December 2010

The Emerging Basle III and its implications for Structured Trade Finance Banks

Andrew Gamble – Afreximbank Seminar on Fundamentals of Structured Trade Finance

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Background

• Bank for International Settlements based in Basel (Basle), Switzerland

• Secretariat for Basel Committee on Banking Supervision (BCBS)

• Group of Central Bank Governors and Heads of Supervision

• Forum for co-operation on banking supervisory matters

• Seeks to promote and strengthen supervisory and risk management practices globally

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The Story so far

• Basel I (1988)

• Basel II (2004)

• Basel III (to be continued)

• Recommendations of best practice to governments / supervisors

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Basel I

• Common measurement of capital

• Common framework for allocation of risk to bank assets (including off balance sheet assets)

• Minimum level of capital by reference to ratio of capital to aggregate risk weighted assets

• Capital Ratio = Regulatory Capital x 100

Risk Weighted Assets

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Basel II

• No change to minimum Capital Ratio

• No change to definition of Regulatory Capital

• Change in the definition of Risk-Weighted Assets

• More convergence of

Allocated Economic Capital

Allocated Regulatory Capital

• Not raise overall Regulatory Capital but redistribute

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Basel III

• Prompted by 2007-8 crisis which exacerbated by weaknesses in banking sector

• Problems

excessive leverage

inadequate and low-quality capital

insufficient liquidity buffers

procyclical deleveraging process

interconnectedness of systemically important financial institutions

• Proposals announced 12 September 2010, endorsed by G20 at Seoul Summit 11-12 November 2010

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Proposed solutions

• Raising quality of capital

going concern

gone concern

• Increasing risk coverage

• Raising level of minimum capital

• Restrict leverage

• Enhance supervisory review process (Pillar 2) and public disclosures (Pillar 3)

• Introduce global liquidity standards

• Promote capital buffers

• More capital for systematically important banks

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What is capital for?

• Cushion against losses

• Demonstrate to depositors willingness of shareholders to put own funds at risk on permanent basis

• Provide resources free of fixed financing costs

• Finance for general infrastructure of the business

Source: The measurement of capital 1980

Bank of England

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What is "Basel" capital?

• Principles:

Ability to absorb loss

No fixed costs

Fully paid up

• Tier 1:

permanent share capital and reserves ("common equity")

perpetual non-cumulative preference shares

• Tier 2 (upper): hybrid instruments, eg

Perpetual cumulative preference shares

Perpetual subordinated debt

• Tier 2 (lower): subordinated term debt

• Tier 3: short term subordinated debt

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Capital – "Quality" proposals

• Still minimum Capital Ratio 8% of Risk Weighted Assets

• Current requirements:

Common equity – minimum of 2%

Tier 1 – minimum of 4%

Tier 1, 2 and 3 – minimum of 8%

• Proposals:

Common equity – 3.5% (2013), 4% (2014), 4.5% (2015)

Tier 1 – 4.5% (2013), 5.5% (2014), 6% (2015)

• Definition of capital e.g. innovative capital instruments (interest rate step-ups) cease to be eligible for Tier 1

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Capital – "Quantity" proposals

• Capital Conservation Buffer

required when credit growth increases risk

increases when good performance

drawn upon in times of economic stress and distributions restricted

countercyclical effect

• Timetable:

0.625%-2.5% of RWA (2016-2019)

Met by provision of common equity

• Aggregate effect (2019):

Total common equity – 7%

Total Tier 1 – 8.5%

Total minimum capital requirement – 10.5%

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Leverage ratio proposal

• Calculates risk-adjusted exposure to certain on- and off-balance sheet items and derivatives

• Exposure not to exceed 3% of Tier 1 starting in 2013

• Impact on trade finance:

unconditionally cancellable facilities up from 0% to 10% CCF

self-liquidating trade LCs/SBLCs/performance guarantees/shipping guarantees up from 20% to 100% CCF (possibly)

• Off-BSA x CCF x RW for on-BSA

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Effect of Risk Weighted Assets

$10m asset

20 % CCF

$2m Risk Weighted Asset

Minimum $160,000 capital8% min. ratio >

100 % CCF

$10m Risk Weighted Asset

Minimum $800,000 capital

Capital 'used'

Capital 'used'

Total Capital Total Capital

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RAROC: The link between capital and pricing

RAROC

25%

20%

15%

10%

5%

0%

Typical RAROC hurdle

Capital allocation under-performing

Capital allocation performing

RAROC =

RETURN – EL – COST

CAPITAL

Where: EL = 'Expected Loss'

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Liquidity proposals

• Designed to:

make banks more resilient to short-term disruptions in funding

address longer-term structural liquidity mismatches

• From 2015, Liquidity Coverage Ratio (LCR) will require banks to hold sufficient high-quality liquid assets measured by reference to cash outflows over 30 day period

• From 2018, Net Stable Funding Ratio (NSFR) will require banks to have minimum level of stable funding

• More an issue for Project Finance?

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Counterparty credit risk proposal

• New stress tests to measure exposure of banks to counterparties

• Have to take into account

market factors (e.g. interest rates, market values)

correlation of risk amongst multiple counter-parties (e.g. several borrowers exposed to commodity price volatility)

risk weighting of central counterparties (e.g. clearing houses)

• Issues for trade finance

hedging

insurance

commodity price risk

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Supervisory Review Process of Capital

Adequacy

To ensure banks have good monitoring and management of risk

processes

Market Discipline and Disclosure

Requirements that allow capital

adequacy to be compared across

institutions

Minimum Capital Requirements to

cover:

Credit Risk

-Market Risk

-Operational Risk

Pillar 1 Pillar 2 Pillar 3

Greater focus on Pillars 2 and 3

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Industry reaction

• HSBC: unfair treatment of trade finance

• Standard Chartered: "2% fall in global trade and a 0.5% fall in global GDP" (Karen Fawcett, Head of Transaction Banking)

• BAFT-IFSA: "Basel II got it wrong even more than Basel I, and now we're jumping off a cliff in terms of Basel III" (Dan Taylor, President and Chief Operating Officer)

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Time to push the panic button?

• Long transition phase (2013-2019)

• Still being finalised

Lobbying continues (BAFT – IFSA, ICC)

National implementation required (e.g. CRD4 to be published in March 2011)

• Other competitors for capital harder hit (e.g. derivatives, trading)

• Impact on pricing?

but lower cost of own funds

more distribution (e.g. MDBs)

• Basel II

not terminal

platform to revisit this?

ICC/ADB: building trade finance credit-loss database

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Documentation impact (Increased Cost Clause)

• The Borrower need not make any payment for an Increased Cost to the extent that the Increased Cost is:

attributable to the implementation or application of or compliance with the "International Convergence of Capital Measurements and Capital Standards, a Revised Framework" published by the Basel Committee on Banking Supervision in June, 2004 in the form existing on the date of this Agreement (Basel II) or any other law or regulation which implements Basel II (whether such implementation, application or compliance is by a government, regulator, Finance Party or any of its Affiliates);

attributable to the implementation or application of or compliance with the “Consultative proposals to strengthen the resilience of the banking sector” published by the Basel Committee on Banking Supervision on 17 December 2009 as amended or supplemented (including by the agreements of the Governors and Heads of Supervision summarised in the Annex to their communiqué dated 29 July 2010) (Basel III) or any other law or regulation which implements Basel III (whether such implementation, application or compliance is by a government, regulator, Finance Party or any of its Affiliates).

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The Story continues

• BCBS continues to work on other initiatives

fundamental review of trading book framework (e.g. retain distinction between banking and trading book?)

reduce reliance on external rating agencies

higher capital for systemically important banks

"Gone concern" capital proposal and cross border crisis management

reviewing large exposure rules

• No particular horrors for Trade Finance here?

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