Trade finance is gaining traction – but more can be done

The banking industry has experienced a turbulent few years since the sector’s 2008-09 crisis, with significant post-crisis regulatory developments aimed at guaranteeing a stable global financial environment. Ongoing efforts by regulators and financiers have subsequently been underway to find the optimal balance between adequate, equitable and risk-aligned regulation, and the imperative to allow trade-based recovery, growth and international development.

Meanwhile, ongoing dialogue across the industry is prompting a rise in awareness around trade finance and a shift towards a more positive attitude.

The opening of the post-crisis gap

A combination of commercial considerations, risk tolerance and regulatory pressure has prompted a process of “de-risking” or “de-leveraging” – the rationalisation of market activity, correspondent relationships and small- to medium enterprise (SME)/commercial portfolios.

The post-crisis has seen the introduction of various initiatives designed to better regulate the financial landscape and prevent a further economic meltdown. However, some of the specific regulatory measures have had unexpected effects on the trade finance industry – and, in turn, on economic recovery, growth and trade-based international development.

The Basel Accords, for instance, enforce capital adequacy requirements on banks in order to ensure their solvency – yet trade finance’s treatment was somewhat misaligned to its credit risk profile.

Meanwhile, compliance relating to anti-money laundering (AML), know-your-customer requirements (KYC/KYCC) and sanctions has created new tasks for banks to undertake – shifting certain investigative, tracking and reporting responsibilities from the police and intelligence services to banks. While few would argue against the intentions behind these regulatory measures, and most financiers recognise the logic of a “follow the money” approach, such requirements can – and do – place significant pressures on the financial sector, requiring due diligence with banks exploring every element of every deal.

For those deals with potentially low returns, undertaking the necessary compliance may not be worth the reward. Indeed, nearly 46% of the banks participating in the ICC 2015 Global Survey on Trade Finance reported terminating correspondent relationships due to the cost or complexity of compliance. Certainly, industry sources estimate that the average cost of maintaining a basic correspondent relationship has increased at least five times since the peak of the financial crisis.

While surveys, data collection and analytics have aimed to measure unmet demand for trade finance, anecdotal evidence suggests that regulatory and compliance pressures have exacerbated the gap in demand. The ICC survey found that small to medium-sized enterprises (SMEs) account for nearly 53% of all rejected trade finance transactions.

By comparison, 79% of trade finance transactions for large corporates were accepted. This reality differs from government policy objectives that seek to encourage greater SME support, since regulatory pressures contribute to a shift towards large or investment grade clients.

Low risk nature of trade finance

For global trade flows to increase and for financing to be available to SMEs and to emerging markets – where the trade finance gap is most severe – an increased global understanding of trade finance and constructive dialogue with regulatory authorities must continue. Ongoing efforts to demonstrate the favourable credit risk profile of trade finance products can also be complemented by the addition of a wider range of products and types of risk.

Certainly, contrary to popular perception, trade finance is, in fact, low-risk; partly because of the nature of the underlying transactions, partly because of the high priority attributed to the settlement of trade debt, and partly because of well-tested and flexible risk mitigation options.

Despite tough market conditions, the low-risk nature of trade finance has been repeatedly illustrated since 2009 through the Trade Register Project – first initiated by the Asian Development Bank (ADB) and now executed through the ICC Banking Commission. Objective data, contributed by 24 leading global trade banks, clearly demonstrates that trade finance is low-risk in terms of credit and credit-related default experience – most recently covered across a portfolio of transactions representing US$7.6 trillion in exposure.

The latest Trade Register report reveals that short-term (ST) and medium to long-term (MLT) trade finance instruments have relatively low default rates. In fact, the default rate for MLT transactions is less than 50% of the default rate of a comparable Moody’s corporate credit portfolio.

ST trade finance products covered in the Trade Register only reach, on average, one fifth of comparable Moody’s default rates. Even the relatively higher default rates of performance guarantees or import and export loans can be represented by a Baa and Ba Moody’s rating.

Traditional trade finance products, such as letters of credit (LCs), fare particularly well. For ST products, the transaction default rate for ST export LCs was 0.01% between 2008 and 2014. What’s more, export LCs compare to somewhere between an “Aaa” and “Aa” Moody’s rating.

Finally, even if a default does occur, recovery is strong: for all ST products, the median result is close to 100% recovery.

Regulatory authorities and policymakers should therefore encourage open, solution-oriented dialogue between industry stakeholders concerning the risk profile of trade finance.

A shift in attitudes

Fortunately, there are signs of a shift towards a more “normal” pre-crisis state, with indications that banks are re-entering the trade finance arena. Indeed, the ICC 2015 survey on reported that 61% of banks have increased activity to meet trade finance demand. An increase that is well-timed, considering estimates from the ADB that unmet global demand exceeds US$1.1 trillion annually.

Certainly, trade finance has benefitted from unprecedented visibility and enhanced understanding since the peak of the global crisis, as well as a renewed appreciation of its role in facilitating a large portion of the US$19 trillion in annual merchandise trade.

Enhanced and coordinated data-based industry advocacy has meant that regulatory authorities are gaining a more comprehensive understanding of trade finance characteristics – facilitated by a shared appreciation of the need to achieve a balance between regulatory aims and the pursuit of value-creating trade. For instance, open and constructive dialogue with the Basel Committee and other regulatory authorities at regional and national level has facilitated a more risk-aligned treatment of certain types of “traditional” trade finance transactions.

Yet opportunities to further align regulatory objectives and trade finance value-creation remain. More can, and should, be done to enhance market understanding of trade financing, including traditional trade finance and fast-growing supply chain finance (SCF). Indeed, trade finance is the backbone to global trade – playing a vital role in fostering economic recovery, growth and international development.

There is ample room for greater communication and understanding among bankers, trade financiers and other stakeholders. For instance, trade-based money laundering, which drives certain types of financial sector regulation, must be further explored – considering that only a portion of such activity actually occurs in the context of trade finance transactions.

Trade finance in the spotlight

The post-crisis environment has fostered improved dialogue and engagement between trade bankers and regulatory authorities. Still, the improved tone, approach and substance of dialogue must continue.

Trade is too important to the global financial system and trade finance is too important to the conduct of trade to once again fade into the background. It is imperative that industry leaders and regulatory authorities keep the “big picture” in focus, and strive to reach informed decisions about the best way forward.

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