Regulatory

Lenders, banking associations and trade finance users are lobbying the European Commission, European Parliament and member states to scrap planned amendments to the treatment of off-balance sheet instruments such as technical guarantees, performance bonds, warranties and standby letters of credit.

Via Global Trade Review (GTR)

Proposed changes to the treatment of trade finance in the EU’s capital requirements regulations could push up financing costs for businesses and allow insurers a bigger slice of the guarantees market, banks and borrowers claim.

The European Commission published the final text of its proposed changes to the Capital Requirements Regulation (CRR) in October last year, part of the bloc’s implementation of the Basel III banking reforms.

Lenders, banking associations and trade finance users are lobbying the Commission, European Parliament and member states to scrap planned amendments to the treatment of off-balance sheet instruments such as technical guarantees, performance bonds, warranties and standby letters of credit.

The Commission has proposed that those products be categorized as medium risk for determining the credit conversion factor, which is used to calculate what a bank might have to pay out under those instruments – taking into account the likelihood the payout obligation will materialize – and therefore the risk they represent on its books.

The planned change would hike the required credit conversion factor for those off-balance sheet trade finance products to 50%, from the 20% under the current CRR.

The lobbying campaign has stepped up in recent weeks. Lenders, corporates and trade groups have sent a flurry of written submissions to the Commission arguing that the increase is incongruous with trade finance’s relatively low risk profile and high rates of recovery in the event of defaults.

In a position paper published in December, the International Chamber of Commerce (ICC) says it is “deeply concerned” that the two amendments “may have severe unintended consequences for the provision of cost-effective trade finance to the real economy”.

According to BAFT (Bankers Association for Finance and Trade), default rates on technical guarantees are only 0.24%. Upping the credit conversion factor to 50% “is therefore excessive and does not seem justified or appropriate”, the association said in a submission to the Commission last week.

“European banks are likely to price technical guarantees at higher rates to clients” if the change goes ahead, BAFT argues. “The effect will be to discourage these business activities and make it more costly to offer trade finance for banks and their corporate clients,” the submission says, disadvantaging small and medium enterprises and making European companies less competitive when bidding for major infrastructure projects.

The proposed changes will increase the capital charge on the trade finance instruments by 150%, according to a joint submission from banking associations in Denmark, Finland and Sweden.

Under the proposal, the cost of a €10mn performance guarantee for a corporate customer would rise from €50,000 to €125,000, the submission says.

Technical guarantees are frequently used by infrastructure, energy and defense companies fulfilling large contracts. Governments can call on the guarantees if the company fails to deliver or meet its performance goals, and often require firms to enter bid bonds when taking part in tender processes.

Engie, the French utilities giant, says in a submission that it has exposure to bank guarantees amounting “to several billions” and that “the proposed revision would imply a severe cost increase for Engie and potentially difficulties to get access to those guarantees, as banks may decide to prioritize activities with higher return on equity”.

It adds that “some banks have already alleged the potential revision of Basel requirements to justify an increase of existing guarantee line[s] that have recently matured”.

Airbus estimates its financing costs will increase by “several millions” per year if the changes go ahead, including the corporate undertakings its parent company makes with its subsidiaries.

The aircraft manufacturer says in a submission that the possible drying up of credit lines due to steeper capital requirements could hinder its ability to meet contractual obligations when its customers request technical guarantees and put its supply chain “at risk”.

“It is very important to underline we are in the real economy,” says Christian Cazenove, group head of trade oversight at Société Générale. “The things that we are dealing with are goods and services…. We are dealing with what allows corporates to succeed abroad.”

“The additional capital costs may lead the banking sector to some extent to disengage from the guarantee business,” Cazenove, who has rallied other banks and clients to campaign on the issue, tells GTR. “Trade finance by nature is still a paper-based industry and not extremely profitable – we, together with clients, really don’t need these additional costs that we would charge to our clients.”

Banks are also wary that the changes will benefit insurance companies at the expense of banks. Baft says its members are concerned that the “excessive pricing of credit risk… will accentuate the current outflow of guarantee business from banks to insurance companies” which are allowed to internally model guarantee risk.

The ICC agrees that the mooted revisions to the law could create “an uneven playing field” between banks and insurers.

Maturity concerns

Those lobbying the Commission are also concerned that a second proposal under the update of the CRR will increase the costs to EU banks of providing letters of credit and other trade finance instruments.

They say ambiguities in the draft text concerning credit risk rating approaches will effectively force financial institutions to treat key trade finance instruments such as letters of credit as having a 2.5-year maturity when they are provided to large corporates.

Currently the CRR exempts trade finance from a maturity floor in recognition that instruments in the sector mature relatively quickly. Most trade finance products have average tenors of under 130 days, according to ICC data.

“Applying an average 2.5[-year maturity] to this kind of transaction will create a significant price increase for European corporates – the main users of trade finance – putting EU exporters in a weaker position than their competitors outside the EU,” the ICC says in its submission.

Banks in the Nordic region fear that adding costs to their trade finance businesses will add further pressure to already expensive correspondent banking networks that underpin global trade.

Michael Friis, a senior adviser on banking regulation with Finance Denmark, tells GTR that the group’s members are concerned that a loss of performance bond businesses and more expensive letters of credit will mean “that some of the volume will go out of the business and make it more sluggish and more expensive”.

The Commission’s proposal will be the subject of negotiations with the European Parliament and member states through the European Council. The trade finance measures are only a small part of a much broader Basel III package being put forward by the Commission and are unlikely to come into effect until around 2025.

A spokesperson for the Commission says that its draft will not be altered following the submissions received since October, but they will be used to inform the talks with the Parliament and Council.

Industry groups are also lobbying EU lawmakers and member states, Friis and Cazenove say. The French finance minister Bruno Le Maire has been made aware of the industry’s concerns over the proposed legislation, Cazenove says.

Via Trade Finance Global

Almost two weeks have passed since the retirement of the world’s most important number: the London Interbank Offered Rate (LIBOR).

For almost half a century, LIBOR functioned as a benchmark for global interest rates, and its ups and downs influenced an entire universe of financial instruments.

From short-term unsecured loans, to floating rate contracts such as derivatives, corporate debt, mortgages, and home loans, LIBOR affected the cost of credit across regions, industries, and currencies.

It was calculated through a daily survey of major global banks, who were asked what their borrowing costs were expected to be over a number of timeframes, up to 12 months.

The highest and lowest quotes were dropped, while the rest were reduced to an average that formed the rate.

So integral was LIBOR to the global financial system, that at its peak in 2020, over $400 trillion in outstanding contracts were exposed to it.

It should come as no surprise, then, that with LIBOR’s demise came a sense of foreboding for the trade finance world.

As the Bank of England’s Alastair Hughes told Trade Finance Global: “If you’re burying your head in the sand because someone’s told you LIBOR was going to continue, or you don’t have to do anything – that’s definitely not the case.

“LIBOR will cease, so you do need to engage, you need to understand what your exposure to the LIBOR rate is, both in terms of future use of products, and, indeed, those legacy products.”

A Financial Millennium Bug

Some worried that LIBOR’s cessation – which took place at midnight on December 31, 2021 – had the potential to cause a ‘Y2K moment’ for global finance.

Also known as the ‘millennium bug’, older readers will recall that this mysterious creature had once threatened to bring down the world’s computer systems overnight.

As 1999 gave way to the year 2000, technicians worried that the widespread use of only two digits for years in the date format of computer programs could cause a global IT crash, as the clocks ticked over at midnight December 31.

Thankfully, however, the transition from 1999 to 2000 passed mostly without issue, and the bug turned out to be quite the anti-climax.

In a similar manner, lights off on LIBOR hasn’t led to a financial meltdown.

On the contrary, the trade finance world has adapted quite smoothly to life without LIBOR, thanks to a new menu of alternatives for banks and corporates both large and small to choose from.

LIBOR Alternatives in Practice – The View from ITFA

As chairman of the International Trade and Forfaiting Association (ITFA), Sean Edwards has had a unique view of the LIBOR transition.

Speaking to Trade Finance Global, Edwards said that the transition has caused very few issues so far for ITFA’s 300-plus members.

“For those currencies where LIBOR is no longer quoted, such as sterling and yen, the transition process has been largely successful,” he said.

“There was a small overhang of deals into the New Year, which we expect to be cleared up in Q1.”

As previously reported by Trade Finance Global, among the alternatives to LIBOR is an interest rate known as synthetic LIBOR.

Synthetic sterling LIBOR is based on the sum of the one-, three-, or six-month Sterling Overnight Index Average (SONIA) reference rate, which is provided by the ICE Benchmark Association (IBA) and the International Swaps and Derivatives Association (ISDA).

Edwards said he sees synthetic LIBOR as a “refuge for the desperate only”, but added that it is “unsurprising” that it has nonetheless found a user base, given that there is “really no choice but to find an alternative.”

Transition from USD LIBOR presents a greater challenge, however, as it will continue to exist in some form until mid-2023.

“With pre-2022 committed facilities continuing to be priced on this basis, there is a competing and confusing array of alternatives to choose from,” said Edwards.

“The regulators – both in the UK and the US – have been clear that they wish to see no new USD LIBOR-denominated transactions, and require banks to reduce the number of legacy transactions.

“However, globally, not all regulators may take the same view, and it is not always crystal clear how a new transaction is defined. This is the problem of new drawings under pre-2022 uncommitted facilities.”

From the menu of available alternatives, Edwards’s personal recommendation is on the Term Secured Overnight Financing Rate (SOFR).

Term SOFR is an observed rate based on real transactions, and is published by the Federal Reserve Bank of New York as both an overnight rate and as 30-, 90-, and 180-day compounded averages of observed rates.

“The direction of travel is clear, not least because Term SOFR is where the liquidity is and where it percolates through,” said Edwards.

“Needless to say, ITFA will be doing its best to clear up the confusion.”

Trade Finance Global has also been involved in clearing up that confusion, having partnered with ITFA to launch a LIBOR For Trade Finance Hub in June last year.

BAFT Calls for ARRC to Endorse 12M Term SOFR

Observers at another industry body, BAFT (Bankers Association for Finance and Trade), have had a similar experience as ITFA’s Edwards.

Diana Rodriguez, Vice President for International Policy at BAFT, agreed that no one rate will replace USD LIBOR in the short-term.

Instead, it will be up to banks to decide which one best suits their needs, now that two tenors of USD LIBOR have ceased, and regulators have been clear that the remaining tenors are for new contracts or renewals.

At BAFT, Rodriguez said she has seen a “significant uptick” in the use of Term SOFR, which was endorsed by the New York Fed’s Alternative Reference Rates Committee (ARRC) in July last year.

She added that the Bloomberg Short-Term Bank Yield Index (BSBY) is also under consideration among BAFT members for certain trade finance products.

“For now, what we are seeing is that one rate will not replace LIBOR,” said Rodriguez.

“Regardless of which rate an institution chooses, bank examiners will want to see that a bank is meeting the safety and soundness principles laid out by regulators.”

Rodriguez stressed that banks should have a clear understanding of the composition of the rates they intend to use, and should have transition plans in place for committed and uncommitted facilities alike.

They should also have plans to effectively communicate with clients throughout the transition process.

“In the final months of 2021, regulators issued clear regulatory guidance, stating that banks need to employ risk management plans to pivot from LIBOR to alternative reference rates,” she said.

“In the coming weeks and months, the trade finance industry would like to see the ARRC formally endorse the 12-month Term SOFR rate, as well as greater industry coalescence on the credit adjustment spread.”

Communication is Key – JPMorgan on Delivering LIBOR Transition to Clients

At JPMorgan, America’s largest bank by market cap, the challenge of communicating LIBOR transition to clients has also been a high priority.

Natasha Condon, Global Head of Core Trade at JPMorgan, said that LIBOR transition presented not just one challenge for the bank, but several challenges rolled into one.

”Firstly, a strategic one, to align the bank’s funding model with regulatory guidance, which has changed multiple times during the preparation stage,” said Condon.

“Secondly, a technology challenge, as not only our systems, but all of our clients’ systems need to be updated to handle the new risk-free rates.

“And thirdly, and most importantly, a communication challenge for the bank with its clients – both corporates and financial institutions.”

Echoing both ITFA and BAFT, Condon said the transition at JPMorgan was well managed, thanks to early preparation and close cooperation with clients.

“The working group at JPMorgan did a fantastic job of managing this transition on all points, and from a technology perspective, I could not have asked for a smoother switchover,” she said.

“But especially in trade finance, I think our key strength has been in client communication, which turned out to be the most critical issue of all.”

Condon acknowledged that, for clients, the LIBOR transition has the potential to be “very confusing”, since different banks may take different approaches to the pricing of a deal, which can make it difficult for clients to compare quotes between providers.

“Our clients in trade finance vary from the most sophisticated banks and corporates – who are already set up to handle multiple rates and fully understand the differences – to smaller clients who have never heard of any of the alternative rates, and have been working happily from LIBOR for many years,” she said.

In practical terms, Condon said that much of the heavy lifting behind the LIBOR transition at JPMorgan therefore fell to the sales team, who were called on to educate and inform clients, and pitch alternatives that best suit their needs.

“The key for our transition was to agree a very simple, extremely transparent communication plan, so that every client who gets a quote from JPMorgan understands exactly what rate they are being offered, and how that compares to the rate they might have been used to before,” she said.

“A lot of the burden fell on our sales team to take our message to the clients, and to ensure they were completely clear on what we were doing.

“As soon as we started communicating in this way, we found that our conversations with clients improved dramatically, and they were much more comfortable doing business based on the new rates.”