In responding to the latest credit crisis, Basel committee has proposed a new capital standard, Basel III. The new standard is expected to fundamentally strengthen international banks' capital position. In various research papers shaping the new standards, Basel committee identifies that off-balance sheet items are sources of "potentially significant leverage". Thus, it is expected that the new standard is going to increase constraint on these off-balance sheet items by pressing stricter credit risk parameters estimation under the Basel Advanced Internal Ratings Based (AIRB) approach. Trade finance (TF) portfolio is a major business line in almost all international banks. Hence it is subject to the new standard. As a result of their features and structure, TF products fall into this off-balance sheet category. To be in compliance with Basel accord, banks have to design new internal credit ratings system and submit this system to regulatory authority for approval. One key input in the Basel AIRB approach is Loss-Given-Default (LGD) . This paper argues that in determining LGD value, TF deserves a more favorable treatment than other conventional lending products, such as corporate term loans and revolvers.
Problem The greatest challenge for banks to accurately estimate LGD is the limitation of available data. There are very few default observations available for TF due to its low credit risk profile. Most defaults were related to sovereign insolvency occurred in Asia, Russia, and Latin America during regional economic crises. As a result, expert opinions from credit risk and trade professionals should be heavily relied.
Solution A feasible approach for banks to meet this compliance challenge is to adjust downward LGD estimates predicted for other lending business lines such as corporate lending to reflect the difference in credit risk profiles between TF and corporate lending by relying on qualitative research as well as expert opinion. Comparing to TF portfolio, corporate loan portfolio has more recovery experience so that LGD values for corporate loan exposure can be reasonably estimated by using statistic methods. This paper gives qualitative support to this downward adjustment.
Qualitative Justification There are two qualitative arguments that banks can use in their efforts to seek regulatory bodies' approval for preferential and distinct treatment for TF: 1) TF's importance in general economy and 2) TF's low credit risk profile.
TF's importance in general economy There is global recognition of the lower risk profile of TF than conventional lending. Many governments and multilateral organizations give TF products preferential treatment as a result of their importance to economy. The following are two examples of this recognition.
International Monetary Fund (IMF) In its own research, the IMF recognizes that emerging markets have historically relied on trade to keep their economies functioning during financial crises. It notes that, when facing difficulties, most countries have not suspended payments on trade credits. In fact, authorities have provided funding directly or through the banking system to trade parties to ease TF shortages, evidences of which can be found in Brazil, Korea and Indonesia. IMF believes that a "coordinated framework for trade finance" is essential for crisis resolution. While the IMF does not go so far as to exclude trade from off-balance sheet items, it does raise an explicit provision on the seniority of TF instruments.
World Trade Organization (WTO) One of WTO's main tasks is to reduce obstacles to international trade among its more than 100 member countries. WTO also delivers a legal and institutional model for implementing and monitoring of trade agreements. These trade agreements among its members provide an extra layer of protection for international trade activities including TF transactions. WTO is also proactive in supporting trade financing, as well as global trade. As the economic crisis took hold in the second part of 2008, WTO was quick to recognize the impact on global trade and the rising cost of trade finance instruments. Given the role played by risk management in this trend, on September 15, 2009, the Director-General of WTO requested, on behalf of the trade and trade finance community, that "the banks should continue to work with the Basel Committee on Banking Supervision on increasing the flexibility of the Basel II rules, with the aim of coming up with tangible solutions at its next meeting," in which the Bankers' Association for Finance and Trade (BAFT) said a "more rational treatment under Basel II of trade finance, given its fixed, short-term, self-liquidating nature, will ultimately have a positive effect on the trade finance markets."
TF's low credit risk profile As noted above, TF often enjoys preferential treatment from governments, central banks, regulators, and market participants. As a result, TF is widely considered to have lower risk than other traditional bank lending products. In addition, TF with bank counterparties has special features and structure that helps further mitigate credit risk. These features and structural elements are highlighted as follows: Short-term: Typically, term to maturity for TF is within one year. Non-renewable nature: Unlike other lending instruments, such as revolvers that can be automatically renewed upon maturity, TF cannot be rolled over at the end of contract. The bank can act proactively if it is not comfortable with the credit standing of the counterparty. The short term nature discussed above also allows the bank to act quickly in times of rapid market deterioration. Documentation: Underlying assets of TF transactions are subject to strict documentation requirements, which are often based on standardized codes of practice, such as ICC Uniform Customs and Practice. These codes provide a measure of control and security since risks can be mitigated by the title of underlying goods. Double-assurance: When the counterparty for a TF transaction is a bank, there are two opportunities to recover upon default, either from the counterparty bank or the importer. The importer will often pay the lending bank directly to protect its banking relationship with the LC issuing bank and its business relationship with the exporter. Governmental support: Governments support TF transactions because TF finance is essential to strategic industries and critical commodities, such as food and energy. Therefore, trade credit products are less risky than conventional lending products because of their special features and structure. In addition, trade credit with bank counterparties specifically, offers further advantages that reduce the level of recovery risk.
Conclusion Given the overwhelming global consensus of the importance of TF, and limited loss recovery experience, TF portfolio deserves a more favorable treatment under AIRB in the modeling of LGD within the scope of Basel III accord than other higher credit risk lending instruments. In addition, banks should consider using qualitative analysis in their efforts to seek regulators' approval for LGD preferential treatment for TF portfolio.