Asiamoney.com: Basel 3 hits the wrong target

Asiamoney.com, October 10 2010

When the Basel 3 standards were announced, there was at first a sense of relief among the world banking community: manageable changes with plenty of time to effect them. But as institutions have had more time to look in detail at the regulatory changes, a growing undercurrent of annoyance has developed. The irritation is coming from trade finance bankers, and Asia is at the heart of it.

The essence of the complaint is that Basel 3 treats trade finance like credit derivatives, when the two areas have almost nothing in common in terms of how they behave.

Consequently, completely the wrong arm of finance is going to be hit, at exactly the wrong time. Standard Chartered calculates that global trade fell 23%, or $3.5 trillion, during the financial crisis, with 10-15% of that figure due to lower trade finance liquidity – meaning that $350 billion to $525 billion of world trade, or 0.6 to 0.85% of global GDP, was wiped out as a consequence of banks slashing trade finance loans to shore up capital positions. Basel, bankers argue, could make things worse rather than allowing them to recover: Stanchart believes that if Basel 3 is adopted as drafted, banks could cut trade finance lending by up to 6% a year, meaning a drop of up to US$270 billion in international trade and commerce, equating to 1.8% of world trade or 0.5% of global GDP.

How can this be? It’s a mix of several things. Trade finance banks say that they will be required to hold up to 10% more capital for their trade finance exposures to large banks (those with more than US$100 billion in assets), cutting their capital adequacy ratios by 10% and limiting their ability to lend. That’s annoying for banks, but a clear consequence of the financial crisis and the sorry experience of the bigger institutions like Citi.

Additionally, a new leverage ratio, intended to make sure banks set aside capital against credit derivatives on their books, has hit trade finance hard – harder than the derivatives themselves, bankers say. Whereas credit derivatives will incur a 20 to 100% leverage ratio, trade finance gets hit by a flat leverage ratio of 100%.

Then there’s a new liquidity requirement, designed to set reserves against off-balance sheet credit derivative products. Among the products caught by this requirement are letters of credit, among the keystones of trade finance. Bankers consider this deeply unfair because default rates on letters of credit are very low. Basel doesn’t actually set a limit on this, but asks national regulators to do so; should they choose to be conservative in their implementation, though, the liquidity requirement could mean banks having to side as much as 100% of their letter of credit outstandings as reserves, badly limiting their ability to lend.

In sum, these provisions could require a huge amount of capital that would otherwise be lent out to support trade instead being kept in reserve. Worse, it’s come at a time when world trade has already been badly dented – down 12% in volume terms and 23% in value in 2009.

Some banks go further still, arguing that Basel 3 will, by making trade finance less attractive for banks, instead encourage their to securitize their trade assets, which actually makes the whole segment more risky. They argue small to medium enterprises, smaller banks and emerging markets will be hit hardest since smaller banks, and those in emerging markets, tend to have a larger proportion of their business in trade finance. As trade becomes more capital intensive it will be less popular among providing banks and so become more expensive, damaging global growth. And all of these side-effects will hit Asia hard: a lot of smaller banks, emerging market exposure, lending to small businesses trying to grow, in the region with the greatest trade financing needs.

It all sounds suitably apocalyptic. Is it so? Well, Basel 3 is still a consultation document; it’s natural that banks who don’t like it will shout their point of view long and hard and there’s every reason they will be listened to. There are two sides to it: the global financial crisis clearly required some response in terms of regulatory capital as there were many exposures that were clearly not properly provisioned against. But trade financiers certainly have a point when they say that a period of sluggish recovery in global growth is an odd time to impede world trade.