Sunday, May 25, 2014

BIS Trade Finance Report – Why trade finance is good for the economy even though nobody knows about it.

First, what is negative about the report? The title („Trade finance – developments and issues“) is boring and the report is a bit too long to read it on the fly. What is positive about the report? It is an excellent means to get a quick view on the industry – its products and current state.

What is trade finance?

Trade finance supports international trade transactions, i.e. exports and imports. The idea is simply to bridge the lag between the time of providing goods/services and their payment. An additional function is reducing payment risk. A simple working capital loan is, therefore, not trade finance. When we talk about trade finance, we usually mean short-term maturity products. In addition, it normally invokes bank-intermediated credit only.

Most common products are

  • the letter of credit (The importer’s bank commits that payment to the exporter will be made by the importer if the documentary conditions are met.),
  • the bank obligation (a sort of letter of credit but without the documentary evidence part), and
  • supply chain finance (i.e. the automation of the documentary process linked to credits across entire supply chains).

When should you use trade finance products? In summary, you should use them if you are not sure of getting paid. This can be due to long distances, newly formed trade relationships, or trade into countries with a weak legal environment.

The alternative to bank-intermediated trade finance products is inter-firm trade credit (usually simply referred to as “trade credit”). This product entails lower fees and more flexibility than traditional trade finance. However, it leaves firms bearing more payment risk, and potentially a greater need for working capital.

How does the trade finance market look like in 2013?

The short answer is: We don’t know! The more politically correct answer of the BIS is: “There is no comprehensive source for measuring the size and composition of the trade finance market.” To be honest, the report actually provides some data. But I must admit that I didn’t find it particularly useful.

In 2013, the market, which is essentially denominated in USD, experienced intense competition among trade finance banks and, thus, historically low spreads in some market segments. The BIS reports two reasons for such competition: abundant short-term liquidity and the use of trade finance as a tool to build customer relationships for other, more profitable business segments.

How can banks distribute trade finance products?

In the past, trade finance was attractive for banks because it was often off-balance sheet and not subject to regulatory capital requirements. Faced with liquidity constraints and tightening regulation, banks thus started experimenting with originate to distribute models.

Historically, trade finance products experienced low loss rates (0.01 % average loss rate during 2008-2011). On the one hand, this is why they should be interesting for non-bank investors. On the other hand, this is also why non-bank investors should shun away: As a matter of fact, low risk means low margin means low return for investors.

The BIS writes, “to date, the scale of activity has been limited.” If, however, investors became increasingly familiar with the trade finance asset class and distribution schemes became more standardized, the distribution of trade finance assets could increase significantly.

Banks can distribute trade finance assets in three ways:

  • In a direct loan sale, the bank simply sells trade finance assets and is paid accordingly. It generates liquidity for the bank and releases regulatory capital but, at least on paper, makes the bank lose its commercial relationship with the client.
  • In an outright securitization, the bank sells assets to a special purpose vehicle funded by issuance of asset-backed securities and commercial paper. Thus, it not only frees up regulatory capital for banks but also provides them with liquidity.
  • In a synthetic securitization, outside investors take a first or second loss position against a portion of a bank’s trade finance portfolio in exchange for a stream of payments and a cash collateral from the bank. As a consequence, it frees up regulatory capital for the bank because outside investors partially assume the risk. Nevertheless, synthetic securitization does not furnish liquidity to banks.

The main challenges for distribution are essentially twofold: First, the level of due diligence to understand trade finance reference pools is high, namely because investors are generally not very familiar with the asset class. Second, extensive due diligence means extensive costs and this makes low margins in trade finance even lower.

How does Basel III impact trade finance?

Does new banking regulation really compromise trade finance, as I suggested above? Reading the BIS report, the answer is somewhat nuanced.

“The global trade finance market historically was considered liquid and well-functioning and accordingly did not attract much attention from policymakers.”

On the merits, current reforms suggest the following:

  • Capital adequacy ratios: The amount of risk weighted assets (RWA) plays a dominant role when calculating capital adequacy ratios. The trade finance community naturally favors a low RWA number for its asset class. As of today, it seems that its lobbying was successful: L/Cs in the amount of 100 will continue to account only for an amount of 20 in RWA. In financial speak, you can also say that L/Cs carry a 20 % credit conversion factor (CCF).
  • Leverage ratio: If trade finance products are usually off-balance sheet, how will they be accounted for when a bank calculates its total exposure under the leverage ratio scheme? After the Basel Committee had initially proposed a 100 % credit conversion factor to all off-balance sheet exposures, it recently reverted to 20 % of short-term contingent trade finance assets. The European (20-50 % CCF) and, especially, the U.S. implementation (100 % CCF) might become more rigorous but nothing is set in stone yet.
  • Liquidity: The question here is which outflow rate will apply to trade finance assets for regulatory purposes? For now, a 0-5 % rate is under discussion.

On the one hand, the Bank for International Settlements says that prices for trade finance products should rise in the near future, due to new capital, leverage, and liquidity standards under Basel III. On the other hand, the BIS writes that, “to date, there is little concrete evidence that the start of the implementation of the Basel III reforms has constrained trade finance activity or trade at the global level”.

How does trade finance interact with economic shocks?

The report looks at two aspects:

  • First, if trade finance is less available, global trade volumes suffer significantly. This is, at least, the position of the doctrine. The BIS observes this phenomenon after the Lehman failure but also says that it was only a temporary effect. In addition, the report is a bit unclear about whether a lack of trade finance triggers lower trade volumes or the other way around.
  • Second, trade finance support can help alleviate stress situations in the economy. But, in order to be effective to that extent, they must be mobilized quickly. The consequence is that mechanisms should exist in advance and be applied flexibly if an economic crisis hits.

“Yet even in crisis conditions it seems that trade finance claims have been relatively safe and liquid assets, themselves posing only limited risks to banks and overall financial stability.”

“Trade finance markets can be a conduit of stress from the financial sector to the real economy.”

The BIS English style guide

Let me finish with a quote that is a great illustration of complicated business language, worthy for being used as a (negative) example in any English style guide:

“However, given the magnitude of the reduction in trade volumes at the onset of the Great Recession, the unexplained residual after taking into account compositional effects remains quite significant in economic terms.”

If you want to have a look, this is on page 24…


Thursday, May 15, 2014

OTC Derivatives – Is the market getting safer?

„Generally, I did not talk about the speculative aspects of derivatives. If pushed, I resorted to the National Rifle Association (NRA) defence – ‘Guns don’t kill people, people kill people’. Derivatives, I argued, were entirely safe, at least in the right hands and when used in the right way.“
Satyajit Das in „Traders, Guns, and Money“ - 2006

It's some time now that derivatives have bad press. We all know Warren Buffet's famous quote about derivatives constituting weapons of mass destructions. But is this still justified? Or are recent reforms showing first effects?

Let's have a look at some BIS data.

OTC Derivatives – Notional Amounts Outstanding

Notional amounts outstanding include all deals concluded and not yet settled. They provide an idea of the market size because they report the nominal basis from which contractual payments are determined. However, it does not represent the amount truly at risk, as this risk is a function of

  • the price level,
  • the volatility of the underlying financial reference index,
  • the duration and liquidity of contracts, and
  • the creditworthiness of counter-parties.

BIS' data shows that interest rate contracts always represent the highest portion of derivatives (81 % on June 30, 2013). Foreign exchange derivatives are another, albeit much less important, business sector (11 % market share on June 30, 2013).

The total notional amount outstanding increased by 10 % since December 31, 2012. Today, it stands at roughly 700 trillion USD. To give you an idea about the size, this is 44x GDP of the U.S. in 2013 or 100,000 USD per habitant of our planet.

“In truth, a good chunk of the activity in derivative markets is driven by speculation. Part of it is obscured by semantics – the boundary between speculation and investment is always hazy. If you lost money you speculated. If you made money you were investing. Or was it the other way around?”
Satyajit Das in “Traders, Guns, and Money” - 2006

OTC Derivatives – Gross Market Value

The gross market value is the cost of replacing all outstanding contracts at current market prices. The term gross indicates that positive and negative replacement values with the same counter-party are not netted. Nor are the sums of positive and negative contract values within a market risk category such as foreign exchange contracts, interest rate contracts, equities and commodities set off against one another. The gross market value supplies information about the potential scale of market risk in derivatives transactions.

Interest rate derivatives represent still the highest portion (75 % on June 30, 2013), followed by foreign exchange derivatives (12 % on June 30, 2013).

Most notably, the gross market value has declined by 26 % since December 31, 2011. In total, the gross market value is 20 trillion USD. This is substantially less than the notional amount outstanding, but still huge. To refer to my above examples again, it represents 30 % more than the 2013 GDP of the U.S. or an exposure of 3 USD per habitant of our planet.

Herfindahl Index

The Herfindahl index measures market concentration and is defined as the sum of the squares of the market shares of each individual institution. It ranges from 0 (fully diversified) to 10,000 (fully concentrated, i.e. only one financial institution)

Both for equity linked forwards and swaps as well as equity linked options, the Herfindahl index in Europe and the U.S. is very low and stable since 2001. Asian countries represent a second group with a somewhat higher index and volatility. Finally, Latin American markets are highly concentrated and volatile.

Foreign exchange derivatives markets are highly diversified for both forwards and swaps as well as options.

Let's go back to my initial question: Is the market getting safer? Looking at the above statistics, the notable recent decline of the gross market value since the end of 2011 strikes me most. The weapons of mass destruction seem to become less dangerous...


BIS Statistical Release – OTC Derivatives Statistics at end-June 2013 – November 7, 2013

Friday, May 9, 2014

After the music stopped – “Yet another work about the crisis and its aftermath”?

This is the question that Alain S. Blinder itself asks at the beginning of his book. On the one hand, he is right, and I hesitated reading the book for exactly this reason: Haven't I read enough on this stuff in the past years? But I admit that the book is still worth reading, especially if you are interested in getting an overview of the U.S. financial system and its recent history.

What caused the financial crisis and what we should learn from it.

The book starts off describing the main causes of the 2007/08 financial crisis and finishes describing the lessons we should learn from it. Both topics are linked and, therefore, the elements Alain S. Blinder points out somewhat overlap:

  • Too much leverage in the system: Banks and other stakeholders in the economy simply borrowed super-abundantly instead of using own equity to buy financial assets.
  • Too much complexity of financial products: Complexity creates opacity and confusion. Why are financial products always that complex then? Alain thinks, the reason is that complexity is a profitable business. The more complex and customized a security is, the harder it becomes to compare its price. And without comparison there can be no effective competition.
  • Too much liquidity and credit: The primary example here is lending to sub-prime mortgage borrowers.
  • Too little regulation and oversight: In the financial sector, we lacked both good laws and their efficient execution. Alain S. Blinder specifically writes that excessive faith in the efficient markets hypothesis and self-regulation by the industry cannot replace good regulation.
  • Wrong remuneration incentives: They relied too much on volume instead of quality of loans financial institutions generated.
  • Keep financial assets on your balance sheet (and not off-balance sheet, to avoid regulatory capital charges).

I like both the beginning and the end of the book. The author's conclusions are perhaps not brand new but he has the merit of describing these complex issues very smoothly.

How the financial crisis developed in the U.S. and reshaped the local banking landscape.

If I had to stick to one argument for reading the book, it would be this part. Alain reports the history of the crisis easily understandable for everybody and gives a good overview of the U.S. banking sector before and after the 2008/09 financial crisis. He describes the following main events:

  • 13 BUSD emergency loan to Bear Sterns by J.P. Morgan, using FED funds: With a strong activity in mortgage origination and securitization, Bear Sterns failed mainly because it refinanced itself with cheap and very short-term funds and ran out of liquidity. In the reasoning of the author, the FED helped Bear Sterns not because it was “too big to fail” but because the FED feared Bear Sterns could be “too interconnected to fail”.
  • Lehman Brothers bankruptcy: Alain S. Blinder describes four reasons that made the U.S. government refusing a bail-out of Lehman Brothers: Markets had enough time to prepare for the bankruptcy, Lehman Brothers seemed less interconnected to fail than Bear Sterns, the U.S. Government lacked the legal authority to organize a bail-out, and it wanted to avoid moral hazard spreading around.
  • Failure of AIG: Due to its AAA rating and extremely lax regulation in the insurance sector, AIG heavily engaged in trading credit default swaps. The FED helped the insurance company by granting a 85 BUSD loan.
  • Sale of Merrill Lynch to Bank of America: After heavy lending to mortgage originators, Merrill Lynch had to write down, during the financial crisis, these loans substantially.
  • Sale of Washington Mutual to J.P. Morgan due to extensive sub-prime mortgage lending by the former.
  • Merger of Wachovia into Wells Fargo

Monetary and economic recovery programs in the U.S.

Alain S. Blinder details the options that the FED had to safeguard the economy, i.e. injecting capital directly into banks, buying toxic assets, refinance banks and their toxic assets, or guaranteeing toxic assets. He develops the following operations initiated by the FED and the U.S. government:

  • 700 BUSD Troubled Assets Relief Program (TARP): Contrary to the U.K. which invested exclusively in banks' equity, the U.S. opted for a mix of the repurchase and equity injection solution. The author reports the political process of adopting the TARP program in the U.S.. Against criticism (namely as regards a missing solution of excessive compensation in the banking sector) by others, he views the TARP program as successful. In my view, the book goes too much into the details of the political process here. I would have been more interested in exploring the pros and cons of the different options to save the banking sector.
  • 200 BUSD Term Asset-Backed Securities Loan Facility (TALF): The FED made non-recourse loans to institutions which were willing to buy certain asset-backed securities.
  • QE1 (Quantitative easing 1): The FED bought debt obligations from Fannie Mae and Freddie Mac.
  • American Reinvestment and Recovery Act of 2009 (ARRA): Overall, Alain S. Blinder judges the economic stimulus package satisfactory as measures have been taken timely, were targeted to stimulate aggregate demand, and temporary.
  • Other quantitative easing programs such as QE2 and Operation Twist: Overall, the author has a positive view on these programs.

In addition to the above, a merit of the book is its clear description and distinction of conventional and unconventional monetary policy measures as well as the moment when central banks switch from the first policy set to the latter. As Alain explains, a switch should be made when interest rates get close to zero.

Too big to fail debate

The author starts off with a very simple solution to avoid banks being too big to fail: Break up financial giants and, thus, simply avoid the existence of systemically important financial institutions. However, the author rightfully rejects this simplistic and unrealistic solution.

What's the alternative then? Stronger regulating the financial system. This is exactly what the Dodd Frank reform does. Alain S. Blinder touches upon every important topic here – from separating investment and commercial banking, over skin-in-the-game requirements for originators of securitized financial assets and capital and liquidity requirements for banks to executive compensation.

The author describes and criticizes the regulatory process following any new law on financial regulation (i.e. proposal of regulation, comments and input by the public, fixing of the regulation). In his view, this process is fundamentally flawed because it is not the general public that gives input but only biased parties and lobbyists.

Exiting extraordinary monetary policy.

For the author, it is a given that the FED must revert to a normal monetary policy in the near future. Otherwise, it would risk fueling the next bubble, namely through interest rates close to zero and excess reserves of banks with the FED.

The question is just when and how. Obviously, this part of the book has been, to some extend, run over by the FED's exit strategy, now being in place since a few months.

Additional topics of the book include the spread of the 2007/08 financial crisis into Europe and the European sovereign debt crisis from late 2009 to 2012. These parts, even though well written, are clearly not Alain S. Blinder's main focus. I would recommend reading the book if you are interested in the U.S. stuff. There are certainly other books out there which treat the European topics better and more extensively.


Additional Quotes

“A bubble is a large and long-lasting deviation of the price of some asset – such as a stock, a bond, or a house – from its fundamental value. Usually it's an upward deviation. The definition of what is large and what is long-lasting makes it difficult to predict and recognize bubbles. The fundamentals always win out in the end, the question is just when.”

“Risk spreads were irrationally small [in the run-up to the financial crisis] and therefore had to widen.”

“Leverage is a double edge sword. It does magnify returns on the upside, which is what investors want. But it also magnifies losses on the downside, which can be fatal.”

“The result of extreme leverage is predictable, though its timing never is.”

“When times are good, asset value are rising, and loan defaults are rare, it is all too easy to forget one of the laws of financial gravity: What goes up too fast usually comes crashing down.”

“Complexity and opacity are potential sources of huge profit.“

“Had Wall Street not concocted a system that was long on complexity and short on liquidity, the panic might have been contained.”

“The fallout from the bankruptcy of Lehman Brothers was the exception that proved the rule [that exceptional adverse economic events do happen].”

“The TARP was among the most successful – but least understood – economic policy innovations in our nation's history.”

“Credit is a coward. It struts around when times are good and lending risks are low, but runs and hides whenever risk rises. Since credit is critical to any modern economy, that's a problem.”

“The financial crisis gave hedge funds a bad name, probably a worse name than they deserved.”

“But no matter how lengthy and complex the law, it is virtually never more than a skeleton. The sketchy, sometimes thematic content of each regulatory statute must be translated into concrete, detailed regulations by the agencies involved.”

“In a capitalist society, rearranging property rights outside of well-established legal channels, such as bankruptcy courts and foreclosure proceedings, is a nasty process – something to be avoided except under extreme circumstances.”

“The more things change, the more they stay the same.”

“The cure [a blueprint for financial reform through the Dodd Frank Act] was being prescribed long before the diagnosis was in.”

“It seems that the FED's exit strategy has to be not too fast and not too slow, but just right. The FED is human; it won't get the timing exactly right. Rather, it will err in one direction or the other. But magnitudes matter.”

“The truly horrendous budget problems for the U.S. come in the 2020s and 2030s, and beyond. The projected deficits are so huge that filling most of the hole with higher revenue is simply out of question. Spending cuts must bear most of the burden. Over the long term, controlling spending means controlling health care spending. It's that simple – and that complex.”

“The story won't be complete until the “exit” from the European sovereign debt crisis comes. And that may be a long way off.”

“Europe dragged its collective feet, each time kicking the can just far enough down the road to get to the next summit meeting.”

“The new LTRO looked like a game changer. But it did not solve the sovereign debt crisis. The central bank can't do that, of course, any more than the FED can solve the U.S. government's mounting debt problem. Only governments can – by cutting spending and raising more revenues.”

“Moral hazard is now an undesirable feature of the financial landscape. One important aspect of Never Again is convincing financial markets that the government will not rescue them from future mistakes. The game of “heads you win, tails the taxpayer loses” is not one we want to keep playing.”

“When the good times roll, investors expect them to roll indefinitely. But they don't.”

“We need real regulation, zookeepers watching over the animals.”

“What you don't know can hurt you.”

“High profits are often illusory, the product of applying high leverage to ordinary investments.”

“Modern finance thrives on complexity; indeed, you might say that the central idea of financial engineering is complexity. But ask yourself whether all those fancy financial instruments actually do the economy any good. Or are they perhaps designed to enrich their designers?”

“Bubbles will be back. So will be high leverage, sloppy risk management, shady business practices, and law regulation. We need to put in place durable institutional changes that will at least make financial disruptions less damaging the next time the music stops.”

Thursday, May 1, 2014

Berne Union Statistics 2008 – 2013

On April 14, 2014, the Berne Union has published new figures of the ECA industry. Here are some highlights:

New ECA Business

Between 2009 and 2013, new ECA business has increased by 39 %. This increase is mainly due to ECA's short term business, whose portion in the business mix increased by 4 % over the same period, to reach 86 % in 2013.

The 2013 ECA business included 86 % short-term, 9 % medium/long-term and 5 % investment insurance. Since 2008, this distribution did not change significantly.

51 % of ECA's new investment business was concentrated in the top ten countries. This concentration is less important for medium/long-term business, i.e. 38 %.

In 2013, a big chunk of new ECA investment business took place in Kazakhstan, China, and Russia. The United States, Vietnam, Russia, Turkey, and Saudi Arabia were the leading countries in the medium/long-term segment.

ECA Exposure

Since 2009, ECA exposure has increased by 36 %. This increase is essentially due to an increasing short-term business, whose portion of ECA exposure increased from 51 % to 53 %.

Today's ECA exposure consists of 53 % short-term, 35 % medium/long-term, and 12 % investment business. Overall, this distribution remained stable over time.

Countrywise, half of today's ECA investment exposure is concentrated on top ten countries (namely Russia and China). For the medium/long-term and short-term business, the figures are 37 % and 56 % respectively. In the medium/long-term, ECAs are heavily exposed to Russia, USA, and India. Main countries of the current short-term exposure are UK, USA, France, Germany, and Italy.

Paid ECA Claims

Compared to other ECA businesses, the portion of paid ECA investment claims is constantly low and never surpasses the 2010 level of 9 %. The medium/long-term business constantly represents the highest portion of paid ECA claims (between 55 % and 60 %).

In 2013, short-term claims account for 43 %, medium/long-term claims for 54 %, and investment claims for 3 % of paid ECA claims.

The 2009 figure represents clearly an outlier. Besides this figure, the 2008 – 2013 tendency is constantly increasing. Paid ECA claims almost doubled, from 2,337 MUSD in 2008 to 4,500 MUSD in 2013.

Paid ECA investment claims are highly concentrated on top ten countries; they represent 88 % of 2013 investment claims. Countries mostly concerned are Libya, Vietnam, Brazil, and Myanmar. Concentration is much less of an issue for medium/long-term claims (64 % in 2013, mostly assumed by Saudi Arabia, United Arab Emirates, and Ukraine) and short-term claims (45 % in 2013, mostly assumed by Italy, USA, Brazil, Spain, and Iran).

ECA Recoveries

ECA recoveries decreased heavily in 2010 (42 %). The decline is even more important over the period 2008 to 2010 (66 %).

The major portion (82 %) of ECA recoveries is on medium/long-term claims. Recoveries of short-term and investment claims play only minor roles (15 % and 3 % respectively).

2013 investment recoveries are, at 99 %, concentrated on top ten countries (mainly, Kazakhstan, Ukraine, and Nigeria). Concentration is significantly lower for medium/long-term (78 % - mainly Egypt, Indonesia, and Iraq) and short-term recoveries (46 % - mainly Iran).


Berne Union Statistics 2008-2013

The whole workbook of visualizations is available here.