Since the global crisis, bankers and their corporate customers face what is arguably the most challenging time in the history of trade finance. Much of that challenge comes from new compliance and regulatory burdens that are here to stay—and likely to increase. There is talk across the industry of a “new normal” in which the high cost of capital and compliance will make trade finance much more difficult for banks to provide. Clearly, trade and trade finance are entering a period of adjustment.
The financial reform that impacts trade comes from several places and overlaps many institutions, businesses, jurisdictions and constituencies. Since 2008, so much regulation has been mandated at the same time that the financial world has taken on a jigsaw quality. The most challenging thing about this new environment may be putting the regulatory pieces together coherently, and understanding how compliance with one set of new rules could impact another set of new or existing rules in an unforeseen and unintended fashion. What protects banks and counterparties in some respects may not prove so beneficial to activities like international trade. This is a concern associated with our continuing fragile recovery, because trade finance is never just a banking issue. It is always a global economic issue as well.
Adapting to Change
During the 2008/9 crisis, transaction banking providers began to hear that big regulatory changes were coming to their industry. These providers are cycling through these changes at varying speeds, with some determined to “run to the fire” and comply with the new rules well before their official implementation dates. Others need more time to understand the situation and identify their options. And some have decided to exit or scale back certain kinds of finance — like trade finance — in the face of the new regulations.
In this climate of almost constant reaction, some trade banks are seeing an opportunity to move forward, viewing regulatory changes as just one more shift in the marketplace. Companies that adapt to such a shift almost always become more competitive because they are forced to find efficiencies by adopting streamlined processes and smarter applications of technology, which should translate to more reasonably priced lending. Until this happens, bankers and their customers are struggling daily with issues related to risk (financial and sovereign), liquidity, shifting trade flows and Basel III.
Regulatory expectations for compliance put pressure on most business processes. The current situation for trade is particularly challenging because different regulations coming from different places can combine to make compliance very difficult. A standardized approach with the goal of establishing a level playing field is clearly preferable, and because an expectation of zero tolerance for compliance failures in this period of change is unrealistic, it is up to the industry to work more closely together to develop standards for trade finance products and processes.
Moving on from Basel III
As data gathering across the industry has shown, trade loans have always been comparatively low risk instruments — short term and self liquidating. But under Basel III, trade banks must now hold considerably more capital than before to keep serving their markets. In the interest of improving transparency in financial institution balance sheets, Basel III virtually eliminates any “off balance sheet” category. Documentary trade instruments such as Letters of Credit — which are contingent in nature and rarely require monetization — will move onto balance sheets, significantly raising the product’s capital costs. The Basel Committee seems to have been unmoved by the ICC’s presentation of compelling data that demonstrated the safety of trade finance transactions through a Default Registry. And while the Basel Committee’s 2011 decision to waive the mandated one-year maturity and sovereign floors for trade finance is of some help to lenders, the industry is still coping with the unintended consequences of applying the same risk and liquidity criteria to trade loans that will apply to much riskier instruments like derivatives.
Basel regulators have also devised various requirements for liquidity thresholds based on exposures and their maturities which are applicable to trade finance. This move is a response to what happened in the depths of the financial crisis, when banks were challenged to meet high-value maturities because they had only limited access to funding markets. However, since many trade finance instruments are unfunded, it seems paradoxical to require liquidity as a backstop for something that is never monetized.
As Basel III implementation rolls out, there is more to think about than the effect of moving traditional trade instruments like Letters of Credit onto the balance sheet. An even bigger issue, potentially, is Asset Value Correlation, which places an additional 1.25% capital surcharge on interbank credit exposure. This could restrain lending between financial institutions, and although it is meant to prevent trouble at larger institutions, it may have a trickle-down effect, with less liquidity available to smaller players. Liquidity requirements to support this kind of lending may even further hamper the infusion of capital into trade, regardless of the size of the bank.
Given the fragility of the financial recovery, what is needed is a lending community big enough to support growth in emerging markets with more liquidity and better tools for risk management – a community that is strong enough to weather future economic crises. The challenge is building that community as a growing number of banks are exiting the trade finance business and some big banks that were once reliable players in trade finance, such as Western European banks, are now deleveraging. Remaining banks may be hard-pressed to meet the demands of the whole market. As a result, small to medium-size companies and the smaller emerging markets that rely on banks for financing are inevitably going to feel some of the pain of regulatory requirements for capital, further impeding global recovery.
The answer to the current set of challenges may be more cross-industry collaboration to fund and process trade finance across the globe — for instance, sending customers to multilaterals as they are not commercial banks and therefore not subject to the same rules and regulations. In another collaborative scenario possible under Basel III, “downstream” correspondent banks could pass trade finance business to larger partners.
With national Basel III implementation underway, the industry is moving its regulatory conversation to the local level in order to do everything possible to ensure that regulators, politicians and other market players understand the dynamics of the industry and get used to the fact that in the wake of the regulatory shakeup and the increased risk and economic profile of trade finance, costs will increase for everyone. Strong trade finance players will show their strength by continuing to build their franchises and invest in their businesses; one of those investments is dedicating the people and other resources needed for implementing financial reform while continuing to conduct a conversation about the unforeseen dangers of a one-size-fits-all approach to measuring risk.
In any event, it is important to acknowledge that the Basel III rules for increased capital come at a cost that will most likely have to be passed on to customers. The positive result in this period of adjustment is that the industry will be forced to become more efficient, and that this efficiency will likely temper some of the increases.
Continuing Compliance Challenges: KYC/AML and Sanctions
Know Your Customer (KYC), Anti-Money Laundering (AML) regulation and sanctions continue to place a heavy load on trade bankers. The sheer depth and specificity of information required for each transaction is burdensome. Inability to collect qualitative and quantitative information – especially in emerging markets where requests for documentation, such as a supplier’s articles of incorporation, are met with bewilderment – may make it difficult for banks to lend.
Further complicating the issue, what may be permissible in one country could turn out to be illegal in another, making banks vulnerable to massive fines or even criminal proceedings. KYC customer standards vary from country to country, and a party from one jurisdiction may not be vetted appropriately within the counterparty’s jurisdiction.
Compliance in trade finance was once defined as the diligent examination of documents integral to completion of a cross-border transaction: keeping an eye out for boycott language, involvement of just four embargoed countries, and a relatively short list of “bad guys.” Nowadays, to take Letters of Credit as just one example, the examination of documents requires extensive screening (against multiple country lists) of numerous data elements embedded in ancillary documents, regardless of their role in the transaction. As database technologies advance, software will execute this screening, but most data elements will need to be transferred manually. Mis-keying of data can result in a false hit — or worse yet, conceal a valid hit. Of even greater concern is the lack of consistency among the various country requirements.
The impact of sanctions on markets like commodities promises to be severe. There is now a great deal of pressure on banks and financial service organizations such as SWIFT to align and comply with the whole array of restrictions which affect banking, shipping, insurance, ports, trade, commodities, and energy transactions. SWIFT, based on new EU regulation, was required to stop providing service to the Iranian banks that are subject to EU sanctions. The SWIFT decision indicates that there will be more need for care in the way international trade transactions are conducted, and in the way banks and other institutions fund and facilitate those transactions in markets like commodities. The impact of the latest round of sanctions on trade is hardly measurable as yet, but it is potentially enormous.
A hiccup in any of these requirements will have a direct impact to corporate supply chains, as transactions are delayed until remediation of the KYC, AML and/or sanction issue. To avoid supply chain disruptions, industry must now work to make trade finance simpler through automation and streamlined, harmonized processes without compromising security or reducing its vigilance regarding fraud.
A New World of Trade
In the new world of trade, there is now a powerful argument for the industry to work together and adopt a common rule book and shared standards. In the case of Basel III, if there are different capital requirements for different countries, business imbalances will result making it harder for banks to serve their clients — especially large corporates expanding internationally. And emerging markets must be protected from unintended consequences of unevenly implemented regulations.
Important work in this area is already being done. Community efforts like the International Chamber of Commerce (ICC) Loss Registry and Trade Finance Definitions from BAFT-IFSA are helping to provide common understanding and bring more transparency to trade lending. Major banks, led by J.P. Morgan, have developed compliance standards for supply chain products and trade loans where no industry standards previously existed. This collaborative effort has resulted in shared guidelines that ensure that a single baseline standard for sanctions compliance is followed by all banks. It will take some time for these efforts to become embedded in day-to-day trade finance processes.
In the coming year, the banking community must continue to move its lobbying effort to local regulators who will be implementing the new regulations. Acting as one voice, the community will be more effective making the inner workings of trade finance understood by regulators. The community must work together to educate customers who will be facing higher costs for their trade finance, and to work across the lending community to stimulate exports and help emerging economies — key to global recovery.
About the Authors
Michael Quinn is a Managing Director of J.P. Morgan responsible for Product Management of the Traditional Trade products in the Global Trade business. Mike has more than 30 years experience in banking with more than half of that time specializing in Trade Finance. Mike has a diverse background in global businesses having managed sales, operations and technology in addition to his product management experiences. He is involved in numerous industry-wide initiatives and associations including his current role as the Chair of the U.S. Council on International Business (USCIB) Banking Committee representing the United States at the ICC Banking Commission and serving on the USCIB’s Executive Committee. He has also served as a director of BAFT-IFSA and as a member of its Executive Committee, and has served as a Director and Chair of the International Financial Services Association. He has also authored numerous articles in various trade and supply chain publications. Mike is a graduate of DePaul University in Chicago.
Dan Taylor is a Managing Director with the Global Market Infrastructures team of J.P. Morgan Corporate & Investment Bank, focusing on transaction banking industry issues that include global trade finance regulation and AML/KYC compliance. Since 1996, he has served as Vice Chairman of the International Chamber of Commerce (ICC) Commission on Banking Techniques and Practices. He has also served as President and Chief Operating Officer of BAFT-IFSA, the organization formed by the merger of the Bankers’ Association of Finance and Trade and the International Financial Services Associations, having led IFSA for 20 years prior to the merger. Before his IFSA appointment, Dan work for 14 years in banking operations, correspondent banking and private banking capacities.