Basel III might add more hurdles for trade finance

One of the hottest topics in commodity trade finance is the impact of Basel III. A majority of practitioners view Basel II as unfairly tough on trade finance in terms of capital requirements under the Standardised Approach, compared to the "one size fits all" approach of  Basel I (with its 20% credit conversion factor for trade finance). Evidences also suggest that the implementation of  Basel II has contributed to a drain out of available trade finance, particularly on SME sector. The safe, short-term, and self-liquidating character of trade finance has not been properly recognised under the Basel II framework and the proposed revised rules ("Basel III") seem to raise additional hurdles to trade finance.

Traders require letters of credit (LCs) and other loans to arrange for the shipment and delivery of their goods. As per WTO, about 80 percent of international trade is financed by some kind of credit. Among the trade instruments that came under the regulatory microscope in the aftermath of the crisis, include off-balance-sheet tools such as LC. These have become prime targets for increased regulation and additional capital charges, to the frustration of commodity traders and banks alike.

It is very positive to see the regulator striving to improve the banking system and aiming to tackle excessive leveraging, one of the focus of Basel III. This all sounds good except for the fact that trade finance might end up being an unexpected casualty in the end again because it also enjoys an off-balance sheet treatment which would now have to bear a flat 100% credit conversion factor.

While there is logic in tightening the treatment of some toxic off-balance-sheet financial instruments, there is less sense in stricter regulation of LC and similar trade bills. The question of why off-balance sheet trade exposures are not being automatically incorporated into the balance sheet (to avoid the leverage ratio) is one of its subtleties. It is argued that the off-balance sheet management of these exposures is necessary and in most cases only a temporary treatment of what would eventually become an on balance-sheet commitment.

The five-fold increase of capital requirements for off-balance-sheet letters of credit would increase the cost of banks in offering such risk mitigation products. Either that cost will be passed on to the customers (commodity traders), making it even more difficult for smaller businesses to trade internationally, or, in the absence of incentives to issue LC, customers may simply choose to use on-balance sheet products such as overdrafts to import goods (as these carry less stringent documentary requirements) which may prove to be potentially far more risky for the banking sector in general.

Unlike some western and European countries, open account financing is not appreciated in India. Traditional LC brings in more security and is highly appreciated. Therefore, the prudential treatment and cost of letters of credit is critical for India.

As the committee is sitting to finalize Basel III, the traders across the world will hope that the fear factor does not translate into unfair treatment of Trade Finance… the impact of that shall be profound in movement of commodities.


Published in The Economic Times 13 Sep, 2010