Basel III and trade finance. Summary of main measures Marc Auboin, WTO

Trade and GDP relationship

Trade and GDP plunged in 2009 and rebounded in 2010, but have since recorded below average growth

The share of fuels and mining in world trade has risen at the expense of agricultural products and manufactures

Distributed production has led to relatively more trade between developing countries and less between developed countries

Basel III and Trade Finance: what is changing and not? *Basel III rules aim at tightening prudential rules on bank-related lending. Indirectly, they will affect importers and exporters, depending on whether their banks charge them for the increased costs inherent to the new capital, leverage, liquidity and maturity structure rules. LCs, import financing and other trade loans (like any other loans) are subject to higher capital ratio (albeit not higher CCF), a leverage ratio, new liquidity rules (LCR, NFR) *Banks may not all react to the same way to Basel III rules, depending on competitive pressure and their own balance sheet structure. The more banks are already compliant with the new rules, which add to existing Basel II rules, the less they are likely to raise their prices, as they have to take into consideration the context of fierce competition, particularly in the trade finance market. Also, banks may try to mitigate the increased capital cost by reducing the “production” cost of some of their products (recent introduction of the BPO on the short term segment). Hence, it is not entirely clear how new prudential regulation will affect pricing, and by how much. *We are in a transitory period, between the adoption of new rules ( ) and the implementation of such rules (from now to 2018). The way in which the different Basel constituencies will implement the new rules will be key to their impact on the pricing of various products. The implementation of these rules may be very different from constituency to constituency, and this in itself may lead to tension, and possibilities (hopefully not) of regulatory discrepancy, if not arbitrage. As always, the devil is in the details.

Basel III and Trade Finance: the devil and the details Capital and maturity floor: Increased amount of capital for on-balance sheet lending based on a 100% credit conversion factor (CCF); capital charge by tier + a special for systemically important banks (common equity will be raised to 4.5% of risk-weighted assets + 2.5% in conservation buffer+ a 0-2.5% countercyclical buffer when prudential authorities consider the bank to build up excessive risk % on common equity for SIBs). All banks must have minimum capital of 8%. The increase in capital ratio will affect all assets likewise, not only open account trade lending. While the absolute capital charge for trade finance increases along with other assets, its relative treatment compared to Basel III is unchanged. For off-balance sheet items, such as letters of credit and guarantees, the credit conversion factor remains that of Basel III, respectively at 20 and 50%. Maturity Floor: Under Basel II, rigidity in the maturity cycle applied to short-term trade lending: while trade finance lending is usually short-term in nature, generally between 0 and 180 days maturity, the Basel II framework applies de facto a one-year maturity floor for all lending facilities. As capital requirements increase with maturity length, the capital costs of trade finance have been felt to be artificially inflated. This measure was removed by a BCBS decision on 25 October 2011, after a dialogue with the WTO and the World Bank. Leverage Ratio: NEW under Basel III. This is one of the main features of the new prudential framework. Basel III adds a flat, non-risk weighted, 100% leverage ratio on all off-balance sheet items – hence regardless their level of risk – be they AAA bonds, CDS, or trade finance contingent instruments. The leverage ratio affects directly letters of credit, and contingent trade instruments of the like. But CRDIV softens this. Basel III provides for a difference of treatment between revocable and irrevocable commitments.

Basel III and Trade Finance: what is changing and not? Liquidity rules of interest to trade finance are mainly the LCR and NSFR Liquidity (I): LCR: new rules on 6 January 2013 for LCR, for short-term, self-liquidating trade finance instruments. LCR defined as the ratio of the “stock of high-quality liquid assets” to "total net cash outflows over the next 30 calendar days". Meant to ensure that banks have enough liquid assets (i.e., 100% of net cash outflows) for a 30-day liquidity stress period. Previously, liquidity guidelines assumed that trade finance exposures experienced a run-off rate equivalent to other corporate exposure (up to 50%) during liquidity stress period. Revised LCR relaxes the outflow assumptions for a number of bank liabilities, including those arising from trade finance. The Committee allows national regulators to set very low outflow rates (between 0 and 5%) for contingent funding obligations from trade finance instruments – significantly below its previous level. This implies that banks will be allowed to hold fewer liquid assets against contingent liabilities and committed funded facilities arising from trade finance, thereby increasing the availability of trade finance. Liquidity (II) : Net Stable Funding Ratio (NSFR): The NSFR and LCR are the new landmark liquidity requirements to internationally active banks. The funding ratio aim to calculate the share of long term assets funded by long term, stable funding (in order to avoid reliance on short term wholesale funding, which create maturity mis-match in bank balance sheets). Stable funding is weighted differently according to the maturity of loans. Off-balance sheet categories are also weighted, as they are considered to contribute to the long term assets. This is explained by the potential for contingent calls on funding liquidity (revocable and irrevocable lines of credit). Once the standard is in place (2018), off-balance sheet commitments, including for trade, will need to be funded, within the stable funding.

Basel III and Trade Finance: what is changing and not? Other issues Asset Correlation Value: Asset Value correlation multiplier for large financial institutions:, the BCBS introduced a multiplier for of 1.25 to the asset value correlation of exposures to regulated financial firms with assets of at least $100 billion and to all exposures to unregulated financial firms (regardless of size). Unregulated financial institutions are defined as legal entities whose main business include the management of financial assets, lending, factoring (trade bills), leasing, provision of capital enhancements, securitization, investments, financial custody, central counterparties, proprietary trading and other financial activities determined by supervisors. The rationale is to reduce interconnectedness. Implementation schedule The Basel III package has to be implemented by 2018, but the schedule is phased by measure. For the leverage ratio, the period of disclosure starts on Jan 1, 2015, with application in Capital common equity is raised up to 4.5% in 2014, but capital conservation buffers and other components are to increased gradually. All in all, most banks must be compliant with the 8% minimum already. The LCR is gradually increased from 2015 on-wards. The minimum standards for the net stable funding ratio is to be introduced in 2018

Basel III and Trade Finance: what is changing and not? Implementation differences The Basel III package is deemed to constitute minimum guidelines. Basel Constituencies may apply tougher requirements. In that case, the law of the land will apply in each constituency. This may lead to differences. Already some countries have given indications on how they intended to implemented such or such measure (the US). Others have already adopted the implementation package in domestic law. This is the case of the EU, with the CRDIV (hard law). There are voices indicating that the divergent implementation of the same minimum guidelines may lead to regulatory arbitrage or competition. There is an issue with respect to trade in CRDIV – notably in the application of the leverage ratio. There are also complaints that the implementation of specific provisions may give rise to differences between regulators. For example, there are voices indicating that the modes of calculation of the leverage ratio is different on both sides of the Atlantic. To be fair to regulators, there has always been differences in the national application of internationally agreed guidelines. Such differences may also reflect the different risk environment of specific financial markets. With respect to trade, there are on-going discussions with the trade and trade finance industry to clarify some of these issues. There is also greater awareness of the trade treatment by regulators. The BCBS has met trade representatives on several occasion, and the BIS is completing a TF survey.

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