LEGAL AND REGULATORY Balancing

Rosali Pretorius and Juan José Manchado consider the unique features of trade and whether the new capital rules in Europe will damage trade

ecently, several commentators Trade finance – a unique asset class? Global Trade Finance Report1 that have expressed misgivings about Trade finance supports the import and trade finance is “relatively low ” 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 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 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 - 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 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

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P40-43 TFR May 2014.indd 40 5/1/2014 10:02:47 AM and 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 of the reflect empirical evidence that trade 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 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 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

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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 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. They waived, for certain models and access to historical data a new requirement. It is trade finance products: may be allowed to calculate their capital meant to be simple, and  the sovereign floor in the standardised requirements applying the foundation approach in respect of exposures to or the advance IRB approaches (FIRB measures capital against unrated issuing banks; and and AIRB). Banks on the AIRB can assets on a non-risk-  the one-year maturity floor under the themselves decide all the parameters weighted basis. It will be AIRB. assumed in the risk weights and CCFs under the standardised approach. The binding from 2018” These two changes have been incorporated four parameters are , in CRR articles 121.4 and 162.3. They loss-given default, maturity and exposure establish, respectively, that: at default, the latter fulfilling the same role Leverage ratio  exposures to an unrated bank, which as CCFs. The leverage ratio is a new requirement. It may be incorporated in an unrated Banks on FIRB may only use their own is meant to be simple, and measures capital country, in respect of self-liquidating models to determine probability of default. against assets on a non-risk-weighted basis. short-term trade finance transactions The other parameters are prescribed for It will be binding from 2018. Set by the with a residual maturity of up to one them. Probability of default reflects the Basel Committee at 3% (the EU has not year, attract a 50% risk weight, or 20% exact estimated default risk of a particular proposed a figure yet) of total exposures, where the residual maturity of those counterparty. Under AIRB this parameter it is volume-based, meaning that exposures exposures is three months or less; and can even incorporate evidence that have to be accounted for at their full value,  a bank using AIRB can recognise the counterparties under technical default may rather than adjusted according to their risk. residual maturity, subject to a one-day still meet their trade finance obligations, It can therefore be understood as a cap on floor, of exposures in respect of self- compelled by the need to maintain access leverage against funding, or as a cap on the liquidating short-term trade finance to funding for their daily operations. reduction in capital requirements which transactions with a residual maturity Loss-given default calculations under the could otherwise be obtained via lower of up to one year, on the condition AIRB approach recognise, for credit risk risk weights. that those exposures are not part of mitigation purposes, goods underlying The leverage ratio will affect financing the banks’ ongoing financing of the the transaction and that the bank takes as structures which are relatively lower risk, counterparty. collateral, although this is subject to proof such as those involved in trade finance, of actual recovery levels. as banks will have an incentive to use Note that unlike in the context of the Basel II applied a one-year floor to the their leverage to enter into riskier but CCF, there is no reference to the shipment maturity parameter under AIRB. It gave more profitable exposures. Furthermore, as collateral for “self-liquidating short term national regulators the discretion to apply it is not possible to use netting of loans finance transactions”. an exemption from the one-year floor to against deposits of the same counterparty In that same review, the Basel certain exposures with an original maturity to reduce the exposure measure for the Committee decided not to reduce the 20% of less than one year and that were purpose of leverage ratio calculations. CCF applying to short-term self-liquidating not part of a bank’s ongoing financing This will hinder the use of cash-backed or LCs. It also declined to introduce the of a counterparty. FSA, in the BIPRU pre-funded structures. The original Basel CCF scale for measuring exposures for sourcebook of its Handbook, made use III accord also demanded that a uniform the leverage ratio, as this would have of this discretion. In other countries, 100% CCF should be applied to off- run counter to the financial stability

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P40-43 TFR May 2014.indd 42 5/1/2014 9:58:19 AM objectives of the capital framework. This ratio of contingent trade finance during a This is because trade finance products are decision was reversed in the review of stress scenario. CRR follows the Basel III prevalently used by mid-cap companies, the leverage ratio international standard, LCR standard (revised in January 2013) in of relatively worse credit standing, often which the Basel Committee published distinguishing outflows from committed in the context of trade with lower income in January 2014. Nonetheless, industry credit and liquidity facilities from those countries. Often, more data is needed to efforts at EU level had already achieved related to off-balance sheet trade finance model the risk parameters needed for the the application, in CRR article 429.10, items. Article 420 CRR requires that banks more flexible AIRB approach accurately. of the same CCF scale as that available assess the potential outflows resulting ICC has already made great strides towards under the standardised approach to capital from trade finance off-balance sheet items, putting together the required data with its requirements. So for the purposes of the taking account of the reputational damage trade register (see note 1). leverage ratio, banks will be able to apply that could result from not honouring Basel III increases the cost of funding either a 20% or 50% CCF depending on those commitments in a stressed scenario. required to back trade finance products. whether a trade finance product is in the Where those potential outflows are However, now, the favourable risk weights medium or the medium/low category. material, banks must report them to their for those which are shorter-termed and regulator, which may apply a run-off rate self-liquidating, and the more realistic of up to 5%. CCFs and outflow rates for off-balance The Basel Committee is currently sheet ones are likely to mean that the “The use of credit ratings consulting on the new NSFR,3 which biggest impact will be felt by banks on the and internal models should ensure a sustainable maturity standardised approach with longer-term put trade finance at structure of assets and liabilities over on-balance sheet trade finance structures. a one-year horizon. Under the NSFR Export credit providers will nonetheless a disadvantage in proposals, published in January 2014, still be able to benefit from the unfunded comparison with other national regulators are given the credit protection offered by export credit banking activities” discretion to determine, based on national agencies. circumstances, the amount of stable funding that will have to match trade finance-related obligations (including References Liquidity guarantees and LCs). The treatment of 1. www.iccwbo.org/products-and-services/ Basel III introduces a liquidity coverage irrevocable and conditionally revocable trade-facilitation/icc-trade-register ratio (LCR) and a net stable funding ratio credit and liquidity facilities, which form 2. Downloadable from the Official Journal of (NSFR). The LCR will start applying in the other category of off-balance sheet the at: http://tinyurl.com/ 2015 at 60% and will be “stepped up” at exposures, can serve as guide to where mlweb3r 10% per annum until its full application required stable funding could lie for 3. www.bis.org/press/p140112b.htm in 2019. The target introduction date for off-balance sheet trade finance. They the NSFR is 2018, although CRR in the are assigned a 5% required stable EU already requires banks to meet long- funding factor. Rosali Pretorius is a partner and Juan José term obligations with adequate and diverse Manchado is a paralegal at Dentons. stable funding. Moving forward Rosali Pretorius will be a panellists at The LCR requires firms to hold Market participants had already expressed TFR’s conference on 21 May in London, enough high-quality liquid resources to concerns over the measures introduced Financing commodities in a changed survive an acute stress scenario lasting 30 in Basel II to enhance the risk sensitivity regulatory environment days, assuming, among other outflows, of the prudential framework. The use increased drawdowns of off-balance sheet of credit ratings and internal models [email protected] commitments. Basel III allows national put trade finance at a disadvantage in discretion in determining the run-off comparison with other banking activities. [email protected]

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