When world trade suddenly contracted in the fourth quarter of 2008, it demonstrated how vitally important trade finance is to the health of the global economy. The crisis was so acute that trade finance was propelled to the top of the agenda at emergency meetings of the G20 group of the worldâs biggest economies in early 2009. Special measures were agreed to increase the availability of trade finance around the globe and to reduce its cost.
And it worked: world trade bounced back in 2010 and continued growing strongly during 2011. But as attention turned to improved banking regulation, memories quickly faded.
Prior to the financial crisis, trade finance had widely been considered niche - a subset of transaction banking. That scarcely mattered 20 years ago when the main piece of global banking regulation, Basel I, was only very general and the regulation of trade finance was largely left to the International Chambers of Commerce (ICC).
Now, the banking industry is faced with as many as 50 major new regulations and directives, from the latest iteration of the Basel Banking Accords to the Single European Payments Area (SEPA). Each has the potential to turn the banking industry upside down and many will affect trade finance, directly or indirectly.
Baselâs broad brush
The challenge of absorbing the many different regulatory proposals was recognised by Europe Economics in a report produced for the City of London in 2010: âMany different forms of measures have arisen reflecting different theories about what went wrong and how best to address it, and these measures are often overlapping. In many cases this provides two or even more different regulatory requirements for addressing the same underlying risk concept, with the danger that some of the measures are superfluous or unnecessary.â (1)
Arguably the most challenging proposals have come from the Bank for International Settlementsâ Basel Committee on Banking Supervision. When the financial crisis struck with a vengeance in 2008, Basel II was in the throes of implementation around the world, but it had been shaping banksâ investment decisions since its publication in June 2004.
Baselâs original mandate had been to deal with the regulatory challenge posed by the increasing internationalisation of banking in the 1970s highlighted, as ever, by two major banking crises. The resulting Basel Concordat of 1975 determined responsibilities of home and host country regulators to cover cross-border banks.
That was quite straightforward, but as banking has grown in internationalisation and complexity, so has the concomitant regulation.
The original Basel II regulations did not recognise the unique value of trade finance as a banking activity, but the proposed amendments published in January 2011 - dubbed Basel III, but in reality more of a Basel 2.1 - would have a direct and deleterious effect.
In a bid to discourage short-term speculation, the proposals treated all short-term banking instruments the same. All transactions of less than one-year tenor required a capital allocation as if it were one year in duration to increase the cost of capital of such transactions. However, this would also affect legitimate banking transactions - especially letters of credit (LCs), which typically run for just 90, 120 or 180 days.
âBy bringing all LCs onto a bankâs balance sheet without recognising that LCs are different, requires a huge amount more capital to be attributed to LC business,â says Geoffrey Wynne, a partner at law firm SNR Denton. âThe problem is not that this might lead to a big increase in the fees associated with such services, but with a dramatic reduction in their availability.â
Pre-crisis, a bank could simply go out and raise the capital required for an activity and pass the cost on to the client. But in the current climate, the one thing that banks cannot easily get is more capital - especially in the ongoing crisis in the eurozone. In other words, Basel III risked causing an even more acute repetition of the trade crisis of 2008 and 2009.
The proposals have therefore been the scene of intense lobbying from across the banking sector, not least from trade finance. Early claims that trade finance should be exempt were met with demands from the Basel Banking Committee to see the evidence. Faced with special pleading from all sides, the committee was not going to make any changes unless it could be incontrovertibly justified, says Malcolm Porter, deputy head of Regulation Development, Group Treasury, at the Royal Bank of Scotland.
In the past year, therefore, the International Chambers of Commerce (ICC) and a group of global banks put together the ICC Register on Trade Finance, a database of more than 11 million transactions from global trade banks in an initiative led by Barclaysâ global head of Trade and Working Capital, Kah Chye Tan, who also chairs the ICC Banking Commission.
The register showed a default rate of a mere 0.077 per cent on import LCS and losses of just 0.007 per cent. Even in the depths of the global financial crisis, export LCsâ average default rate was just 0.09 per cent. With the evidence on the table and members of the Basel Committee possibly taking some uncomfortable calls from G20 leaders, it still was not an open-and-shut case.
The Basel Committee finally relented on the one-year maturity floor for a number of instruments, including LCs, but with caveats: initially only for banks that have implemented the most advanced internal ratings-based systems introduced under Basel II, which would still have ruled out banks based in emerging markets.
On top of that, Basel II had ruled that banks could not enjoy better treatment than the sovereign under which they operated, which until the recent crises in the eurozone would have almost exclusively affected emerging markets. This rule has also been relaxed for inter-bank dealings so that emerging market banks are not harshly punished for the sins of their governments.
Perhaps if the trade finance community had been as diligent in lobbying the Basel Committee over Basel II it might already enjoy some degree of protection. Under Basel II, some categories of banking were singled out for special treatment, including project finance and self-liquidating commodity finance. Trade finance, though, missed out.
âIf we could persuade the regulators to recognised that the business of structured trade - well-structured trade finance transactions - should be given better treatment, then the combination of that, with the help provided in Basel III, could put trade finance where most of us want to see it: as a very good and safe source of lending that ought to be encouraged, not discouraged,â says Wynne.
With the storm clouds of recession gathering once again, it might also be the shot-in-the-arm for traditional transaction banking that the world economy needs.
(1). Europe Economics - The Future of Banking Regulation report