Rethinking Bretton Woods | Sat, Sep 1, 2012
Recent changes introduced to the Basel agreement on capital requirements have sought to assuage concerns about how the recent Basel agreement reforms might affect trade finance. This article reports on on the response by a sector of the business community (the Business 20) to such changes.
The abrupt fall in availability and costs of trade credit experienced during the global financial crisis has been identified by some analysts as a cause for the historical drop in trade flows, with a multiplier effect in the transmission of the crisis for countries most dependent on trade.
The most recent report by the Expert Group on trade finance of the World Trade Organization confirmed that the situation had gone back to somewhat normal in some markets (particularly Asia), difficulties continued in Western and Eastern Europe, the MENA region and Sub-Saharan Africa.[i] Moreover, given signs of a new slowdown in the global economy, there are reasons to have a pessimistic bias regarding prospects.
The International Chamber of Commerce and other private sector lobbies have been putting pressure on regulators to relax capital requirements associated to trade finance. The G20 agreed in 2009 to request the Basel Committee on Banking Supervision to review Basel III rules on trade finance they asked regulators to “make use of available flexibility in capital requirements for trade finance.”[ii]
Two main changes were introduced in revisions that were approved by the Basel Committee on October 2011.[iii] First, 90- to 115-days issued and confirmed letters of credit would need to be capitalized only for that maturity, whereas before they would have had to be capitalized for the minimum of 1-year maturity.
Second, counterparties in trade finance transactions will be able to receive a rating, for risk-weighting purposes, higher than the sovereign country where they are based. Before, counterparties could not have higher rating than the sovereign country where they were based, which in many cases meant that traders with good track records would still be given low ratings if they were operating in poor countries that often feature no rating or a low one.
The industry is not content with the achieved changes, as shown in a Task Force of the Business 20 submitted to the G20 Los Cabos Summit. The Task Force on Financing Growth and Development, while welcoming the changes made by the BCBS, expressed that such changes only partially addressed the capital and liquidity impediments banks face when offering trade finance.[iv]
One of the B20 demands for reforms to go further is that the waiver of the 1-year floor on maturity of trade finance should be applied not just to the documentary credits, but to all trade loans and receivables.
Another demand of the business sector concerns a ratio that the Basel Committee decided not to revise: the leverage ratio. The leverage ratio is potentially one of the most meaningful reforms in the Basel III. The other ratios in the Basel framework are calculated on the basis of “risk-weighted assets,” thus giving banks a great deal of flexibility to calculate the risks on the basis of their own models and, with that, great room to understate their true level of risk – as the recent incident involving losses of near USD 6 billion and counting at JP Morgan can attest.[v] In fact, the system gives not just room, but an incentive for banks to game it, as put by former FDIC Chief, Ms Sheila Bair (among bankers the practice receives the more elegant name of “risk-weight asset optimization,” though).
But the leverage ratio is calculated on the basis of total assets, so it does not allow for the degree of gaming that other ratios allow.[vi] Not surprisingly, the financial industry succeeded so far in making the leverage ratio only of optional implementation in the legislation meant to implement Basel III in European jurisdictions (the still-under-discussion Capital Requirement Directive IV).
The B20 demanded that trade finance exposures be, for the purposes of the leverage ratio, given a conversion factor of between 20 and 50 per cent. That means, capital would need to be provided for an exposure of 20 to 50 per cent of the actual value of the loan. If adopted, this recommendation could, under the guise of helping traders in poor countries obtain trade finance, initiate a slippery slope. Once trade finance transactions are attributed a risk weight, what is going to prevent other so far considered “safe” assets to also be excluded from the leverage ratio? It is worth noting that the leverage ratio is, after all, a complementary ratio.
Another concern with this proposal is that banks are reportedly seeking to securitize trade finance assets in the way that mortgages and other loans are securitized to generate Collateralized Debt Obligations.[vii] This is not just a response to the costs to be imposed by Basel capitalization rules, but also to the interaction of such factor with the growing costs of commodities – which banks argue makes it harder for them to maintain commodity trade transactions on their balance sheets.[viii] The question is, would such an instrument be susceptible of the same excesses and manipulations that led to the US mortgage market meltdown and ultimately the global financial crisis of 2008?
There is no reason, in principle, to believe that the arbitrage between the actual risk attached to underlying assets and an understated risk attached to the respective CDO — could not take place in the case of securities based on trade finance loans. The wider such arbitrage is, the more profitable the scheme is, so the incentives certainly exist.
It is likely that regulators today would be more vigilant about the extent to which banks genuinely transfer risk away when these assets go off-balance sheet. The leverage ratio requires that items transferred off balance sheets are still considered essentially as if they remained on the balance sheet. But this would also change if concessions are made to business demands for a “special” leverage ratio for trade finance products.
[i] WTO 2012. Report on G20 Trade Measures, May 31.
[ii] G20 2009.
[iii] For a detailed explanation of how changes compare to the previous rules under Basel I and II see Cornford, Andrew 2012. Remarks on Basel III and trade finance (available at https://www.coc.org/rbw/trade-finance-latest-revisions-its-treatment-bas...)
[v] Caliari, Aldo 2012. JP Morgan losses shatter financial reform illusion.
[vi] Unfortunately gaming is not completely excluded, for instance accounting for derivatives transactions on a net or gross basis and the ensuing differences they could generate in calculating this ratio have been the subject of great controversy (see Caliari, Aldo 2012. G20 Bailed Out by European Crisis, available at https://www.coc.org/rbw/g20-bailed-out-european-crisis-july-2012)
[vii] A CDO is a security backed by a pool of underlying assets. The investor can purchase different “tranches” of the CDO, which carry different risks and /or maturities.
[viii] Jenkins, Patrick and Brooke Masters 2012. Banks test CDOs for trade finance, in Financial Times, April 8; Blas, Javier 2012. Bid to unlock commodities liquidity crunch, in Financial Times, March 30.