Trade finance: balancing regulation with economic growth

July 2016  |  PROFESSIONAL INSIGHT  |  BANKING & FINANCE

Financier Worldwide Magazine

Eight years after the financial crisis sent shockwaves through the global economy, we face a transformed, and more secure, financial landscape. New banking regulation has played a significant role in this stabilisation. Yet, there remains room for improvement – refining the balance between comprehensive and secure regulation with the imperative of fostering global economic growth is crucial – particularly given that around 90 percent of all global trade requires some form of trade finance.

Certainly, an increased recognition around the importance and low risk nature of trade finance – demonstrated by the International Chamber of Commerce (ICC) Banking Commission’s Trade Register – has inspired ongoing dialogue aimed at ensuring this balance is addressed.

A revised and regulated landscape

Currently, global bank retrenchment and tighter global capital requirements – driven partially by financial, regulatory, economic and political considerations – pose a challenge for global trade growth.

The Basel Accords, for instance, have pressed banks to raise minimum capital requirements in order to prevent insolvency and another financial crisis. As such, global banks are increasingly withdrawing from some business lines, including the financing of emerging market companies and trade finance, considered non-core by many financial institutions.

Additionally, anti-money laundering (AML), and know-your-customer (KYC) requirements, while essential, has weighted banks with increased investigative, tracking and reporting responsibilities. Although not the sole reason for the reduction of bank activity in – perhaps riskier – markets, such compliance measures certainly add materially to the challenges involved in remaining engaged in these markets and with certain client segments. And the regions and activities they pull back from are too often trade hubs, or markets to which global supply chains are anchored.

The security of trade finance

This is supported by the findings of the ICC Banking Commission’s 2015 Global Survey on Trade Finance, which is an annual report highlighting the perspective, insights and opinions of trade finance practitioners all over the world.

The survey found evidence of a persisting trade finance gap, which the Asian Development Bank (ADB) estimate stands at US$1.1 trillion. Specifically, 53 percent of survey respondents reported a gap between the demand of trade finance and their ability to meet that demand.

While, of course, many factors play a part in the termination of banking relationships, respondents stated that it was at least partially due to the increased costs and complexity associated with such relationships, as well as the materially increased compliance and reputational risk associated with the maintenance of large networks of correspondent relationships. In fact, industry sources estimate that the cost of maintaining a basic correspondent relationship has increased at least five times since the height of the financial crisis.

Unfortunately, such retrenchment is particularly affecting small and medium-sized enterprises (SMEs), which are often less profitable – and therefore appealing – for banks to finance. In fact, the 2015 survey reported that nearly 53 percent of all rejected trade finance transactions belong to SMEs. For perspective, 79 percent of large corporate’s trade finance transactions were accepted.

Sharpening the regulatory treatment

Of course, it appears the seeds planted through the continuous efforts to address this trade finance gap are starting to bloom. Indeed, the signs indicate that banks are steadily re-entering the trade finance arena. In fact, 61 percent of banks featured in the survey reported increased activity aimed at meeting the trade finance demand. In part, this is due to the growing awareness surrounding trade finance, including its benefits – and necessity – but particularly its low-risk nature, as empirically demonstrated by the Trade Register Report.

The Register demonstrates the fact-based advocacy efforts of the ICC Banking Commission and numerous industry leaders and partners by delivering clear and concise empirical data on trade finance default and credit risk.

The Trade Register, which includes data from over 24 global trade banks, accounting for over US$7.6 trillion in exposure, shows that the highest performing trade finance products include Letters of Credit (LCs), at both customer and transaction level, as well as when weighted by exposure. For short term (ST) products, the transaction default rate for ST exports LCs was 0.01 percent between 2008 and 2014 – equating to a Moody’s rating between ‘Aaa’ and ‘Aa’.

Medium to long-term finance (MLT) products are also performing well. From 2007 to 2014, the annual loss rate for these products was lower than the loss rate reported by Moody’s for ‘Aa’ rated bonds. In fact, Moody’s default rate for all rated corporates is 1.9 percent – contrasting corporate default rates for MLTs, which stand at 0.88 percent.

The survey also found that both ST and MLT trade finance instruments have fairly low default rates. The default rate of all trade transactions equates to less than 50 percent of the default rate of a comparable Moody’s corporate credit portfolio. And the default rate is even lower for ST products – reaching an average of one-fifth of comparable Moody’s default rates. Even the relatively higher default rates of performance guarantees of import and export loans can be represented by a ‘Baa’ to ‘Ba’ rating by Moody’s.

What’s more, even in the event of default, trade finance instruments hold record high recovery rates – the median result is close to 100 percent, in fact. Certainly, the average expected loss for all ST trade finance products is below that of typical corporate exposures.

Opening communication and collaboration

And these efforts to demonstrate the low risk nature of trade finance, along with open and constructive dialogue, have led to progress.

Indeed, among other developments, the Basel Committee has shown a welcome willingness to refine its approach to a more risk-aligned treatment of certain trade finance products – a movement toward balancing regulatory treatment of trade finance.

Of course, while we have made a strong start, further opportunities to sharpen the objectives of trade finance value creation remain. Trade-based money laundering, for instance, drives certain financial regulation, and yet, only a limited portion of such activity actually occurs in the context of trade finance transactions.

Certainly, greater communication and understanding between regulatory authorities and trade finance stakeholders is needed in order to move forward.

Alexander Malaket is the president of OPUS Advisory Services International Inc, and deputy head of the executive committee at the ICC Banking Commission. Mr Malaket can be contacted on +1 (647) 680 6787 or by email: ar.malaket@opus-advisory.com.

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BY

Alexander Malaket

ICC Banking Commission