Regulation and recovery: a period of adjustment

Four years after 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 affects trade comes from several places and overlaps many institutions, businesses, jurisdictions and constituencies. In the last three years, 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 affect another set of new or existing rules in an unforeseen and unintended fashion. We are discovering that 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 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 2008/2009 crisis, transaction banking providers began to hear that major regulatory changes were coming to their industry. They are now cycling through these changes at varying speeds. Some seem 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 already decided to exit or scale back certain kinds of finance – like trade finance – in the face of the new regulations. This flux is adding complexity to an already complex situation. With economic signals continuing mixed across the globe, bankers and their customers are now confronted daily with issues related to risk (financial and sovereign), liquidity, shifting trade flows – and sooner rather than later, Dodd-Frank and Basel III.

In this climate of almost constant reaction, some trade banks are seeing an opportunity to move forward. Regulatory changes, they reason, are just one more shift in the marketplace. Companies that adapt to a shift like this almost always become more competitive.

In such a period of adjustment, many providers will be forced to become more efficient because of regulatory and compliance red tape. The result will be streamlined processes, smarter applications of technology, and, it is hoped, reasonably priced lending that has been made possible by the gained efficiencies.

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 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. Important work in this area is already being done. Community efforts like the International Chamber of Commerce (ICC) Loss Registry and the newly articulated Trade Finance Definitions from BAFT-IFSA are helping to provide common understanding and bring more transparency to trade lending. In addition, an effort by major banks, led by J.P. Morgan, is providing 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.

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 in order to keep serving their markets. In the interest of improving transparency in the balance sheets of financial institutions, 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 recent 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.

Since the crisis, Basel regulators have 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.

In view of the fragility of the financial recovery, what is now needed more than ever is a lending community large enough to support the fragile growth in emerging markets with more liquidity and better tools for risk management. But with capital costing so much more and the impact of liquidity ratios still undetermined, a growing number of banks may exit the trade finance business. Some major banks that were once reliable players in trade finance are now deleveraging, and those remaining may be hard pressed to meet the demands of the whole market. Small to medium-sized companies that rely on banks for financing are inevitably going to feel some of the pain of regulatory requirements for capital. The answer to the current set of challenges may be more collaboration to fund and process trade finance across the globe – for instance, sending customers to multilaterals which 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.

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.

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 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.

With national Basel III implementation under way, 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 shake-up 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.

Coming soon: the Legal Entity Identifier (LEI)
As post-crisis regulation took shape in 2010, US financial regulators and the Financial Industry Regulatory Authority (FINRA) held a workshop on regulatory data. They agreed that there was currently no standard way to identify parties to financial contracts, and that a standard or “universal” identifier could serve as a “linchpin” for improving regulatory compliance, managing private enterprise risk, and streamlining and improving business processes.

A month later, Dodd-Frank established the Office of Financial Research (OFR), giving it the authority to create identification standards for US-based financial companies. By November, the OFR had published a policy statement promoting the establishment of a universal Legal Entity Identifier (LEI), and the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) were also proposing the use of a universal identifier when reporting swap derivatives transactions.

All of these bodies argued that the financial industry runs on information and data, and that one of the most fundamental data building blocks is reference data about companies. It was therefore clear that the most essential piece of reference data possible would be a systematic structure or code that uniquely identifies entities and their legal relationships with other business entities. This code would be critical for efficient financial transaction processing and reporting and for clear, unambiguous identification of all the parties and counterparties involved.

New financial legislation such as Dodd-Frank now seemed to require the establishment of a standard, with implementation scheduled sooner rather than later. By March of 2011 the concept had gone global, with the International Organization for Standardization (ISO) creating a dedicated working group to establish the LEI standard. Just a year later, the finance industry was anticipating the first reporting to the CFTC and SEC on swap derivatives using and interim version of ISO’s LEI (CICI). Banks now have much work to do to bring all their reporting and data management into line with LEI, and not much time to do it. Reporting with the LEI to the CFTC for interest rate swaps begins in September. Their customers will be asking to receive reporting organized on the principle of universal IDs – both for their own compliance purposes, and for better management of their day-to-day operations.

The global regulatory community led by the FSB continues to work to develop a governance framework and a global operating model for LEI. The global model is expected to be available in March 2013. The use of the LEI for swaps and derivatives is more likely a starting point. Many industry participants expect the use of the LEI to expand to other financial transactions.

Continuing compliance challenges: KYC/AML and sanctions
Know Your Customer (KYC) and Anti-Money Laundering (AML) regulation continues to place a heavy load on trade bankers. 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, for the involvement of just four embargoed countries, and for 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 Letter of Credit. As database technologies advance, software will execute this screening, but most data elements will need to be transferred manually. Miskeying 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.

What may be permissible in one country turns out to be illegal in another, making banks vulnerable to massive fines or even criminal proceedings. Compliance challenges go beyond transaction processing. Know Your Customer standards vary from country to country, causing disruptions to the free flow of cross-border transactions. A party from one jurisdiction may not be vetted appropriately within the counterparty’s jurisdiction. Until remediation is completed, the transaction is delayed and supply chain disruption is the likely result. Without compromising security or reducing its vigilance regarding fraud, the industry must now work to make trade finance simpler through automation and streamlined, harmonized processes.

As tensions have increased in Africa and the Middle East, 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 a greater 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 new world of trade
In the new world of trade, there is now a powerful argument for 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 be the result. It will be harder for banks to serve their clients – especially large corporates expanding internationally. And emerging markets must be protected from unintended consequences of unevenly implemented regulatory compliance.

The banking community must move its lobbying effort from Basel to local regulators who will be implementing the new rules. It is even more important to educate customers who will be facing higher costs for their trade finance and work across the lending community – private lenders, Export Credit Agencies and Multilateral Agencies – to stimulate exports and help emerging economies. Banks ahead of the regulatory curve are working to identify efficient, streamlined ways to comply with the new rules without embedding their customers in unfriendly


For more information, please contact
Michael Quinn
Managing Director
Global Trade Product Executive
Tel: +1-212-552-7730

Dan Taylor
Managing Director
Global Market Infrastructures Executive
Tel: +1-212-552-1786

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