Trade in the New Regulatory Environment

John Ahearn, Citi, Global Head of Trade

Shannon Manders, Global Trade Review

Speakers

Shannon MandersDeputy Editor,

Global Trade Review

John AhearnGlobal Head of Trade,

Citi

Overview

• Trade Finance Banks face multiple challenges

• Focus of global trade on emerging markets has some banks developing new models

• Raising capital continues to be difficult; while competition is increasing

• Increased Regulation including Basel III will have further impact on how banks and their clients do business

• Despite challenges, Global Trade continues to play an important role in the development of the world’s economy

Higher Capital and Liquidity Costs for BanksEuropean Bank CDS Spreads (bps)

United States Bank CDS Spreads (bps)

Both European and US banks continue to have high capital costs following the financial crisis.

Although CDS prices have fallen from extreme highs in 2008, volatility remains

Internal liquidity premium charges are having an impact on deal returns

Funding costs are rising for European and Asian banks without sources of dollar deposits

Use of leverage has enabled banks to stay in the market, though this option is now going away

Bank Weighted Cost of Capital (as of Q1, 2011)

In P

erce

ntag

e

Source: Bloomberg

Source: Bloomberg

Corporate Pricing Continues to FallCorporate Bond Rates Remain Low

Coupons At All-Time Lows

Corporate cost of funding has been decreasing

As organizations move to club or bi-lateral structures, there are fewer deals in the market

Banks that survived the consolidation of the market during the crisis are now eager for the right deals and are competing for a smaller pie

This has led to a downward trend in pricing despite continued high capital costs for banks

Certain programs that gained ascendancy during the crisis, such as supply chain finance, lose some of their luster as spreads compress and liquidity remains an issue

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500

10yr UST S&P 500

3%

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9%

Jan 2008 Jul 2009 Dec 2010

'A' IntermediateCorporate'BBB' IntermediateCorporate

Basel – Where are we now? Basel III was introduced in November 2010 and is designed to further strengthen existing capital requirements.– Specifically the reforms cover:

Capital quality; capital requirement, leverage ratio and liquidity requirements.– Implementation will be phased on a gradual basis from January 2013 through 2019.

Basel II and now III will have a significant impact on the cost of financing trade and of issuing confirmed letters of credit as a result of the following factors:– Increased capital requirements under Basel III– Increased Loss Given Default Requirements under Basel II and III– Elimination of beneficial Credit Conversion Factor for Letters of Credit under Basel III– Capital requirements for short term trade

New Approach to Trade Business ExpectedHistorical Bank LeverageTotal Assets and Profits of Largest Banks

Certain Trade business models are driven by the transfer of assets from corporate balance sheets to bank balance sheets

Growing bank balance sheets and increasing leverage leading up to 2008 made these businesses attractive with strong margins

Post-crisis, the old model has been discredited and banks will not be able to rely solely on their balance sheet to meet corporate demands

The new regulatory regime will also play a fundamental role in reshaping how banking, including trade finance, is implemented going forward

Distribution strategies will become increasingly important

Basel III will significantly impact the amount of capital required by banks– Increase capital ratios and calculations of risk weighted assets (RWA)– Will set minimum leverage ratio and liquidity coverage ratio– Extra loss absorption capacity of systemically important banks

Capital RequirementsIn November 2010 the Group of Governors and Heads of Supervisors of the Basel Committee on Banking

Supervision published the Basel III rules text on bank capital adequacy and liquidity, which was endorsed by the G20 Leaders at their November Seoul summit.

Basel I / II Capital Composition Basel III Capital Requirements

Tier 2 Capital+ General Provisions

+ Revaluation Reserves+ Hybrid Capital Instruments+ Subordinated Term Debt+ Undisclosed Reserves

Less: Certain Investments

Tier 1 Capital = 4%+ Common Equity (2%)

+ Retained Earnings+ Capital Securities

Less : Goodwill

Total Capital = 8%

Tier 1 Capital = 8.5%+ Common Equity (4.5%)

+ Common Equity Capital Buffer (2.5%)Less: Certain significant investments, mortgage services, and

deferred taxes+ Retained Earnings+ Capital Securities

Less: Trust preferred securitiesLess : Goodwill

Tier 2 Capital+ General Provisions

+ Revaluation Reserves+ Hybrid Capital Instruments+ Subordinated Term Debt+ Undisclosed Reserves

Less: Certain Investments

Total Capital = 10.5%

Counter Cyclical Buffer= 0 – 2.5%

Basel II Impact: Basel I vs. Basel II

Basel I – Standardized risk weighting by simplistic categorization of obligor (i.e. corporate vs. bank) and

product type (Banker’s Acceptance vs. Commercial Letters of Credit)– Established a minimum ratio of required Tier 1 capital to Risk Weighted Assets (RWA)– RWA assigned only for credit risk

Basel II– Basel II allows several methods for calculating RWA for each of the three risk types it recognizes:

Market Risk: enhanced standards to model default riskCredit Risk: formula-based calculation utilizing an institution’s internal risk parameters associated with each facility, such as Probability of Default (PD), Loss Given Default (LGD), etc.Operational Risk: new internal simulation model incorporating estimates of the frequency and severity of operational losses

– Basel II is designed to be more risk sensitive than Basel I as the RWA is now aligned with actual economic risk and a bank’s internal measurement of economic capital

The Trade business has become more challenging due to credit tightening, changes in accounting regulations and stringent capital reserve requirements, namely through Basel II. Basel II will have a more comprehensive approach to calculating risk capital than Basel I. Basel III tightens up on contingent instruments

Risk Weights and Capital Required Vary with Credit Quality

0

50

100

150

200

250%

AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-

Unsecured LoansMaturity = 5

Maturity = 1

IG HY

Basel I

Ris

k W

eigh

ted

Ass

ets

For a ‘B’ rated unsecured loan, Basel II Regulatory Capital

requirements increase from Basel I

For an ‘A-’ rated unsecured loan, Basel II Regulatory Capital

requirements decrease from Basel I

Collateralized Loans Maturity = 5 Maturity = 1

A critical difference between Basel I and Basel II is that under Basel II, Risk Weighted Assets and capital are based on the same drivers as Risk Capital: – Probability of Default (PD)– Loss Given Default (LGD)– Exposure At Default (EAD)– Maturity (M)

- Illustrative -

Majority of SMEs fall in this quadrant

Basel III Proposals Will Have Further Impact

Leverage ratio requirements

New leverage ratio requirements on a gross (rather than risk adjusted) basis– US regulators use a similar ratio today, although the new ratio is

expected to generate a larger assets ‘denominator’– This type of ratio has not typically been used outside the US

Counterparty Credit Risk Capital Treats CVA volatility as a “bond equivalent” exposure in addition to VaR

Liquidity risk measurements Defines short-term and longer-term funding ratios under stressed scenarios

New definition of Tier 1 capital

Greater alignment of Tier 1 with common equityLimitations on the use of deferred tax assets, MSR’s, etc.

Capital Ratios

Minimum capital requirements increase significantly – Core Tier 1 (equity and retained earnings) increases from 2% to 4.5% of Risk Weighted AssetsAdditional “capital conservation buffer” of 2.5% of Risk Weighted Assets – if the capital ratio falls below this buffer, rules restrict dividends, share buy backs, etc. when capital is below buffer level

Basel II and Basel III outline new regulations that may have a significant impact on trade finance and the amount of capital allocation required for short-term credit and trade

One-year maturity floor for short-term self-liquidating trade transactions does not reflect the majority of trade assets, which are typically 180 days or less– ICC Banking Commission estimates that removal of the maturity floor could cut capital requirements for 90 day trade

finance obligations by 20-30%

Application of key risk attributes for trade finance assets do not reflect industry expert judgment– Currently lack of historical data on “loss given default” and “credit conversion factor” model inputs to promote industry

benchmarking– ICC and Asian Development Bank set up a Register on Trade and Finance that found a low instance of default across all

trade product types

Basel III would change the credit conversion (CCF) factor for off-balance sheet operations to 100% from 20%– Would impact credit allocation requirements for SBLCs and similar off balance-sheet trade bills– When used for calculating a leverage ratio, may encourage a diversion of capital to higher risk/higher return products

rather than highly documented and short-term, self-liquidating trade instruments

Industry concern is that trade lending, especially for smaller firms, will be adversely affected by current regulatory proposals

Impact on TradeThe Basel III 5 key amendments focus on ensuring resiliency of banks at a micro level, while taking into account system wide risks and the potential for pro-cyclical amplification of risks.

Source: Mark Auboin, International Regulation and Treatment of Trade Finance: What are the Issues? WTO, February 2010 and internal Citi sources

2019

Basel Implementation Timeline

Basel I Implemented since 1988… …To be run in parallel after 2011

Basel III2010 – 2011:

Details FinalizedPhased Implementation

from 2013 - 2019

… … …1988 2010 2011 20122004 2013

2008: In effect in EuropeBasel II

2004: Proposed

2010/11: US banks report both Basel I & II to regulators

From 2Q2011: In effect for US Banks

Note: Basel II is mandatory for large, internationally active banks with total assets of more than $250 bn.

Dodd-Frank Legislation

Risk Participation Agreements govern the transfer of economic benefits and risks of a bank loan from a seller to a buyer. In the US, agreements are modeled on The Loan Syndications & Trading Association

(LSTA) templates out of New York while in Europe and Asia, agreements are modeled on templates published by the Loan Market Association (LMA) in London.

In US-style agreements, the participant receives a beneficial ownership interest in the underlying loan, while the London-based agreement creates a debtor/creditor relationship.

Differences between these two forms of agreements could lead to significantly different regulatory results under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which becomes

effective July 2011

Dodd-Frank provides new regulations that categorize over-the-counter derivatives as “swaps” and could treat London-style LMA participations as both a “mixed swap” and a “security-based swap” with

regulatory oversight by both the SEC and the CFTC.

Potential consequences of treating LMA-style participations as swaps:

Trades would need to be made “on the public side” and impact borrower’s ability to raise capital in the loan markets

Require registration with SEC as dealers and use of central clearing houses

Require participants to be an “eligible contract participant” as defined in the US Commodity Exchange Act and to obtain contractual representation to that effect

Subject to margin, capital and books and records requirements applicable to registered broker-dealers

Source: Dodd-Frank Crosses the Pond by Jon Kibbe, Julia Lu, and Carl Winkworth of Richards Kibbe & Orbe LLP

ICC-ADB Register on Trade & FinanceIn November 2009, the International Chamber of Commerce (ICC) and Asian Development Bank (ADB) established the Register on Trade & Finance that pooled performance data for trade finance products from leading banks*– Created in response to concern that capital requirements under the Basel II framework for trade

finance will increase disproportionately to their risk profile– Provide empirical evidence of the low-risk nature of trade finance transactions– Promote recommendations for the Basel Committee and national regulators to reconsider the

treatment of trade finance products under the Basel II framework and Basel III proposals

Methodology of the register

Number of Banks Participating 9

Number of Transactions 5,223,357

Time Period of Data 2005-2009

Total Throughput USD 2.5 trillion

Trade Finance Products Analyzed Import L/Cs IssuedExport Confirmed L/CsGuarantees and Standby L/CsImport LoansExport Loans

* See Report on Findings of ICC-ADB Register on Trade & Finance published by the International Chamber of Commerce on July, 26 2010

Key Findings1. Short tenor of trade transactions

- Average tenor of all products is 115 days

- Average tenor of off-balance sheet products less than 80 days

2. Low instance of default across all product types

- Only 1,140 defaults out of 5,223,357 transactions

- Only 110 defaults for off-balance sheet transactions out of 2,392,257

3. Relatively few defaults observed through the global economic downturn

- Only 445 defaults in 2008-2009 out of over 2.8 million transactions in that period

4. Good average recovery rates observed for all product types over the 5 years

- Average recovery rate of 59.7% across all product types

5. Demonstrated contingencies limited the conversion of exposures from off- to on-balance sheet

- Average of 50% of document sets presented to banks under import L/Cs contained discrepancies on first presentation

- Significant proportion of L/C facilities expire unutilized

ICC Rethinking Trade & Finance Survey 2011

1. Recovery is taking place globally. – Trade flows have rebounded after the 23% drop during 2008-2009, but recovery has been uneven– Average price for L/Cs in large emerging economies fell from 150-250bps in 2009 to 70-150bps in 2010

2. Supply of trade finance has significantly improved in both value and volume– 58% of respondents reported an increase in export L/C volume and 66% increase in import L/C volume

3. Region show uneven results– Greatest number of L/Cs were issued in the Asia-Pacific countries, with most of this traffic consisting of intra-

regional transactions

4. Traditional trade finance instruments gained prominence– Respondents continue to report an increase in demand for documentary credits

5. Affordability of trade finance– 75% of respondents reported that fees for issuing bank undertakings had not changed in 2010

6. Still intense scrutiny of documents– There continues to be a large number refusals and levels of court injunctions have also increased

7. New regulatory regime may have unintended consequences– Increase in leverage ratio is expected to significantly curtail availability to provide affordable financing to businesses

in developing countries and SMEs

8. Multilateral development banks are playing a vital role– Important role played in building trade supply chain networks between banks in emerging markets and in providing

liquidity as well as promoting increased South-South trade

The ICC undertakes a yearly survey of trade finance that collects feedback from the industry on trade finance and enables the proposal of specific measures to policy makers

Register on Trade & Finance StatisticsProduct # of

TransactionsAverage

Tenor (days)

Cycles over 5 Year

Period

# of Defaulted Transactions

Average Default Rate*

Average Recovery

Rate

Discrepant Documentary Presentations

Unutilized L/Cs

Import L/C 1,196,270 79 23 23 .058% 50.0% 50% 11%

Export Confirmed

L/C

405,312 53 34 33** .008%*** 28.1% 58% 12%

Guarantees and

Standby L/Cs

599,014 76 24 53 .010% 77.0% n/a 86%

Corporate Import Loans

584,681 115 16 206 .124% 50.3% n/a n/a

Bank Import Loans

808,671 91 20 29 .293% 73.0% n/a n/a

Corporate Export Loans

877,053 90 20 630 .168% 60.7% n/a n/a

Bank Export Loans

752, 356 256 7 116 .023% 81.5% n/a n/a

* Default rate in the product = total yearly exposure in default/total exposure at a given balance sheet date** 27 of these happened in 2009 due to bank failures in Kazakhstan and Ukraine

***Default rate for Export L/Cs= total number of defaulted transactions/total number of transactions. A slightly different calculation was used for Export L/Cs since the factors underlying a default are usually unique to each particular transaction.

Sovereign Crisis – Not Yet Played OutEuropean Sovereign CDS Spreads (bps) Select European GDP Percent Changes

Government Debt to GDP, % “Kicking the can down the road…”

Source: Bloomberg

Sovereign bond spreads for the periphery countries remain high, in some cases nearing their levels of May – June.

With large twin deficits in fiscal and current account balances, PIIG countries continue to need support from

Europe.

Without growth restoration, a permanent improvement of public finances in these countries seems unlikely.

There is continued lack of consensus among European leaders on how to tackle the renewed instability.

Source: Citi, European Credit Outlook, Oct. 5

Bank stress- test results released

Economic Stimulus

Act signed

Europe Continues to Lag Events in the USBear Stearns

pledges $3.2B to aid ailing hedge

funds

BNP freezes 3 funds

String of major bank write-downs

begins

1st TAF auction

March 2008Collapse of Bear Sterns

TALF established

FDIC takes over IndyMac

Sept 2008Fannie and Freddie in Federal

conservatorshipCollapse of

Lehman, AIG, and Wachovia

TALF established

11 largest banks downgraded

Feb 2009Statement on

stress-test related capital injections

June 2009GM

declares bankruptcy

CIT bankruptcy

Banks begin to repay TARP

funds

Northern Rock Nationalized

Sept 2008Ireland

guarantees largest banks

ECB and European banks cut

rates

UK announces bank rescue plan

Ireland credit rating

cutGreek banks downgraded

Spain raises budget deficit

forecast

Greek rating downgraded

Spain rating downgraded

May 2010Greek bailout

Additional sovereign

ratings downgrades

United States Timeline

European Timeline

Run on Northern Rock Bank

Portugal rating downgraded

Ireland rating

downgraded

ECB Bailout of Ireland €67.5Bn

Ireland Credit Rating

Downgraded Further

Allied Irish Nationalized

Some Spain banks

nationalized

Portugal ‘s credit rating cut, fear of bailout, PM

resigns

Q1 2011

Political Crises Erupt in the Middle East and North Africa

Contagion is occurring throughout the region

Tunisia – weeklong “Jasmine Revolution” overthrows President Zine Al-Abedine Ben Ali

Jordan – King Abdullah dismisses government of SamirRifai following protests in the streets of Amman. Marouf Badhit is named successor

Egypt –President Mubarak has resigned, power is transferred to the Supreme Council of Armed Forces.

Libya – Thousands are fleeing as fierce fighting is taking place between rebels and pro Gaddafi forces. UN Security Council has placed an arms embargo and asset freeze on the government, and Allied forces are enforcing a no fly zone.

Yemen – Protests demanding the resignation of President Ali Abdullah Saleh

Bahrain – Protestors are demanding a more equal distribution of wealth. Saudi and UAE troops are involved, and a three month state of emergency has been declared.

Syria – Protests in multiple cities

Situation Update

Brent Spot Oil Prices –

1 year

Oil Prices – rise in oil prices rise on concerns over disruption in the Suez Canal, an important supply chain route. Suez Canal contributes to 7.5% of global world sea trade, according to Deutsche Bank

Rush to Safe Havens – dollar demand has been high while there has been significant outflows of short-term Treasury bills

Egypt CDS USD SR 5Y

Primary Concerns

Source: Bloomberg

Business Model of Banks is Under Fire

Expected Trade Trends Moving ForwardThe post-crisis environment, coupled with a new regulatory regime, is resulting in fundamental

shifts to the trade business

1. Consolidation of business with core trade banks– New flows between developing economies and within regions makes it harder for banks to compete that do not have an

extensive branch network– Banks for which trade is not a core business line may determine that the increased capital costs are too expensive to

make the business worthwhile– Top 5 Trade banks in terms of LC activity capture the majority of the market. In net LC activity, the number 1 ranked

bank processes 870% more in dollar terms than the number 6 bank (DCW Dec 2010)

2. SME sector may be hard hit– Increased capital requirements are felt most strongly with lower rated assets, providing an incentive to go up-market

3. Pricing needs to increase– Current model is not sustainable as banks begin to pay more for their capital even as pricing does not meet internal

hurdles– Pricing is expected to increase by as much as 30-40%

4. Banks will begin to act as intermediator between corporates and investors with lower capital costs– Banks will no longer focus solely on book-and-hold strategies

5. Banks will increasingly rely on risk distribution strategies to manage their own balance sheet– Banks may also want to work together to support an industry distribution channel

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