07 January 2019
Five minute guide.
Basel 3 requires banks to keep high levels of capital against trade finance including letters of credit that they issue. Many banks are reducing or pulling out of trade finance services as a result.
This guide is longer than most as it gets into the details as to what Basel 3 says about trade finance and why. This is a complicated topic.
Banks are regulated.
The Basel committee on banking supervision was formed in 1974 to coordinate banking regulations around the world. It has 45 members from 28 jurisdictions. The committee publishes "accords" which set out detailed provisions for bank regulation, and most regulators derive their domestic regulations from the Basel committee accords. The most recent accord is Basel 3, published in response to the financial crisis of 2007/8 and updated in 2017.
Basel 3 is being interpreted and adopted at different speeds by local banking regulators around the world in their home countries.
Banks are regulated because they usually take deposits from ordinary people and must not be allowed to act recklessly with the deposits that they take. Regulations exist principally to protect depositors, and because banks can become systemically important in the economies where they operate.
The Basel 3 accord was published after the global financial crisis in 2007/8. The changes being introduced are intended to make banking safer, learning the lessons of the crisis.
There are many adjustments involved, and the main areas include:
Requiring banks to keep more capital overall.
Additional rules for "systemically important" banks.
Tougher rules on liquidity management.
Consolidating previously off-balance sheet items into capital ratios, so the whole of a bank's business is taken into account, not just parts of it.
A new "leverage ratio" that acts as a backstop to all the capital calculations.
The material impacts on trade finance and letters of credit arise from (4) the consolidation of previously off-balance sheet items into the capital charge, and (5) via the leverage ratio.
Basel 3 proposes an unattractive capital treatment for the issuance of letters of credit relative to Basel 2 and relative to the treatment of other types of banking business.
Basel 3 is being gradually implemented in local banking regulations. The changes have led many banks to reduce support for trade finance or even pull out of the trade finance business.
Banking regulations are the rules that govern how organisations must operate if they have a banking licence.
Amongst other things, the rules set how much capital is required to support different things that banks may do. The regulations have evolved over many decades and each country has its own banking regulations that are set by a central authority (central bank or banking regulator). In most, if not all countries, such regulations also reference the Basel committee recommendations, Basel 1, Basel 2 or most recently Basel 3.
Bank regulations cover many things - but one of the main requirements is that banks put up "capital" to absorb the credit and other risks that they take. This requirement protects you, me and other ordinary depositors from the risk of losing our money. Capital is the shareholders' money (tier 1 capital), and additional money that is specifically raised by the bank which takes any losses before depositors if there are problems.
One of the major factors that banks consider when pricing their services is the amount of capital that different services require. The more capital that is needed, the less attractive the business becomes. The more capital that is needed, the higher the rates and charges that the bank will want to impose.
Since Basel 3 drives the direction and detail of the regulations, what it says about banking capital is very important.
Basel 3 is long and complicated. Here is the most recent update: click here. The matters discussed in this guide are referred to on pages 157 and 158.
There are two main touch-points for banks, among many:
How much tier 1 capital is required to support a given activity? This is determined by the "leverage ratio".
How much regulatory capital is required to support a given activity?
There are two concepts here: tier 1 capital and regulatory capital.
Tier 1 capital really means shareholders' equity - retained earnings and subscribers' capital.
Regulatory capital is tier 1 capital plus additional categories of finance, often raised from institutional investors. This is a broad definition of risk-absorbing money that a bank may hold on top of its tier 1 capital to provide further protections for depositors' money.
A bank usually has much more regulatory capital than tier 1 capital - perhaps 2x or 3x as much.
The leverage ratio is formally expressed as the "capital measure divided by the exposure measure". This is best thought of, approximately, as being the total assets of the bank (adding everything in) divided by the capital of the bank (shareholders' funds). The rule for most banks is a ratio of at least 3%, or $33 of assets to at least $1 of capital. But in the calculation, different types of assets are weighted by something called the CCF - and this is the important point. See further below about why the CCF is bad for trade finance.
The main reason why there are two ratios is that, in 2008, regulators discovered that many banks seemingly had a lot of regulatory capital but not enough tier 1 capital, given size of their business.
Banks had created lots of complicated instruments that counted as regulatory capital. They were taking more risks than they should supported by less shareholders' capital than might be prudent. Moreover, regulators became nervous that the regulations might not completely capture all the possible scenarios going forward, given the complexity of the issues involved.
What is regulatory capital in a bank and how much regulatory capital is needed for a given class of banking business is subject to negotiation and discussion with the regulator. So just in case, the regulators have further proposed the leverage ratio as a non-negotiable backstop. The leverage ratio is there to make sure that there is a simple overriding test in the background that no bank can easily work around.
The challenge for bank issuance of letters of credit is the leverage ratio.
Letters of credit are low risk and usually short-dated. They are also off-balance sheet - meaning that there is no cash paid out upfront and the cash is only paid out if certain conditions are met (so it is "contingent"). Historical information shows losses are very low.
The ICC in 2011 reported less than 3,000 defaults on over 11 million transactions in its submissions to the Basel committee (click here to read).
Regulatory capital: LCs can be efficient. These low risks provide banks with plenty of opportunity to negotiate an efficient regulatory capital treatment with regulators. Internal rating models can be used to assess the risks and compute the capital requirements (the so-called IRB approach).
Leverage ratio: no room for argument. The leverage ratio offers no flexibility - it is a simple non-negotiable calculation. The amount of tier 1 capital needed to support LC business simply is what it is.
For most banks, the leverage ratio is at least 3%, or 33:1, and it is tougher than that for the biggest banks.
A ratio of 33:1 means that each $33 of business that a bank executes must have $1 of tier 1 capital (broadly shareholders' funds) in support.
But, as mentioned above, different types of activities have different weightings in the calculation - called a "credit conversion factor" or CCF. We refer to this simply as the weighting. The weighting varies between 10% and 100%. At 10%, it means that $330 of business can be done supported by $1 of tier 1 capital - which is a high level of leverage.
The rule for letters of credit is that they are 100% weighted in the calculation, unless the letter of credit is collateralised when it is weighted 20%.
For a $100.00 LC, the bank must allocate $3.00 of tier 1 (share) capital to support it.
If the LC is collateralised, the $100.00 LC only needs $0.60 of tier 1 capital in support.
This ratio is high, especially given the low risk of letters of credit. But it is what the Basel committee has decided. By way of comparison, asset-based lending (factoring, leasing and receivables financing) usually offer higher returns and are always weighted 20%. That makes these other products very attractive compared to the LC. This puts LC business at a significant disadvantage.
For letters of credit:
If the LC is collateralised, it can be weighted 20% for the leverage ratio. This makes the return on capital acceptable for most banks, given market rates for the provision of the LC service;
But if the LC is weighted 100%, then 5 times as much capital has to be committed. This makes the returns look low relative to alternative uses of the bank's credit lines and capacity; banks do not really want to do LCs on this basis.
It depends upon whether your bank is currently considering Basel 3, and it depends upon who you are.
In many emerging market countries, regulators are not yet implementing Basel 3. This means that the implications of the leverage ratio for trade finance may not yet be visible. But this is not the case in the UK, Europe and the US. In these markets, Basel 3 has already arrived.
In terms of who you are:
Small or mid-sized importer: expect your bank to ask for collateral. If the bank already has collateral from you, then this will be marked $ for $ against the LC. If your bank does not have collateral, they are likely to ask for cash upfront at 100% of the LC value.
Larger importer (for example, over $500m turnover): your bank may well provide you with an LC without asking for collateral. But for the bank, this will be based upon their relationship with you and the other business they are doing. They will not get a good return on the LC by itself. It will be a matter of the strength of the relationship.
For regulators, the leverage ratio is a sensible step to make sure that there is a simple and non-negotiable test to ensure that banks have enough capital.
But for trade finance departments in the banks and their importing customers, the leverage ratio has led to a difficult outcome. An importer typically arranges trade finance, like a letter of credit, in order to provide a guarantee of future payment to an exporter.
The LC issuance is collateralised. This makes it work for the bank, but unattractive for the importer. The importer might as well pay the exporter directly and avoid the costs and hassle of the LC, especially if the bank asks for 100?sh collateral upfront; or
The LC is uncollateralised, in which case the capital usage for the bank is too high to make it an attractive proposition by itself.
The leverage ratio creates a situation where the letter of credit no longer really makes sense for the bank and the importer involved. Both parties should really find another way to bridge the working capital gap between exporter and importer - for example, from a specialist like PrimaDollar.
Many banks considering the implications of Basel 3 have reduced the scope of trade finance services that they provide, or have even pulled out of trade finance altogether.
It is unlikely that the regulatory position will change in the near term.
The leverage ratio was introduced in 2010. In the original version, letters of credit were weighted 100% regardless of collateralisation.
There was an outcry from the trade finance industry. A negotiation followed supported by representations from various trade bodies, including the World Bank, the WTO and the ICC.
The Basel committee then agreed to the 20% weighting for collateralised and "self-liquidating" LCs as a concession. This was agreed in 2011, click here to read.
But as can be seen above - this is a hollow victory for the industry.
So that is why you may find your trade finance bank is asking you for 100?sh collateral in advance to support an LC.
This collateral is required upfront even though the LC will only pay out to the exporter much later, and only if a set of defined conditions are fully met.
We are not a bank and we are not funded by deposits. We are funded in the international capital markets by large banks and fund managers. Rules which are designed to protect depositors do not apply to us - so we are not governed by banking regulations.
As a result, we can continue to provide trade finance solutions without requiring collateral. This can include arranging LCs for importers, as well as providing payment guarantees to exporters against their shipping documents and allowing buyers to pay later.
With 10 offices on three continents, talk to us: click here to connect to your local office. You can also read further articles on our site:
One minute guide. What is it? Export finance helps exporters to offer credit to their buyers. This means that they can offer "ship now, pay later" terms to buyers - and this is what buyers want. Export finance
One minute guide. Who is PrimaDollar? PrimaDollar is a UK-based trade finance platform working with exporters and importers on a global basis. What does PrimaDollar do? PrimaDollar
One minute guide. What is it? Dual factoring is the process of coordinating two factoring companies so that one of the companies can purchase an invoice from an exporter in one country and relying upon the other factoring company to collecting the amount due