TWN Info Service on Finance and Development (Mar10/04)
26 March 2010
Third World Network

Trade finance and the implications of Basel-2
Published in SUNS #6888 dated 22 March 2010

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, Geneva, a former  senior economist at the UNCTAD Secretariat and who has been closely  following and monitoring the Basel banking supervisory processes.

[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 (Basel 1). The other more advanced  options of Basel-2 provide for the setting of capital requirements on the  basis of the banks' own internal estimates of the determinants of credit  risk (these include the Foundation and the Advanced version). The latter  options, Cornford says, appear to be the principal target of the banker's  representations concerning the negative impact of Basel-2 on trade  finance.

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 the United States is an especially important concern of the  banks making them.

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 Basel 1.

-- 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 Basel 1.

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. +