Trading Cos Look at New Sources of Financing after Credit Squeeze

Global trading companies’ talent and deep pockets have helped them get incredible powers. Regulators may be cracking down on big banks and hedge funds internationally but trading companies have largely remained untouched. Many are unlisted or family-run and have immense political clout. The commodities trading industry has diversified its sources of credit over the last decade as rising raw material prices have increased financing needs. However, most trading companies remain dependent on cargo-by-cargo short-term letters of credit.

Unlike commodity producers, trading firms don't just make money when prices go up. Most rely on arbitrage -- playing the divergence in prices at different locations, between different future delivery dates, between commodity qualities in different places… thus liquidity and cash flows are important.

The gains made in situations of short squeezes can often get negated if liquidity and credit squeezes have been triggered by their own banks. Global trading companies used to operate on huge liquid credit lines given by bankers. It seems that with the latest credit squeeze, trading companies are aggressively hunting for fresh lines of credit in the non-traditional geographies.

Three years ago, it was a freeze in trade lending which slowed global trade flows. Unfortunately, Europe’s sovereign debt and banking crisis is now resulting in numerous unintended consequences, especially in the commodities space. French banks such as BNP Paribas, SocGen and Credit Agricole are the main financiers of big commodity trading houses, many of which are run out of Switzerland. In recent weeks, as these lenders engage in significant asset contraction, they are reducing the availability of credit and raising its cost.

Three years ago, some of these large trading companies would have hardly glanced at alternative sources of commodity trade funding in non-traditional geographies. The scenario seems to be changing and borrowing in alternative currencies (other than US dollars) is no more exotic.

Trade finance is a huge business, with lending hitting more than US$170 billion. A drive by some banks to reduce the size of the balance sheets have aggravated the impact on commodities trade finance in light of new Basel III capital rules. While banks needed to hold capital equal to just 20% of the value of letters of credit under Basel II rules, the new agreement raises the bar to 100%, greatly increasing the cost of lending.

Trade finance, which supports US$14-16 trillion in annual global commerce, is crucial for international trade. Fewer than 3,000 defaults were observed by International Chamber of Commerce (ICC) in the full dataset comprising 11.4 million transactions. Therefore, it was argued that the increase in the leverage ratio under the new regime would not reflect market realities and may significantly curtail banks’ ability to provide affordable financing to businesses in developing countries and to SMEs in developed countries.

Following the recent consultation between the Basel Committee on Banking Supervision and World Bank, WTO and ICC, the rules for Basel III have been tweaked to promote trade with low-income countries. These alterations will reduce the amount of capital that confirming banks have to hold against letters of credit issued by lenders in low income countries.

The earlier insistence on the “sovereign floor” rule had made trade finance too expensive, even though it was extremely safe. The agreement to waive the so called sovereign floor for certain trade-finance related claims on banks using the standardised approach for credit risk will make credit more accessible in the low income countries. 

Published in The Economic Times

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