Monday, September 5, 2016

The Basel III Leverage Ratio – Leverage Trade Finance?

No, introducing a leverage ratio in the Basel III framework does not leverage trade finance. It rather kills it. You can debate whether it actually leverages the security of the financial system, even though this is, at least, its purpose.


The leverage ratio is meant to complement the risk-weighted capital ratios. In other words, whereas the capital ratios compare different forms of capital and risk-weighted exposure, the leverage ratio compares Tier 1 capital and non-risk weighted exposure.

Here is the formula, to be calculated quarterly:

Leverage Ratio = Tier 1 Capital / Exposure Measure 3 %

It’s perhaps a bit intriguing that the leverage ratio is here a minimum ratio as we are more used to see leverage as something bad (“The more your company is leveraged, the more dangerous it is.”). In banking, it’s the other way round.

Tier 1 Capital is the smallest form of capital. Extremely simplified, we add up equity, retained earnings, and other paid-in and not subordinated capital instruments.

The fact that the numerator is the smallest capital form makes the denominator even more important: The Exposure Measures comprises

  • On-balance sheet exposures +
  • Derivative exposures +
  • Securities financing transaction (SFT) exposures +
  • Off-balance sheet (OBS) items

Trade Finance increases OBS, decreases the leverage ratio, and harms bank profitability.

Trade finance consists of letters of credit and guarantees. Both are off-balance sheet items. Hence, a trade finance instrument issued by a bank requires a specific amount of Tier 1 Capital to keep the leverage ratio above the 3 % threshold.

So far, so bad. But this is actually not all.

Let’s remind ourselves how we calculate RWA for trade finance instruments when it comes to capital ratios:

  • 1st step: We multiply the nominal with a credit conversion factor as follows

  • 2nd step: We multiply this converted value with a probability of default (which depends on the rating of the Instructing Party) and deduct the result from the converted asset.

The 2nd step is skipped when it comes to calculating the leverage ratio. This is precisely the raison d’ĂȘtre of the leverage ratio.

But the 1st step is altered as well because the proposed credit conversion factors are actually higher:

Syndication doesn’t lead you anywhere.

If you (I suppose you are a trade finance banker!) don’t have enough by now, let me add a final surprise well hidden in an Annex called “Basel III Leverage Ratio Framework”:

[…] Banks must not take account of physical or financial collateral, guarantees or other credit risk mitigation technique to reduce the leverage ratio exposure measure.”

I wish good luck to a company which has just secured a multi-billion export contract, needs a performance guarantee for such contract, and is looking for a bank to issue this guarantee without being able, from a leverage ratio perspective, to syndicate its exposure.

What’s next?

The Basel Committee on Banking Supervision has proposed the above rules in April 2016 and envisages application in January 2018.

Until then, there is plenty of time to debate and, hopefully, amend the proposals.


Tuesday, June 21, 2016

“There is always work to be done, a second curve waiting to be invented.” – Charles Handy’s new book

Technology threatens jobs. Old institutions cannot guarantee employment any more. To sum it up: The future is uncertain! What to do?

There are no simple answers. But Charles Handy provides a tool that might help – The constant search for a second curve.

The concept of the second curve

The sigmoid curve is a mathematical concept that, according to the author, applies to all aspects of our lives: organizations, businesses, governments, empires, alliances, etc.

A sigmoid curve has four phases:

  • Investment period: During this period, you invest (money, time to educate yourself, etc.) and have less in return than what you have invested. The curve goes down.
  • Growth period: You benefit from your investment and your output exceeds your input. The curves goes up.
  • Peak phase: Your output doesn’t increase anymore; it is simply enough to cover your input. Profits have gone; the curve flattens out.
  • Decline phase: Your output declines but your input remains. You start losing out; the curve goes down again.

Charles Handy makes two central assumptions:

  • First, he argues that the decline phase is inevitable.
  • Second, he says the shape of the curve has been proven. Only its speed varies. The decline of the Roman Empire, which took 400 years, serves as an example here.

You have to accept these assumptions. If you don’t, it’s actually not worth reading the book.

Nobody likes decline. The only way to avoid it is to start a second curve before the first curves peaks.

The problem of timing

The second curve approach is easy to understand. But it seems to me that its application is all the more difficult. How do you actually know where you are on the curve and when the next phase comes?

Charles Handy admits this, writing that “the problem is knowing when the first curve is about to peak:

  • On the one hand, first-curve success can make you blind and not see the peak, for example due to a new technology. On the other hand, acting too early makes you miss the growth phase.
  • Acting too late, i.e in the declining phase, is psychologically difficult because you will have to start something new precisely when your income, productivity, and reputation are going down.”

I haven’t really found a solution to this problem in the book. But I tend to think that a solution is impossible because it depends on the underlying facts to which you apply the second curve image.

In the rest of the book, Charles Handy applies his idea to various aspects of our life. I only pick a few examples here.

The second curve in your career – “Work is what we do, not where we go.”

Charles Handy’s message is pretty simple: Jobs change more and more rapidly and technology threatens everything besides jobs where creativity is key and where personal attention is needed (nursing, health care, social work, care of the elderly); performing arts, tourism, and entertainment might also escape.

Therefore, people will have to change jobs frequently. If you have to do that anyway, the author recommends that you do it before the declining phase, when things are (still) going well.

Instead of today’s big employers, Charles Handy imagines a pure contractual organization, where you as a specialist contribute your know-how only if and when it is needed. But instead of seeing this gloomily, the author turns it upside down: “Groups of specialists form independent groups and contract their work back to the organization, trading security for independence, better rewards, and more control.”

From the company’s standpoint, this involves not only advantages: “Critically, however, there is no more sense of community in a contractual organization, no core values, nothing to inspire loyalty. Where contracts are key the spirit is lost.”

Let’s turn to the critical question: How can you be sure to earn more money on your second curve? Actually, you can’t. But for the author, it’s not only about money:

It can be more satisfying, and often more profitable, to grow different rather than bigger. This is the premise behind the Second Curve, that different is more fruitful than more of the same.”

The second curve for companies

Shamrock organization

Charles Handy imagines the future company as a “shamrock organization”:

  • The first leaf represents the core workforce.
  • The second leaf represents secondary organizations to which some of the subsidiary work or the organization is outsourced.
  • The third leaf stands for the individuals hired either on a project or on a part time basis. These individuals are either highly skilled or lower-skilled.
  • The stalk of the leaf is the management that holds it all together.

The exact balance between the three leaves depends on the needs and situation of each organization and, therefore, is a major strategic decision for any company.

Contrary to the current curve, the shareholders are not and cannot be part of the shamrock. Charles Handy is obviously not a fan of the shareholder value doctrine.

Doughnut jobs

Surround people with too many rules and regulations and they stop thinking for themselves.”

Charles Handy thinks that people should be granted flexibility and criticizes that too many firms kill their people’s creativity for the sake of efficiency. He uses the image of a doughnut:

  • The jam in the middle represents the core essentials of the job that are required of the person or the group. If you don’t deliver the jam, you will have failed.
  • The dough represents the empty space around the jam which is available for new initiatives.

The current curve tends to produce jam only; the second curve should favor the dough instead.


Charles Handy praises federalism as a way to keep people engaged locally while leveraging on the strength of size. In his view, this is not only a political concept but applies to corporations as well.

Good bye to the almighty headquarter that prescribes how things ought to be done! Local issues should be decided locally!

What am I here for?

By the end of his book, Charles Handy asks fundamental questions: What are all these curves good for?

One thing is for sure: It’s not about money: “Many in our capitalist age would settle for money, and then more money. But this only postpones the problem, for money is only an intermediate purpose, a means to a bigger end.” In the author’s view, money only keeps you busy going nowhere.

To determine the ultimate purpose of life, Charles Handy recurs to Aristotle – Achieve excellence in accord with virtue through eudaimonia. He defines eudaimonia as being more than happiness – “doing your best at what you are best at, for benefit of others” or, in other words, “living up to your potential”.

The book is worth reading. It’s sometimes a bit too much visionary stuff for me, but that is, of course, a question of personal preference.

Some additional Quotes


Charles Handy – The Second Curve – 2015

Wednesday, June 8, 2016

Sanctions Clauses in trade finance instruments? – No, thank you!

When I throw the key words “sanctions” and “trade finance” at you, I trust that you immediately think about ruthless bankers sacrificing honorable political goals for big personal bonuses at the end of the year.

The reality is pretty different today, as I have recently experienced firsthand, where banks wanted to be better than the best in class by introducing ever more contractual clauses allowing them to impose sanctions laws on their counterparts.

This situation is strange. Let me make an example: In my country, insider trading is forbidden and punished as a crime. Before I started working for my bank, I actually didn’t negotiate a clause in my employment contract saying that I cannot be obliged to do insider trading for my bank. I don’t think that anybody would have been particularly impressed by my integrity if I had tried to negotiate such a clause. It is simply unquestionable that both my bank and I respect the applicable criminal Law, in particular with regard to insider trading. The fact that insider trading cases regularly pop up in the financial press doesn’t really change anything here.

But – surprise – this is exactly what happens today when banks would start trying to negotiate sanctions clauses in trade finance instruments. I admit, the question of the applicable law is a bit trickier than in my example. But still, there are rules in place to determine the applicable law.

This is why I think it is a good moment to remind the ICC’s recommendation of 2014 to not include sanctions clauses in trade finance instruments:

  • Banks should refrain from issuing trade finance-related instruments that include sanctions clauses that purport to impose restrictions beyond, or conflict with, the applicable statutory or regulatory requirements.
  • In trade finance transactions involving letters of credit or demand guarantees subject to ICC rules, practitioners should refrain from bringing into question the irrevocable, independent nature of the credit, demand guarantee or counter-guarantee, the certainty of payment or the intent to honor obligations. Failure to do so could eventually damage the integrity and reputation of letters of credit and demand guarantees which may have a negative effect on international trade.”

Let me sum up the ICC’s reasons for its recommendations in my own words:

  • First, if you start rewriting obligations in your contract that apply to you anyway, people will start wondering why you do so and whether you don’t have any hidden agenda. In addition, there is a high chance that you will create problems when reformulating national laws and regulations in your contract and putting them in another (contractual instead of criminal) context. In some countries, it may even be illegal to go beyond applicable sanctions and, thus, discriminate parties who are not meant to be discriminated against.
  • Sanctions clauses in trade finance instruments can question the irrevocable / documentary nature of a guarantee / letter of credit. This can ultimately interfere with the equilibrium among all stakeholders that the ICC Rules on trade finance instruments have had a hard time to implement in the first place.


Monday, June 6, 2016

Financial Services to Iran? – Why it is so difficult to lift sanctions

Iran is back in the international business community. We all know this since last summer (July 14, 2015 – to be precise), when Iran has signed a Joint Comprehensive Plan of Action (JCPOA) with the UN, U.S., and EU.

But is Iran really back? Have sanctions really been abolished? One way to find answers is to go through the agreements and implementing U.S. and EU legislations.

Selling yes / Paying no

Let’s say, you want to export to Iran. You must obviously be allowed to ship your stuff to Iran. Let’s assume this is the case. Then, you will only do this if you can get paid. And this is where the trouble starts and financial sanctions kick in.

Now, let’s further assume that you are a European bank. In theory, it is easy to establish whether you can provide financial services to Iran: As you are subject to the European regulator, you simply look at the most recent version of Regulation 267-2012 concerning restrictive measures against Iran, currently the version dated April 16, 2016.

Here, you face a first problem: You basically want to be sure that the type of financial service you want to provide is not prohibited by the EU. Why is that so complicated to establish? It is simply because the EU Regulation tells you what is forbidden but not what is allowed. Confirming something that doesn’t exist is always as hassle in the legal business. The reason is that your response would require the interpretation that your financial service to Iran is allowed because it is not forbidden under current EU legislation. Because the topic is complex and many banks have made bad experiences with sanctions in the recent past, I wish you good luck for getting this confirmation from your lawyer!

A second problem is my assumption that a European bank applies only European sanctions. Regrettably, this is only partly true. In fact, the U.S. regulator could see things differently and impose U.S. sanctions on any (U.S. or foreign bank) operating in the U.S. As every international bank works with USD and/or in the U.S., nobody wants to risk trouble with U.S. authorities. This is why many European banks, in practice, not only respect European, but also self-imposed U.S. sanctions. First, this doubles your work as need to go through U.S. sanctions legislation as well. Second, the definitions of what is (no more) sanctioned are not the same in Europe and the U.S.

EU Sanctions to be lifted

Here is what the EU has promised to lift:

  • Financial, banking, and insurance measures (transfer of funds between the EU and Iran, opening of representative offices, subsidiaries, or joint ventures in Iran/the EU by EU/Iranian banks or financial institutions, correspondent banking relationships, insurance and re-insurance for Iranian entities, financial messaging services to Iranian entities, EU member states’ commitment to provide financial support for trade with Iran (export credits, guarantees, insurance, etc.), and sale or purchase of public guaranteed bonds to and from Iran)
  • Oil, gas, and petrochemical sectors (import of Iranian crude oil and petroleum products, sale of equipment and technology, and financing to the oil and gas sector)
  • Shipping, shipbuilding, and transport sectors (sale of naval equipment and technology, access to European airports for Iranian carriers, cessation of inspection and seizure of cargoes from Iran, provision of bunkering or ship supply services)
  • Gold, other precious metals, banknotes, and coinage
  • Nuclear proliferation-related measures
  • Metals
  • Software
  • Arms
  • Asset freeze and visa ban on listed persons, entities, and bodies

To see which sanctions still remain in place today, the consolidated version of EU Regulation 267-2012 of April 16, 2016 is a good starting point.

U.S. Sanctions to be lifted

U.S. authorities have made similar commitments:

  • Financial and banking measures (lifting of sanctions on Iranian individuals and entities, lifting of sanctions on the Iranian Rial, provision of U.S. banknotes to the Government of Iran, transfer of Iranian revenue held abroad, possibility to purchase Iranian sovereign debt, and the capacity to provide financial messaging services to Iranian financial institutions)
  • Insurance measures (insurance to Iranian entities)
  • Energy and petrochemical sectors (lifting sanctions on Iranian crude oil sales, petrochemical products, and natural gas, possibility to provide investment, technological, and technical expertise)
  • Shipping, shipbuilding, and port sectors
  • Gold and other precious metals
  • Software and metals
  • Automotive sector
  • Removal of Iranian persons and entities from U.S. sanctions listings
  • Nuclear proliferation-related measures (lifting of sanctions linked to the mining, production, or transportation of uranium)

To U.S. Department of the Treasury has summed up the current status of sanctions lifting in a guidance paper dated January 16, 2016, available here.

The Joint Comprehensive Plan of Action (JCPOA)

As a background, the above commitments from the EU and the U.S. have been fixed in the Joint Comprehensive Plan of Action, which the UN Security Council has endorsed, on July 20, 2015. The goal of the JCPOA is to promote and facilitate the development of normal economic and trade contacts and cooperation with Iran.

On Iran’s side, the Government

  • reaffirms that under no circumstances will Iran ever seek, develop or acquire any nuclear weapons;
  • agrees to limit its uranium enrichment and uranium enrichment related activities including R&D activities to a maximum uranium enrichment of 3.67 % for 15 years;
  • engages to implement the roadmap agreed upon with the IAEA, especially with regards to the new heavy water research reactor in Arak;
  • shall allow the IAEA to monitor its nuclear commitments.

In return, the international community commits to lift sanctions as outlined above.

A look at the implementation plan of the JCPOA shows that the topic will stay with us for some time: The IAEA is granted 8 years until it shall reach the broader conclusion that all nuclear material in Iran remains in peaceful activities and the UN Security Council is granted additional two years to fully terminate the sanctions lifting process.


Thursday, June 2, 2016

Who gets what and why – How market design makes us happier and richer

Alvin E. Roth has written a great book about market design. Here is why I recommend reading it.

“As an economist approaching a new market, I am something of a generalist, sort of like an experienced mountain climber approaching a new mountain.”

Market design and matching

First a definition: What is market design? It actually refers to setting the rules of how a market operates.

Second, why does this matter? The reason is that markets help matching offer and demand. In the words of the author, it determines “how we get the many things we choose in life that also must choose us”. The consequence then is that this matching process is one of the most important elements which influences on our life.

Matching is a pretty simple process only where the price is the only parameter deciding who gets what. Standardized commodity markets can serve as an example here. However, only very few markets work like this. Usually, a market involves other parameters, in addition to pricing: timing, availability, personal preferences, technical or biological compatibility, etc. This is usually where design problems kick in.

Market efficiency criteria

Before a market actually needs some form of design, you first need to know whether it is actually an efficient market or not. In his book, the author discusses the following criteria:

A market is thick when there are a lot of participants. Oftentimes, this is not an absolute question but depends on timing. In other words, you need lots of buyers at the same time when there are lots of sellers. Another aspect of market thickness is that it is self-reinforcing: As the Amazon marketplace shows, more buyers attract more sellers and vice versa.

Congestion means that there are too many participants. Alvin E. Roth has a nice formula here: It's the economic equivalent of traffic jam. The opposite of congestion is speed. But sometimes, markets can also become too fast to be efficient. The author gives the example of financial markets where market makers are driven out of the market by high frequency traders. The faster the market is the less have market makers the possibility to make money on a bid-ask spread. This makes market makers disappear. Thus, there will be less bid/ask offers in total on the market.

Market safety has three principal enemies:

  • Obviously, an illegal market (for example drugs or prostitution) cannot be safe as you cannot enforce a transaction in case your counter party defaults.
  • A related execution problem might even come up in legal markets: In the early days of the Internet, people were reluctant to buy on line because it was often unclear whether you would ever receive the ordered goods.
  • The market might be legal but dangerous (for example taxi drivers at night) and, thus, hamper people to participate in it.

The author sums market safety up in the statement that “participants on both sides of a transaction must be able to rely on each other and on the technology”.

Market simplicity is mainly about the way people communicate with each other. The easier it is for people to exchange offers and responses, the simpler a market will become. Recent digital technology has naturally helped a lot here. However, despite technology, confidentiality about people's wants and needs often complicates a market. Indeed, buyers can be reluctant revealing their true needs and preferences because they fear that sellers would then sell them a less desirable product only because they are willing to accept it.

A market is reliable when buyers are not only sure to get the ordered goods but also any additional service that they have agreed upon. This also applies to any information / customer experience about the product.

A repugnant market is the younger brother of the illegal market: Although no-one prevents people from transacting, public opinion simply finds a transaction inappropriate. These can have three main roots:

  • Objectification is the fear that the act of putting a price on something moves the object into the class of impersonal objects. This is the risk of something loosing its moral value.
  • Coercion = Substantial monetary payments might prove coercive, i.e. provide an offer that one cannot refuse. This can make people open to exploitation from which they deserve protection.
  • Allowing a transaction may not be criticizable as such. However, it may lead to a future development that we could regret. The author's example here is buying and selling kidneys.

Let's finish with market trustworthiness which is simply the sum of market safety and market reliability.

Market failures and design solutions:

“The “magic” of the market doesn't happen by magic: Many marketplaces fail to work well because of poor design.”

Once a market has failed, market design actually uses any tool that can enhance the above described efficiency criteria.

Solutions to market failure are sometimes invented, sometimes discovered, and often a bit of both. In addition, designs of markets usually evolve through trial and error.

Some of the tools that Professor Roth describes are:

  • Commoditizing a market enhances market efficiency in that sellers can sell to the whole market and buyers know exactly what they get.
  • Product differentiation is the opposite: It helps buyers to find the precise product they want but usually increases their dependency on a specific seller.
  • A clearinghouse makes it safe for people to state their preferences honestly: The clearinghouse only registers the preferences and tries to match them without communicating the positions to both parties.

The frustrating (or interesting – It depends how you see it.) feature of market design is that it will always be temporary. Markets actually evolve, fail, get fixed again and again...

Let me finish with a short quotation:

“I hope, [this book] will give you a new way to see the world and to understand who gets what – and why.”

In my view, this is a bit too ambitious. But the book is definitely worth reading.


Alvin E. Roth – Who gets what and why – 2015

Monday, February 1, 2016

Liquidity – Fuel for financial markets

The Latin term “liquidum” can have two meanings: Literally, it refers to water or other forms of liquids. In a figurative sense, it means clarity or certainty.

In the financial world today, nothing is certain or clear. Therefore, liquidity must be some form of liquid fueling financial markets. In a recent report on global financial markets liquidity, consultants of Pricewaterhouse Coopers (PwC) have gone into further detail.

What is liquidity?

Liquidity is the ability to execute large transactions with limited price impact. Nice, but when can you actually execute large transactions with only limited price impact?

This is possible when

  • it doesn’t take you a long time to sell. The longer it takes, the more potential sellers will know that you are desperate to sell and, thus, increase the price. This phenomenon is called immediacy and refers to the time it takes you to complete a transaction.
  • you are always able to find someone to buy. This is what experts call market depth and resilience. Basically, the larger the flow of trading orders on both the buy and the sell side, the better it is.
  • you can sell quickly everything you own, be it stocks, debt, certificates, etc.. Finance professionals call this market breadth and, ideally, want liquidity being distributed evenly among asset classes and across markets.
  • it doesn’t cost you a lot to execute trades: The higher the transaction costs the less you will be able to sell without an important price impact. The consultants of PwC talk about tightness and measure this through bid-ask spreads.

Why is liquidity important?

Without liquidity, markets are not efficient. And if markets are not efficient, economic resources cannot be allocated properly, central bankers have a hard time implementing monetary policy, and economic agents cannot manage their risk and funding properly.

Since 2010, liquidity is declining.

PwC gives some examples: The trading volume for European corporate bonds has declined by 45 % since 2010. Banks hold 40 % less trading assets, compared to 2008. Between 2011 and 2015, the market for single name CDS has been cut by half.

Where does this declining trend come from? The PwC experts identify five main reasons:

  • New financial regulation since the crisis penalizes banks holding assets. Very simplified, the need to refinance through equity, everything else being equal, reduces banks’ return on equity. PwC doesn’t tell us whether this is actually good or bad. Their statement is so balanced that, in the end, you don’t really know what their opinion is:
There are grounds for a review of the calibration of the reforms to date and ongoing regulatory agenda, in order to properly understand and consider the effects of regulatory initiatives on market liquidity by asset class, and to consider whether upcoming regulatory initiatives could likely exacerbate the trend in liquidity.”
  • In addition, since the financial crisis, regulators focus more and more on central counter parties replacing parties transacting over the counter to reduce the concentration of counter-party risk. This, coupled with increasing use of electronic trading platforms, might improve the liquidity for standardized instruments. However, it significantly reduces the liquidity for tailor made instruments, namely regarding corporate bonds and infrastructure finance hedging.
  • Today, regulators ask big banks to increase the total loss absorbing capacity (TLAC). This pushes banks to prefer long-term over short-term funding structures and is actually less suited to trading activities.
  • Given the current benign economic environment, volatility in financial markets is too high. The authors of PwC’s report argue that this actually favors a decline in liquidity in financial markets.
  • Market trends don’t favor the liquidity situation: Today, less corporates are issuing bonds and the few who issue do so on a much larger scale. In addition, as banks retreat from commodity markets, market participants become less diverse and bid-ask spreads widen.

The trend of declining liquidity has not been offset yet by increasing electronification and digitalization in financial markets. Obviously, in the long run, the development of electronic trading platforms should favor liquidity because it contributes to lower transaction costs and improved transparency.

What are the repercussions of declining liquidity?

If holding financial assets becomes more expensive, market making become less profitable. If banks practice less market making, fewer people will be there to maintain prices during the next financial crisis. The impact of stress events on prices will then be all the more forceful.

A side aspect of declining liquidity is a phenomenon called bifurcation: This means that liquidity is increasingly concentrating in the most liquid instruments and falling all the more in less liquid assets. This actually disadvantages longer term FX forwards, high yield debt, single name CDS, interest rate derivatives, and mid-cap equities.

After reading PwC’s report, I conclude that liquidity is actually the opposite of what it was supposed to be in ancient Rome. It’s more a source of instability and uncertainty for market participants than a resolving substance.


Global financial markets liquidity study – PwC – August 2015