As the global economy slowly finds its footing in the wake of the credit crisis, regulators are tightening risk standards for banks. Though this response is understandable, keeping a close hand through tighter regulations also requires a closer eye to avoid disruptions in global trade. Broad-brushstroke regulatory changes should come with a warning label-and with sufficient time for informative exchanges between affected parties.
At the encouragement of the G-20, the Basel Committee on Banking Supervision drafted recommendations for changing bank capital and liquidity standards (often called "Basel III") in an effort to promote a more resilient banking sector that can be a foundation for sustainable economic growth. The fundamental goals of stronger capital and liquidity are on target, but some of the recommendations work at cross-purposes to those goals.
In comment letters to the Basel Committee, BAFT-IFSA outlined some of our key concerns that focus on trade finance, which has historically maintained a low risk profile in comparison with other financial transactions. As background, trade finance transactions generally involve fixed, short-term instruments that cover the movement of goods. They are not automatically renewed or extended upon maturity and they are self-liquidating by nature. In stress situations, countries and banks have traditionally continued to prioritize the repayment of short-term trade finance obligations as they fall due because these obligations are fundamental to commercial exchange. Failure to honor them can put at risk invaluable trading partner relationships. And, as a result of the short-term, self-liquidating nature of trade finance transactions, banks active in this business are generally able to react swiftly to deteriorations in bank and country risk.
This notwithstanding, the implementation of the Basel II accords, concomitant with the global recession, put more pressure on banks to not only meet additional capital requirements under Basel II, but also to reconsider certain proposed transactions because of global risk deterioration. This dynamic propelled deleveraging even further during the economic crisis.
Recent surveys conducted jointly by BAFT-IFSA and the IMF indicated dramatic changes in the volume and value of trade finance transactions during the crisis. In particular there was a growing sense among banks that the value of transactions had declined because of decreased demand for trade activities.
Trade underpins the prospects of global economic recovery, and any measures that potentially restrict the willingness or ability of banks to support trade have the potential to disrupt global economic growth. Take the Basel Committee's latest recommendations regarding capital. For the purposes of calculating a leverage ratio constraint under Basel II, the committee would require banks to hold a higher quantity and quality of capital, and proposes increasing the credit conversion factor (CCF) for trade-finance instruments and other off-balance-sheet items to 100 percent. Currently, the most frequently used value for trade-related contingencies is 20 percent. Increasing the CCF by a factor of five for trade-related contingencies does not account for their intrinsically safe structure and could disadvantage banks that are focused on trade finance. Such a high leverage ratio may encourage the diversion of capital to other financial instruments, resulting in significantly reduced lending or increased cost of providing trade finance for customers.
The Basel Committee also proposed specific tests designed to improve liquidity management. Banks engaged in transaction banking generally support creation of a framework for a quantitative liquidity regime. Recent indications that the timeframe may be extended for implementing some of the liquidity recommendations have been well received; allowing for a greater understanding of the impact the liquidity proposals will have on banks' ability to provide transaction banking services is crucial.
The financial crisis was not driven by transaction banking, and just as too much risk is undesirable, regulations that go too far in their attempt to purge certain risks from bank loan portfolios have the potential to hamper recovery. Global trade relies on cost-effective and accessible financing for trade transactions. And as global trade has grown, trade finance has grown with it, facilitating the reliable and secure movement of goods and services across the globe. That is well worth preserving.