Balancing Basel

LEGAL AND REGULATORY Balancing Basel Rosali Pretorius and Juan José Manchado consider the unique features of trade finance and whether the new capital rules in Europe will damage trade ecently, several commentators Trade finance – a unique asset class? Global Risks Trade Finance Report1 that have expressed misgivings about Trade finance supports the import and trade finance is “relatively low risk” and Rthe potentially restrictive impact export of goods across the global market not to be “feared” nor “overregulated”. of the new capital requirements, forged by funding production or helping mitigate The ICC’s Trade Register data shows in the wake of the 2008 global financial credit and liquidity risks. It takes many that the default rate across global trade crisis, on trade. forms, ranging from pre-export finance to finance activity stands at 0.02%. Other In this article, we start by outlining the standby letters of credit (LCs). industry associations have pointed to the capital requirements in the Basel framework Some trade finance products are contradiction between more restrictive and how they have been reflected in the on-balance sheet and others remain off- prudential requirements and governments’ EU legislation. balance sheet. But they all create exposures, efforts to stimulate global trade and the We then look at how regulators have actual or potential, for the banks involved financing of SMEs. addressed concerns over the impact of in extending, issuing or confirming the The Capital Requirements Regulation capital requirements on trade finance. different products. Capital rules require 648/2012 (CRR)2 implements the Basel After considering the capital framework, banks to match those exposures with III global framework in Europe. Some we consider developments in the new minimum levels of funding, in the form of of its provisions have been in force since liquidity framework, which are still a work loss-absorbing capital, and liquid assets. The January this year. The CRR acknowledges in progress. We focus mainly on short- size of those prudential cushions should that trade finance products are different term and off-balance sheet trade finance depend on the potential impact of losses to other bank assets. The recitals describe products, as they are the most distinct from caused by trade finance on the resilience trade finance exposures as “small in non-trade finance alternatives and it is on of banks. value and short in duration and having them that industry persuasion efforts and The International Chamber of an identifiable source of repayment... successes have concentrated. Commerce (ICC) stresses in its 2013 Inflows and outflows are usually matched 40 TFR MAY 2014 P40-43 TFR May 2014.indd 40 5/1/2014 10:02:47 AM and liquidity risk is therefore limited”. The and to any unregulated financial sector subject to a risk weight below 100%. This recitals also acknowledge that trade finance entity. This is meant to address the increased the capital required for confirming is “underpinned by movements of goods systemic risk that the interconnectedness letters of credit (LCs) issued in respect of and services that support the real economy between financial institutions creates. It importers in lower income countries. The and in most cases help small companies will increase the cost of export-confirmed sovereign floor has been the subject of in their day-to-day needs, thereby creating letters of credit, where an accepting bank much criticism – mainly because it did not economic growth and job opportunities”. becomes exposed to the credit risk of the reflect empirical evidence that trade debt in issuing bank. emerging markets is often more likely to be Regulatory capital requirements Finally, as a backstop to risk-weighted repaid than other indebtedness. Methods for calculating regulatory capital capital requirements, Basel III introduces When calculating capital requirements requirements were laid down in the first the leverage ratio, which we discuss in under the standardised approach, the two iterations of the Basel accords. Basel more detail. potential exposure created by an undrawn III has not changed the fundamental off-balance sheet commitment must also requirement that banks must have be multiplied by a credit conversion factor qualifying capital equal to 8% of risk “Under Basel III, banks (CCF) reflecting the likelihood that it will weighted assets. But it amends inputs on must improve quality be drawn. The Basel framework sets CCFs both sides of this fundamental equation, and quantity of their by reference to the classification of off- and supplements it with several other ratios. balance sheet assets. This is now reflected Under Basel III, banks must improve regulatory capital” in CRR Annex I. Medium risk assets attract quality and quantity of their regulatory a 50% CCF and medium/low risk assets a capital. So, for example, by 2015, banks 20% CCF. will need a capital buffer composed, at The standardised approach to Documentary credits are categorised least, of common equity tier 1 (CET 1) calculating RWAs as medium risk. They will be medium/ instruments amounting to 4.5% of that Using the standardised approach, RWAs low risk where the “underlying shipment bank’s assets, topped up with 1.5% in are arrived at by multiplying the exposure acts as collateral”. “Other self-liquidating additional tier 1 instruments and a further of a bank to a transaction by a prescribed transactions” are in the same category. It is 2% in tier 2 instruments. These capital risk weight. Risk weights are based, broadly not clear what “self-liquidating” means in requirements can be increased further by speaking, on the class of counterparty this context. Normally, “self-liquidation” supervisors requiring banks to build up and its external credit rating. External means that a facility will be repaid with the a countercyclical buffer during periods credit ratings are provided by external proceeds from the sale of the goods the of excessive credit growth. Basel III also credit assessment institutions (ECAIs). facility has served to produce or acquire, includes measures to stop distributions and The counterparty’s credit rating is then rather than from the resources of the bonuses when capital falls below a certain mapped into a credit quality step. Adopting borrower. But by using the word “other” level (capital conservation buffer). This will this approach for trade finance, where after “documentary credits in which effectively mean that banks are incentivised exposures are often not posed by rated underlying shipments acts as collateral”, to hold an extra 2.5% in capital. institutions, is problematic. The Basel CRR seems to suggest that only those To capture differences in the non- framework made it possible to apply a 50% documentary credits where there is such repayment risk posed by different risk weight for exposures to unrated banks, collateral are “self-liquidating.” This goes counterparties, the Basel framework or 20% where the original maturity of the against the normal understanding in the has always allowed banks to risk weight exposure was three months or less. market that documentary credits linked to assets before applying the capital ratio These concessions were subject to the a shipment of goods are all self-liquidating. calculations. Basel III has not changed overarching requirement that no claim on an Furthermore, CRR’s requirement that the the approach to weighting introduced unrated bank can receive a risk weight lower underlying shipment must act as collateral in the Basel II accords. Risk-weighted than that applied to claims on its sovereign for the documentary credit for that credit assets (RWAs) can be calculated using of incorporation. This became known as to be in the low/medium bucket is strange the standardised approach or one of the sovereign floor, and is based on the and needs clarification. With documentary the internal ratings based approaches. assumption that unrated banks cannot be credits, banks do not usually take security We consider these approaches, and the less risky than the sovereign country in over the goods themselves. Sometimes they concerns they generated for trade, below. which they are incorporated. As risk weights take a pledge over the bill of lading, but Basel III now also requires the for unrated sovereigns are set at 100%, that document does not normally give legal application of a 1.25 multiplier for large this meant that exposures to the unrated title to the goods. exposures to large financial sector entities banks of unrated sovereigns could never be Shipping guarantees, customs, and www.tfreview.com 41 P40-43 TFR May 2014.indd 41 4/30/2014 3:56:06 PM LEGAL AND REGULATORY tax bonds are medium risk. Trade finance where the parameter for maturity did balance sheet exposures, given that they warranties, guarantees and standby LCs not correspond with the actual effective were a source of potentially significant that are not credit suitable are deemed maturity of transactions, short-term trade leverage. This lack of recognition of the medium/low risk. Agreements to provide finance was affected negatively. This floor low conversion rates of trade finance guarantees or acceptance facilities, or did not recognise the lower risks linked would have made the its provision an undrawn credit facilities for tender to the lower maturity of some trade unviable banking activity. and performance guarantees, which finance and contrasted with the favourable are unconditionally cancellable or are treatment the standardised approach grants Changes to the capital framework cancelled automatically on occurrence of to exposures with less than three months’ and review of the leverage ratio credit events, benefit from a 0% CCF and residual maturity. As with the sovereign In response to the G20 commitment to therefore do not pose an exposure. floor, this has now been addressed. evaluate the impact of bank prudential regulation on low income countries, the Internal ratings-based approach to Basel Committee made in October 2011 calculating RWAs two changes to the capital treatment of Banks with experience at using internal “The leverage ratio is trade finance.

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