Increased capital requirements threaten to restrict banks’ ability to fund trade finance deals and further constrain economic growth.
In this guest-authored piece for The Fintech Times, Christoph Gugelmann argues that the distribution of trade finance assets to investors is emerging as a practical solution to a looming lending crisis
Gugelmann is the CEO of Tradeteq, a trading venue that enables banks and financial institutions to connect, interact and transact. The company’s AI-driven credit scoring, advanced analytics and investment management engine provide risk transparency and informed decisions.
Likewise, its streamlined securitisation tools reduce complexity and seek to make trade finance investments efficient, liquid and transparent.
The increased capital requirements outlined in Basel IV are set to restrict banks’ ability to lend, when many businesses already lack the funding they need. Here, Gugelmann discusses of bank distribution of trade finance assets is key to freeing up balance sheets:
The implementation of Basel IV is set to commence in January 2023 and, with the clock ticking, firms are grappling with their plans. However, Basel III has already placed tight restrictions on banks active in trade finance lending and so the worry is, without adequate preparations, Basel IV will further amplify the problem.
Basel IV’s evolution began in 2017 when amendments to address credit risk calculations emerged to complete Basel III. Nicknamed Basel IV, the amendments were set for initial implementation in March 2022 before the latest 2023 start date. There are, however, some regional variations. The European Commission and the Bank of England later pushed the EU and UK deadlines back to 2025 amidst concerns that banks’ ability to lend is crucial to post-pandemic recovery, so more time was needed to prepare.
The updates have continued to be the subject of concern and debate among industry stakeholders. The International Chamber of Commerce highlighted how they could cause damage to banks, saying they “may have severe unintended consequences for the provision of cost-effective trade finance to the real economy.”
Various banking associations have weighed in, including Finance Denmark, which stated in a memo that the changes “will result in an overall increase in capital requirements for EU banks of 23.6 per cent” and that the figures “are in sharp contrast to G20 indication that the final Basel III revision should not bring about a significant increase in overall capital requirements.”
The widening trade finance gap
The problem is there is a looming crisis for businesses, many of which already struggle to secure trade financing from banks. It’s a persistent problem that has led to the widening of the trade finance gap – the shortfall between supply and demand. Research from the Asian Development Bank estimates that the gap stands at a significant $1.7trillion.
Basel’s capital constraints sit at the heart of the problem. The regulation demands banks to put aside more capital for trade finance deals, meaning they have had to raise capital requirements and reduce their standardised risk weights.
Basel IV’s higher thresholds will further restrict banks’ ability to lend and, therefore, have a major impact on the availability of finance. Without a solution, the trade finance gap will continue to expand – and the World Economic Forum expects it to increase to as much as $2.5trillion by 2025.
Distribution of trade finance
A large part of the gap results from SMEs in emerging markets and given Basel IV’s impact, it will be difficult to address through additional lending or credit. In the absence of increased funding, solutions have emerged, such as the possibility of co-financing and greater digitalisation.
An alternative, however, is the distribution of trade finance instruments to other banks and the capital markets. Banks recognise that by adopting an originate and distribute model for their trade books, they can increase their net interest income, boost return on equity and open up additional sources of funding. This benefits not only the banks but also their investors and the businesses and communities that depend on trade finance.
All this, however, depends on investors being able to access this asset class – and currently, they are restricted due to the need for the repackaging of portfolio risk and operationally intense reporting requirements.
For an investment bank to execute on behalf of an asset manager, the transaction costs for a low-risk, low-yielding product would regularly exceed the asset spread of short-term bank exposure. This limits access to a small portion of riskier assets. Commercial banks distributing trade finance via investment banks face similar cost barriers due to the need to repackage instruments from a legal and regulatory standpoint.
What is needed is a more cost-effective approach to make trade finance a palatable investment proposition. As a result, we are starting to see the steady dismantling of old, complex and convoluted processes with little transparency and standardisation.
Technology is now opening the door to this huge opportunity, enabling assets to be bought and sold through private distribution networks. In particular, infrastructure exists to enable end-to-end straight-through-processing of hundreds of thousands of instruments in a low-cost way. This is equipping asset managers and commercial banks with direct access to trade finance assets, enabling alternative investors to channel more capital into banks and onto corporates.
At a time when banks are having to do more with less, practical approaches are needed to help mitigate any negative, unintended consequences from Basel IV. With investors able to access trade finance as an asset class, banks have more options to originate higher volumes.
As such, trade finance distribution is emerging as a lifeline and a necessity, enabling firms to remove debt from their balance sheet and continue lending. With geopolitical events, supply chain disruption and currency volatility shaking the markets, efforts such as this will be essential to spur future economic growth.