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ICC's Banking Commission Fails to Make the Case that Trade Finance is a Lower-risk Asset Class

by Bob Lyddon

The International Chamber of Commerce's Banking Commission has recently issued its 2018 report, called the ICC Trade Register Report, into the global risks in trade finance.

The Report draws on an impressive set of institutions, who input their data into an analysis model designed and maintained by Boston Consulting Group. The contributors are "25 trade finance and export finance banks – a representative set of global trade finance and export finance transactions that amount to 24 million transactions in total and exposures in excess of USD12 trillion".

It is claimed that the "combination of import letters of credit, export letters of credit, and performance guarantee exposures in the Trade Register for 2018 is equal to approximately 35% of global traditional trade finance flows".

Global trade flows (merchandise and services) are quantified in the report as amounting to USD18.5 trillion in 2018 but, of this, Open Account trade covers about 80% of merchandise trade flows (and possibly 100% of services trade flows). Where the Report claims that their data deals with "approximately 35% of global traditional trade finance flows", this means at most 35% of the 20% of the USD18.5 trillion that is not transacted on Open Account terms.

Nevertheless, handling USD1.3 trillion of nominal trade flows appears to create "exposures in excess of USD12 trillion", and this is part of the problem that the Report seeks to address: a single trade transaction can cause parallel exposure to banks to a multiple of its face value if it is handled using traditional trade finance instruments:

  • Bonds and guarantees outstanding from the time the bid for the business is made until after the contract is fulfilled (bid bond to retention bond cycle); plus
  • Letter of credit issuance (risk of importer's bank on the importer); plus
  • Letter of credit confirmation (risk of exporter's bank on importer's bank)

Each instrument ties up capital, and for a period much longer than it is genuinely at risk: for example a Letter of Credit is issued for a shipment amount many weeks before the exporter has goods to that value available to be shipped.

The Report then makes the plea that traditional trade finance is a low-risk business for banks because of low recorded losses as reported by the sample group. The contention is then that trade finance should be accorded appropriately low ratings by regulators in the Basel Risk-Adjusted Capital Allocation methodologies run by banks i.e. banks ought to be allowed to transact many times the nominal amount in trade finance business compared to in ordinary lending business, based on the same amount of capital.

There are three flaws to this argument.

Firstly, the data shows that loss rates have fallen, but in part due to sample group banks de-risking. Banks have either exited trade corridors or a country's correspondent banks and so they make no losses on trade with that country because they have not done any. This does not mean that losses are not being made, but rather that they are being made by banks outside the sample group, or by exporters and importers who no longer enjoy risk protection and take the losses themselves.

Secondly, the Report makes much of the low losses incurred by banks when they undertake loans that are backed by "ECAs" – Export Credit Agencies. These are agencies of OECD governments who issue insurance policies or guarantees to banks for lending in support of companies in the respective OECD member state. The coverage is usually 95% of principal, interest and recovery costs. In addition, despite the ECA having paid out 95% to the bank, the bank still receives 5% of any further recovery the ECA obtains. The loser in all of that is the taxpayer of the OECD member state providing the ECA cover, if the ECA pays out the bank but does not recover the money from the borrower.

The Report contains no data about whether the ECA made substantial losses, so it fails to prove the point that ECA-backed lending contains some inherent superiority, and limits itself to an "I'm alright, Jack" approach from the lending banks' point of view.

Thirdly, there is scarcely a mention of why trade finance business used to receive favourable ratings from regulators under the Basel I and even Basel II regimes: that it was assumed that banks, within a Letter of Credit transaction, had title to the goods, were in a position to seize the goods in case of non-payment, and were able then to liquidate the goods for cash and directly reduce their loss.

The bank would enjoy such a position where it had a blank-endorsed on-board Bill of Lading, meaning the goods had gone by ship and were carried as a distinct cargo. Conveyance by lorry, rail and air produces a Waybill, which is not a document of title. Marine cargo has largely switched to containers so, unless the Bill of Lading relates to the entirety of one or more containers, it is impractical to seize just the goods referred to in it, even if one is issued.

This is an aspect of 80% of global trade flows being transacted on Open Account: counterparties will trade on that basis if they have no concerns about credit risk, transfer risk, fraud risk and so on. If they do have concerns, they will use "traditional" trade finance tools for risk mitigation.

While a counterparty's opinion as to whether they would be at risk trading on Open Account has some subjective element to it, the bedrock of trade finance is risk concern. In consequence the fulcrum of counterparty credit risk in a portfolio of trade finance business must sit lower down – not higher up - the scale than it would in a portfolio of unsecured lending to counterparties who trade on Open Account. The trade finance instruments manage the risks upwards, but they do so from a lower startpoint.

Bob Lyddon is an author for accountingcpd. To see his courses, click here.

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