New horizons in trade finance

Finance, Trade and Commerce — By on April 5, 2012 at 11:23 PM

Matthew Parish

The market for financing commodities trades, long dominated by a handful of European banks, is becoming more restrictive. Major players have been tightening rules to exclude certain categories of commodities deals and reduce trade finance as a proportion of their total book of business.

The “Basel III” agreement will significantly increase the capital adequacy buffers all banks are required to hold. Basel III is an international agreement between banking regulators, overseen by the Bank of International Settlements, a group of the world’s central bankers. The underlying theory is that the 2008 banking crisis was caused in significant part by liquidity failures, and that if banks are required to keep sufficient reserves, a systemic crisis is unlikely to recur.

The international banking industry has responded with intense lobbying, complaining that forcing banks to maintain minimum capital levels will raise the cost of lending by keeping funds lying idle. Trade finance is particularly susceptible to the impact of Basel III because it requires high levels of capital reserved for low-risk business. Defaults in trade finance transactions run at less than 1%, and levels of non-recovery are even lower. For this reason it is a low-fee business for banks, and the obligation to maintain substantial reserves against trade finance transactions is likely to make them uneconomic.

Regulators have responded to this lobbying by making changes aimed at reflecting the risks involved in trade finance more fairly. The “sovereign floor”, which provides that the creditworthiness of a trade finance counterpart cannot exceed the creditworthiness of the country where the goods are bought, has been abolished. The one-year maturity floor, requiring banks to risk-assess transactions on the assumption that funds will be committed for at least 12 months, has also been abolished for letters of credit. (In practice, few trade finance transactions have maturity dates beyond 80 days.)

However, Basel III by itself cannot fully explain the current reduction in trade finance volumes. It has not yet been finalised or come into force: states are obliged to give it effect from 1 January 2013, with full implementation by 2019.

Ironically, trade finance may be less popular amongst bankers due to its relative safety. In challenging economic times, banks are under increased pressure to generate shareholder value. Because trade finance is low risk, the margins are also low. Trade finance departments are finding it increasingly hard to compete for funds in their own banks with other investment banking activities offering higher risks and returns.

An additional factor is that commodities transactions are almost all denominated in US Dollars. For European banks to lend US Dollars they must hedge their Dollar exposure. The weak Euro makes hedging transactions more expensive.

If trade finance becomes more difficult and more costly, commodities trading will be squeezed and commodity prices will increase. One option may be to release the stranglehold of the US Dollar on global commodities markets. If the biggest traders agreed to move to another currency for trade in certain commodities, or even an agreed basket of currencies, the rest of the market would surely follow. Commodities prices would be relieved of the volatility caused by FOREX fluctuations, an often overlooked cause of price spikes. Trade finance would also become cheaper without the hedging costs involved in international banks investing in a single currency.

Another option is to expand the market in trade finance. Banks in emerging markets could take a role, particularly where countries, such as China and India, have an interest in moderating commodity prices or where countries, such as Brazil and Russia, are exporters of commodities with an interest in facilitating the commodities trading market. Emerging market sovereign wealth funds might have similar interests.

Finally, traders could start financing themselves, or each other. Larger traders could provide funds to smaller ones, to keep the market liquid. It is arguable that they would not be bound by Basel III rules.

Whatever solutions are adopted, the world of trade finance could be about to change. For more information, please contact Matthew Parish, Partner on +41 22 322 4814, or matthew.parish@hfw.com, or your usual contact at HFW.

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