Banks will face higher capital requirements for common trade finance instruments such as stand-by letters of credit, guarantees and warranties under plans unveiled by the UK’s prudential regulator.
The Prudential Regulation Authority (PRA) has proposed to increase the capital provision banks must make for several off-balance sheet trade finance items, which it says will better reflect the higher risk they pose.
The plans are part of the regulator’s proposed implementation of the final tranche of Basel IV banking reforms, which were conceived in response to the 2008 global financial crisis and are designed to standardise risk measurement and the comparability and consistency of capital ratios.
Under existing UK laws, inherited from the EU’s Capital Requirements Regulation, banks are required to make a capital provision of just 20% for such exposures with a maturity of more than one year.
However, in a November 30 consultation on the UK’s implementation of the Basel IV, the PRA said it plans to lift that provision to 50%, mirroring what it sees is heightened risk that banks will have to pay out under the instruments and convert them to balance sheet items.
The changes will apply to letters of credit (LCs) with a maturity of one year or greater, warranties including tender and performance bonds, irrevocable standby LCs and shipping guarantees. The conversion factor applied to self-liquidating LCs with a maturity of less than a year would remain at 20%, according to the consultation.
The PRA says that it “has reviewed relevant empirical data and analysis relating to these transaction-related contingent items” and “considers that the existing 20% [conversion factor] does not fully reflect the risks of these items”.
The conversion factor should reflect the probability of a “trigger event”, short of a counterparty default, that could engage the financial institution’s obligation to pay, the PRA says. A spokesperson for the regulator declined to comment when asked what data had informed its decision to opt for a higher conversion factor.
The planned reforms mirror the European Commission’s approach to Basel IV implementation, published in 2021, which triggered a backlash from some of the continent’s banking heavyweights and large corporations, who united to lobby against the reforms. The Commission and European Council are currently negotiating over the final version of the updated rules.
Trade finance providers argue that trade finance is a low-risk asset class with paltry default rates, but the UK and EU’s plans to raise capital requirements on some trade finance instruments underline the struggle the industry has faced to persuade regulators and the Basel Committee on Banking Supervision.
Lobbying efforts lean heavily on the International Chamber of Commerce (ICC) Trade Register, the most comprehensive data available on the performance of trade finance products, but those who work on the project acknowledge that the limited dataset it draws from is not persuasive enough to convince regulators.
The most recent iteration of the trade register showed defaults across trade finance asset classes fell in 2021 following a small uptick during the first year of the pandemic, according to a summary of its findings published in October.
For import LCs, the default rate per obligor was 0.29% in 2021 and just 0.05% for export LCs, according to the figures. Defaults per obligor for performance guarantees also dropped to 0.26% in 2021 from just under half of one percent a year earlier.
In a submission to the European Commission on its proposals earlier this year, the Bankers Association for Finance and Trade said default rates on technical guarantees are only 0.24%, meaning the proposed 30% lift in the conversion factor would be “excessive and does not seem justified or appropriate”.
The proposed changes in the EU will increase the capital charge on the affected instruments by 150%, according to a joint paper by banking associations in Denmark, Finland and Sweden also submitted as part of the Commission’s feedback process. The cost of a €10mn performance guarantee for a corporate customer would rise from €50,000 to €125,000 under the proposals, the associations said.
UK banks are still digesting the consultation and crafting their position, according to Sean Edwards, chairman of industry group the International Trade and Forfaiting Association. But he says that if the reforms go ahead as planned, the cost of the products are likely to go up.
“If they are going to be more capital intensive, there’s probably going to have to be an increase in the price,” he tells GTR. “So, we’ll either have to charge the customer more or make even less profit on them – and they’re not on the whole terribly profitable products.”
Long-term off-balance sheet instruments are a small but “indispensable” part of corporate trade finance needs and are usually provided as part of a broader relationship with a customer, Edwards says. “It is going to cost us more or some relationships are going to have to be reviewed.”
The PRA is inviting feedback until the end of March. The EU’s final position – although it will also have to be approved by the European Parliament – is likely to coalesce while the PRA’s consultation is underway or it is still mulling the responses from the industry.
The regulator “expects other jurisdictions to apply broadly similar conversion factors for off-balance sheet items and, therefore, the proposals should not adversely impact competitiveness”, it notes in the consultation.
Edwards argues that if the EU drops the planned hike to a 50% conversion factor, the UK will have to follow suit or London will lose business to its rivals in continental Europe.
The PRA has also mooted changes to the risk weighting for exposures to SMEs, including abolishing a “support factor” for SMEs introduced after the financial crisis but also slightly lowering the risk weight for unrated corporate SME exposures.
Sam Woods, the PRA’s chief executive, said in a statement concerning the entire reform package that “alignment with strong international banking standards promotes economic growth by underpinning the competitiveness of the UK as a financial centre, supporting investors’ confidence in the UK banking system and ensuring that banks can finance the economy during downturns”.
“Our proposals for implementing the latest Basel standards, with appropriate but limited adjustments for the UK market, aim to deliver these goals,” he said. “We encourage anyone with an interest to send us their views and evidence.”
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