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…