change in comparison with
Fragmentary estimates suggest that under the Internal Ratings-Based Approach, there will be increases in capital requirements for borrowers with credit ratings lower than investment grade. However, the implications of such estimates for banks' pricing of their loans should be treated with a certain amount of caution, says Cornford.
Increases in capital requirements under Basel-2 will lead to matching increases in loan prices only if banks take as their cost of equity a target rate of return on minimum required regulatory capital (as set by Basel-2) rather than on economic capital, i. e. the capital which a bank allocates to future unidentified losses in abstraction from regulatory rules except to the extent that these constitute a floor.
The paper states that, also worthy of special attention, in connection with the effect of Basel-2 on borrowing costs, and the costs of trade finance, for developing-country entities are the implications of the banking model incorporated in the fundamental assumptions of Basel-2.
Under issues for possible future action, the paper states that probably the most important point emerging from the discussion is the need for national regulators and supervisors to exercise fully their discretion under Basel-2.
Subjects singled out for such discretion include the procedures for estimating the effective maturity of loans as a determinant of credit risk weights and the credit conversion factors (CCFs) for off-balance-sheet exposures.
Other subjects meriting special attention for possible future action include a revisiting of the rules of Basel-2 related to off-balance-sheet exposures linked to trade-finance transactions, data on trade finance, and the situation of developing-country borrowers which face large increases in borrowing costs under Basel-2.
Regarding off-balance-sheet exposures, representations to the Basel Committee concerning what many banks consider excessive credit conversion factors (CCFs) for trade-finance exposures deserve further attention. Since the outset of the process of drafting Basel-2, there have already been changes to the rules on CCFs, which indicates the Basel Committee's potential flexibility on this issue.
Representations concerning this subject would be strengthened by the provision of further systematic data on the experience of risks associated with trade finance. The ICC is taking actions in response to a request by the WTO to set up a database which would track the default history of the trade-finance industry. However, the ICC anticipates that this will be a long-term project, and that data sufficient to justify a comprehensive re-evaluation of the risks involved are still lacking for the probability of default, loss given default and exposure at default for trade-finance exposures.
The lack of the data required under the rules of Basel-2 by banks for adoption of its more advanced approaches remains a problem in several jurisdictions and not just with relation to trade finance. Its resolution may require closer cooperation between banks and their supervisors.
Cornford says that trying to deal with the problem of the higher borrowing costs associated with Basel-2 which face some developing-country borrowers through adjustment of the rules of Basel-2 would be questionable since arguably such action would contribute to frustrating the underlying aim of the whole exercise, that is, to produce a closer correspondence between regulatory capital requirements and banks' actual risks.
An alternative approach, he suggests, would involve greater use of the instruments of credit risk mitigation (collateralisation, guarantees, etc.) which can reduce credit risk weights under Basel-2. Programmes for the provision of these instruments by national official and intergovernmental financial institutions already exist, and expanded use of them is already envisaged as part of the policy response to the current crisis. +