TWN Info Service
on WTO and Trade Issues (Oct11/05)
Geneva, 26 Oct (Kanaga Raja) - The Basel Committee on Banking Supervision (BCBS) has adopted two technical changes to the Basel regulatory capital adequacy framework concerning the treatment of trade finance that the BCBS said will help promote trade with low-income countries.
In an announcement on 25 October, the BCBS said that it came to this decision following an evaluation of the impact of Basel II and Basel III on trade finance in the context of low-income countries.
According to a BCBS press release, the Committee agreed to waive the one-year maturity floor for certain trade finance instruments under the advanced internal ratings-based approach (AIRB) for credit risk.
It also agreed to waive the so-called sovereign floor for certain trade-finance-related claims on banks using the standardized approach for credit risk.
According to BCBS, the agreed changes will improve access to and lower the cost of trade finance instruments for low-income countries.
The Committee said that it conducted its evaluation in consultation with the World Bank, the World Trade Organization (WTO) and the International Chamber of Commerce (ICC).
In a joint statement posted on the WTO website, both WTO Director-General Pascal Lamy and World Bank Group President Robert Zoellick welcomed the technical changes on trade finance undertaken by the BCBS.
"We welcome the technical changes to the regulatory regime of trade finance announced today (25 October) by the Basel Committee on Banking Supervision. This is a useful step that will help promote trade with low income countries."
"We look forward to continuing consultations with the Committee. While necessary, the strengthening of prudential standards for the financial industry needs to take account of the low risk nature and the pro development impact of trade finance," they added.
According to the WTO, more than 90% of trade transactions involve some form of credit (in particular short-term), insurance or guarantee.
The supply of trade finance used to be more resilient in periods of financial instabilities until the Asian crisis. But trade finance has now become extremely sensitive to liquidity squeezes, as shown in the Argentinean crisis (2002) and most recently in the context of the sub-prime mortgage crisis. Trade credits are no longer distinguished from other loans by creditors - and hence are subject to the same restrictions in case of risks, said the WTO.
According to the BCBS document titled "Treatment of trade finance under the Basel capital framework", the Committee's focus has been on confirmed letters of credit, the most typical form of bank-intermediated contingent trade finance products and commonly used in trade with low-income countries.
While data is scarce on the relative importance of the different types of trade credit, rough estimates based on ICC data show that letters of credit represent approximately 20% of all trade finance instruments but are particularly important for low-income countries.
Taking into account the focus of the Committee's work on the impact on low-income countries, the Committee in particular considered four main issues: The 100% Credit Conversion Factor (CCF) in calculating the leverage ratio for contingent trade finance exposures; the 20% CCF under the risk-based standardised and foundation internal ratings-based (FIRB) approaches; the one-year maturity floor for trade finance under the advanced internal ratings-based approach (AIRB); and other ways of addressing the impact of the capital requirements on low-income countries.
The Committee evaluated whether the 100% CCF for contingent trade finance products in calculating the leverage ratio is too high and whether the 100% CCF disadvantage banks specialising in trade finance.
In principle, it said, off-balance sheet positions are subject to a CCF when calculating the risk-based capital adequacy measure under the Basel capital framework. The CCF reflects the likelihood of an off-balance sheet position becoming an on-balance sheet item.
The Committee said it decided to not change the CCF for calculating the leverage ratio. The calculation of the leverage ratio was intentionally designed to be simple and not based on any differential risk weighting. For example, government bonds are included in this calculation based on their face value.
"Changing the CCF for trade finance under the leverage ratio would be inconsistent with the core financial stability objectives of the capital framework."
In the context of the 100% CCF for calculating the leverage ratio, the BCBS document noted that Basel III applies a 10% CCF to commitments that are unconditionally cancellable and it also has been argued that such an exception could also be made for trade finance commitments.
However, the 10% CCF treatment will only be made for commitments that are unconditionally cancellable at any time by the bank without prior notice. Those commitments are significantly different from contingent trade finance products which are binding commitments for the respective bank, i.e. they are irrevocable and cannot be cancelled without prior agreement of the beneficiary. Undrawn unconditionally cancellable commitments to issue contingent trade finance products will, of course, also be eligible for the 10% CCF.
The Committee also said it evaluated the case for lowering the 20% CCF under the Basel II standardised and FIRB risk-based measures. The CCF is relevant for short-term self-liquidating trade letters of credit arising from the movement of goods. Essentially, it reduces capital requirements by 80% as compared to positions that are subject to a 100% CCF.
The current 20% CCF has been part of the Basel capital framework since their inception in 1988. The CCF expresses the likelihood of an off-balance sheet position to become on-balance sheet, i.e. it is not related to the riskiness of a counter-party which is expressed by the position's probability of default.
In its evaluation, said the document, the Committee reviewed a credit register established by the ICC in 2010 to pool performance data on trade finance products. Nine internationally active banks participated in the registry.
"The Committee is of the view that the credit register does not provide sufficient analytical evidence for reducing the CCF in the risk-based approach below the currently applied 20%. In addition, the data presented is more relevant for the probability of default of a trade finance instrument rather than its likelihood of becoming on-balance sheet."
The Committee however said it supports further work by the ICC, as well as the WTO and World Bank, to strengthen data on trade finance.
BCBS noted that in principle, Basel II requires banks, when calculating risk weighted assets under the AIRB, to measure the effective maturity for each facility subject to the provision that it cannot be less than one year.
The rules do, however, contain an exception for the one-year maturity floor for certain short term exposures, in particular repos/reverse repos and securities lending/securities borrowing transactions. Other transactions, among which are short-term self-liquidating trade transactions, may also be eligible for exemption from the one-year floor, but subject to national discretion.
According to the BCBS document, it has been argued that the one-year maturity floor under the AIRB is also inappropriate for short-term self-liquidating trade finance instruments given their average tenor of well below one year.
"The Committee agreed, therefore, to base the calculation on the effective maturity for transactions with a maturity of less than one year. It believes that this should become the rule rather than an item left to national discretion."
The Committee further agreed to include, in the revised treatment, issued as well as confirmed letters of credit which are short term (i.e. have a maturity below one year) and self-liquidating. Other trade finance transactions which are not letters of credit can continue to be exempted from the one-year floor, subject to national discretion.
The Committee said it evaluated the impact of its regulatory regimes on trade finance for low-income countries. For those countries, confirmed letters of credit are of specific importance.
Confirmed letters of credit provide exporters with additional protection against any losses incurred from importers' and issuing banks' failure to meet their obligations of payments. A typical example is the export of goods to a low-income country which in almost all cases requires a confirmed letter of credit since the exporter generally will not rely only on the creditworthiness of the importer and its bank, it added.
While waiving the one-year maturity floor also addresses this issue, the Committee considered other ways to reduce capital requirements related to low-income countries in the context of trade finance transactions.
It agreed to waive the so-called sovereign floor for claims of the confirming bank on the issuing bank under option 2 of Basel II's standardised approach for credit risk in the context of short-term self-liquidating letters of credit.
Under this approach, said the document, the exposure's risk weighting depends on the rating of the issuing bank.
The risk weighting of an un-rated bank is, in principle, 50% or even 20% for short-term claims (with an original maturity of three months or less). However, Basel II also states that the risk weighting cannot be lower than that which is applicable to the sovereign in which the bank is incorporated. For low-income countries, this would be 100%.
"Thus, the preferential risk weights for un-rated banks under option 2 cannot be applied. To make access to trade finance instruments easier and less expensive for low income countries, the Committee agreed to waive the sovereign floor for short-term self-liquidating letters of credit. This will allow banks to take advantage of the reduced risk weights," said BCBS.