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TWN Info Service on Finance and Development (Mar11/01)
3 March 2011
Third World Network

Trade finance industry impact on Basel capital standards
Published in SUNS #7097 dated 28 February 2011

Geneva, 25 Feb (Andrew Cornford*) -- The lobbying of the trade-finance industry concerning Basel-III capital standards has recently been having an increased impact, and policymakers are beginning to acknowledge that the new capital rules for credit risk may adversely affect the provision of trade finance, special concern being expressed regarding the consequences for low-income countries.

Concern over the effects of the new capital rules on the provision of trade finance was expressed in the communique of the G20 Summit of April 2009, which stated, "We shall ask our regulators to make use of available flexibility in capital requirements for trade finance".

The target of this request was clearly Basel II, an agreement already being revised and extended - and now renamed Basel III. This statement followed discussion of the subject in the WTO Working Group on Trade, Debt and Finance.

In the communique of the Seoul summit in November 2010, the G20 reiterated its concerns, stating that "we agree ... to evaluate the impact of regulatory regimes on trade finance". In a January speech in Cape Town, the Chairman of the Basel Committee on Banking Supervision (BCBS), Nout Wellink, noted that the G20 had asked the Committee to examine the treatment of trade finance under Basel III "with a particular focus on low-income countries" and that the subject was now on the Committee's agenda.

Under the 1988 Basel Capital Accord or Basel I, the minimum regulatory capital for credit risks was to constitute 8 per cent of banks' risk-weighted assets. The attribution of risk weights to banks' loans and other on- and off-balance-sheet positions followed a relatively simple scheme. Off-balance-sheet exposures were converted to their on-balance-sheet equivalents by multiplying them by credit conversion factors.

In this framework, where trade finance took the form of bank lending, the rules were subsumed under those for lending generally. Where trade finance took the form of off-balance-sheet exposures or contingent liabilities, it was covered by the system of credit conversion factors to estimate the equivalent on-balance-sheet exposures:

-- direct credit substitutes were attributed a credit conversion factor of 100 per cent, that is to say, they were treated in the same way as lending.

-- certain transaction-related contingent items (such as performance bonds and standby letters of credit) were attributed a credit conversion factor of 50 per cent
(corresponding to a capital requirement of 4 per cent for an exposure to a non-financial firm).

-- short-term self-liquidating trade-related contingent liabilities (exemplified in the text of Basel I by documentary credits collateralised by the underlying shipments) were attributed a credit conversion factor of 20 per cent (corresponding to a capital requirement of 1.6 per cent for a bank's exposure to a non-financial firm).

-- lending commitments (such as formal standby facilities and credit lines) were attributed a credit conversion factor of 50 per cent or 0 per cent according to whether their original maturity was greater than or up to one year.

In Basel II and Basel III, minimum regulatory capital requirements for credit risk are calculated according to two alternative approaches, the Standardised and the Internal Ratings-Based.

Under the simpler of the two, the Standardised Approach, the measurement of credit risk follows a system similar to that of Basel I but with a finer calibration of credit risk based on ratings provided by external credit assessment institutions, expected in most cases to be credit rating agencies.

With only limited exceptions, under the Standardised Approach of Basel II, the credit conversion factors for contingent liabilities commonly associated with trade finance follow closely those of Basel I.

Under the alternative Internal Ratings-Based approach of Basel II and now of Basel III, for the major categories of exposure, banks use their own rating systems to measure some or all of the four determinants of credit risk, namely, the probability of default, loss given default, exposure at default, and the remaining effective maturity of the exposure.

Under the Foundation version of the Internal Ratings-Based Approach, banks estimate the determinants of default probability but rely on their supervisors for measures of the other determinants of credit risk.

Under the Advanced version of the Internal Ratings-Based Approach, in addition to the probability of default, banks estimate the loss given default, the exposure at default, and the remaining maturity of the exposure (subject to a floor of one year and a ceiling of five years).

Regarding trade finance, the following features of the Internal Ratings-Based Approach merit particular attention:

-- The Internal Ratings-Based Approach provides only a framework of rules for estimating one or more of the determinants of capital requirements for credit risk. The actual levels of these estimates are the responsibility of banks themselves.

-- In the Foundation version of the Internal Ratings-Based Approach, the credit conversion factors used to estimate the exposure at default of off-balance-sheet exposures in the case of instruments which may be used as part of trade finance follow closely the credit conversion factors of the Standardised Approach. In the Advanced version of the Internal Ratings-Based Approach, banks make their own estimates of these credit conversion factors subject to floors applicable in certain cases.

In the case of both the Foundation and the Advanced versions of the Internal Ratings-Based Approach, the remaining effective maturity for trade-finance exposures is generally subject to a one-year floor. However, in the case of the Advanced version of the Internal Ratings-Based Approach, exceptions to this floor may be accorded to banks at supervisors' discretion in cases which include short-term self-liquidating trade transactions such as "import and export letters of credit and similar transactions". These "could be accounted for at their remaining maturity".

Regarding liquidity ratio, in Basel III, the rules for capital requirements are to be supplemented by an aggregate liquidity ratio. In the version of this ratio fleshed out in the blueprint for Basel III published in December 2010, the ratio will measure banks' high-quality (so-called Tier 1) capital in relation to on- and off-balance sheet positions (where the latter includes derivatives and contingent liabilities).

The main target of the trade-finance industry's initial representations concerning Basel II and Basel III were the estimates of weights for credit risk under the Internal Ratings-Based Approach of Basel II and the one-year floor for the maturity of exposures. The weights for credit risk, the industry maintained, did not take proper account of the low risks of much trade finance for which various documentary techniques assign and transfer physical and legal control of the goods shipped until payment.

The weights for credit risk were considered likely to raise capital requirements for all but highly rated borrowers - from developed and developing countries. This expectation was borne out by evidence collected in a series of surveys conducted in 2009 and 2010 by the International Chamber of Commerce (ICC), the Bankers' Association for Finance and Trade, and the IMF. The reduced access to trade finance due to Basel II was found to be especially marked for SMEs and banks in emerging markets.

More generally, attention was drawn by the critics to the pro-cyclical character of the minimum regulatory capital requirements of Basel II and Basel III. Other features of the Internal Ratings-Based Approach of Basel II and Basel III targeted by the critics were the application of the one-year floor to the effective maturity of trade-finance exposures (which also raises capital requirements) and the minimum data requirements for estimating the probability of default and loss given default.

Criticisms of Basel II and Basel III by the trade-finance industry have nonetheless been accompanied by industry acknowledgement of the flexibility of the rules of the two accords and of their character as soft law, i. e. internationally agreed standards whose detailed introduction is the responsibility of national regulators.

These features of the two agreements leave open possibilities for mitigating the adverse effects of Basel II and Basel III on trade finance as part of national implementation. Moreover, the trade-finance industry has expressed a mea culpa regarding longstanding deficiencies involving data concerning trade finance - deficiencies which it is now attempting to remedy.

As part of initiatives under this heading, the ICC and the Asian Development Bank have established the ICC-ADB Trade Finance Default Register. The initial phase of this project was completed in mid-2010. The results have confirmed the ICC's expectations as to the low risks associated with the instruments of trade finance.

Data concerning 5,223,357 trade finance transactions with a value of $2.5 trillion included the following:

1. the transactions had a relatively low average maturity of 115 days;

2. the transactions had a low incidence of default involving less than 1,400 or less than 0.02 per cent of the total;

3. the off-balance-sheet transactions had an even lower rate of default involving only 110 out of 2.4 million transactions;

4. the average recovery rate for transactions in default was 60 per cent, implying an average loss given default of 40 per cent.

In this regard, a somewhat more radical approach to mitigation of the rules of Basel II and Basel III than those put forward so far may be worth considering. This would involve addressing directly the way in which the risks of trade finance are incorporated into the estimation of risk weights in Basel II and Basel III under the Internal Ratings-Based Approach.

The focus of the trade-finance industry's criticisms of Basel II and Basel III has been the Internal Ratings-Based Approach. The weights of the Standardised Approach (which as mentioned earlier, follow closely those of Basel I) are considered by the industry to be much less objectionable. In view of this, it is worth considering whether it may be possible to categorise trade-finance instruments as an asset class to which the Internal Ratings-Based Approach would not apply, but would be replaced by the Standardised Approach even for a bank applying the Internal Ratings-Based Approach for other asset classes.

Allowing such an exception would involve an extension of the flexibility regarding the adoption of the Internal Ratings-Based Approach across asset classes - something already provided for in the rules of Basel II. This flexibility in the rules is intended by the Basel Committee to be temporary, the bank in question moving eventually to the Internal Ratings-Based Approach for all asset classes except those which are immaterial in terms of size and risk profile.

The proposal mooted above to categorise trade-finance instruments as an asset class to which the Standardised Approach would apply, even for a bank applying the Internal Ratings-Based Approach for other asset classes, could be adopted by national regulators, even if it cannot be negotiated internationally, and the flexibility (of Basel III) for an appropriately defined asset class consisting of trade-finance instruments, would be permanent, not temporary.

More recently, the principal focus of the trade-finance industry's criticism of Basel III has shifted to the leverage ratio. For the estimation of the denominator of the leverage ratio, i. e. a bank's on- and off-balance sheet exposures, contingent liabilities, including those associated with trade finance, will have a credit conversion factor of 100 per cent, and not the lower credit conversion factors allowed in the estimation of risk-weighted exposures for the minimum regulatory capital requirements for credit risk of Basel II and Basel III.

The decisions concerning the leverage ratio in Basel III appear to have been preceded by consideration by the Basel Committee of alternatives. For example, in the 2009 consultative document on Basel III preceding the fully worked-out version of December 2010, the Basel Committee stated that it also "proposed to assess the impact of applying the Standardised Basel II credit conversion factors", while rejecting the use of an internal models approach "as not appropriate for a simple non-risk based measure".

In its critique of this use of a 100-per-cent credit conversion factor for trade-finance exposures in the liquidity ratio, the ICC has reiterated several of the arguments commonly made concerning the low risks associated with trade finance. The Chamber's recommendation is that "off-balance-sheet trade products should be allowed to retain the credit conversion factors used by banks under the current ‘risk-weighted assets' calculation", a recommendation which would go in the same direction as the option of applying the credit conversion factors of Basel II's Standardised Approach - precisely the option which was to be considered during the consultations on the Basel Committee's proposals of December 2009 but has nonetheless not been accepted in the document on Basel III of December 2010.

To an outside observer of the choices made by the Basel Committee regarding rules concerning the leverage ratio, trade finance would appear to have been caught up in the consequences of the determination of regulators from the Committee's member countries to take a strong line with respect to off-balance-sheet exposures and other activities which were associated with the shadow banking system that helped to trigger the financial crisis.

However, this determination may in fact be directed principally against lobbying efforts designed to water down the importance of the leverage ratio by consigning it to nothing more than a role in supervisory guidance as opposed to according to it a key position among the rules of Basel III.

In other words, the principal target of regulators' determination concerning the leverage ratio may not be the treatment of trade finance. If this is the case, further efforts to achieve inclusion in the leverage ratio of credit conversion factors for trade finance more in tune with what the trade finance industry maintains are its real risks may still succeed.

Moreover, even if such efforts prove fruitless, there remains the option of persuading the regulators responsible for Basel III's national implementation of the merits of greater flexibility regarding the way in which account is taken of trade finance in the estimation of the liquidity ratio.

(* Andrew Cornford, with the Observatoire de la Finance, contributed this article based on comments made by him at the 2011 UN Conference on Trade and Development's Global Commodities Forum on 31 January.) +

 


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