Changes in regulatory requirements for trade finance Marc Auboin, WTO

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

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

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, including open account trade lending (relative treatment compared to Basel III unchanged). For off-balance sheet items, such as letters of credit and guarantees, the CCF is unchanged at 20 and 50%. 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. Liquidity: Liquidity Coverage Ratio (LCR), 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. The Net Stable 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 (weighted according to loan maturity). Leverage Ratio: NEW under Basel III. In its 2011 rules on the leverage ratio, the BCBS added a flat, non-risk weighted, 100% CCF for leverage on all off-balance sheet items regardless their level of risk – so affecting also trade letters of credit, and contingent trade instruments of the like. CRDIV had first softened this, until the BCBS Decision on 12/01/14 reduced to 20% the CCF used for leverage, for trade, self liquidating LCs.

Basel III and Trade Finance: what is changing and not? Three landmark Decisions on 25 October 2011, the BCBS modified two of its Basel II rules as far as short-term, self- liquidating trade finance instruments were concerned, to reduce the excessive risk weighting on low-income countries, and to allow for capital requirements to be matched with the effective product maturity (hence waiving on the one-year maturity floor applying to letters of credit and the like). Both measures are of great importance in removing obstacles to the provision of trade finance in low-income countries. This decision is explained in the document "Treatment of trade finance under the Basel capital framework" of the BCBS, available at on 6 January 2013, the new Basel III guidelines on liquidity (concerning the liquidity coverage ratio, LCR) proved to be favorable to short-term, self-liquidating trade finance instruments. In its Decision ( the LCR was defined as the ratio of the “stock of high-quality liquid assets” to "total net cash outflows over the next 30 calendar days". It is meant to ensure that banks have enough liquid assets (i.e., 100% of net cash outflows) for a 30-day liquidity stress period. Previously, the liquidity guidelines assumed that trade finance exposures experienced a run-off rate equivalent to corporate exposure (up to 50%) during a liquidity stress period and required a proportionate buffer of liquid assets. The 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.

Basel III and Trade Finance: what is changing and not? Three landmark Decisions On 12 January 2014, the BCBS modified its 2011 regarding the leverage ratio on trade letters of credit and other self-liquidating trade-related instruments, to reduce it from a 100% CCF to a 20% CCF (like for capital purposes). In 2011 initial Decision on the leverage ratio, the BCBS added a flat, non-risk weighted, 100% CCF for leverage on all off-balance sheet items regardless their level of risk – thereby also affecting trade letters of credit. One point made by the WTO has been the absence of leverage involved in trade finance transactions, due to the one-to-one relationship with merchandise trade. Moreover, contingent trade finance obligations, such as letters of credit, are off the balance sheet essentially for process reasons. This argument was accepted by several interlocutors, within and outside the BCBS. The 2014 modification was hailed by the Director-General of the WTO "as being of particular significance for the availability of trade finance in the developing world, where letters of credit are a key instrument of payment. This is good news for developing countries, for the expansion of their trade and for the continued growth of South-South trade flows.” All in all, the situation on the regulatory front is looking better than it did a few years ago, thanks to the institutional dialogues opened by the WTO and the Basel Committee, and the data support provided by ICC. There is no doubt that such initiatives contribute to improving the policy coherence between the prudential and central bank community on the one hand, and the trading community on the other.

Basel III and Trade Finance: what is changing and not? Decision of the Basel Committee on 12 January 2014 (Document: “Basel III leverage ratio framework and disclosure requirements”) “For the purpose of the leverage ratio, OBS items will be converted into credit exposure equivalents through the use of credit conversion factors (CCFs). Certain transaction-related contingent items (eg performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions) will receive a CCF of 50%. For short-term self-liquidating trade letters of credit arising from the movement of goods (eg documentary credits collateralised by the underlying shipment), a 20% CCF will be applied to both issuing and confirming banks.”

Basel III and Trade Finance: what is changing and not? Implementation differences: the specific case of the leverage ratio

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 always 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. The BCBS is aware that divergent implementation of the same minimum guidelines may lead to regulatory arbitrage or competition – probably one reason behind changes in rules on the leverage ratio. 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.

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