Feared trade finance squeeze compels bankers to explore alternatives

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Banks are developing what could become a primary market for institutional investors to participate in trade finance as new banking regulations could potentially squeeze traditional sources of capital.

The comments were made this week at an annual international trade conference in New York hosted by BAFT-IFSA, a global financial services association. The group plans to keep ongoing discussions on getting new investors to consider trade finance as an asset class as well as further discuss the topic in a conference scheduled early next year, the trade association’s chairman who also serves as vice chairman for Barclays, on the sideline at the conference yesterday.

The ultimate concern for bankers is that traditional sources of capital for trade finance could potentially be constrained with the new Basel III regulatory frameworks coming into place, Wilson said. Trade finance bankers will need to find alternative sources of investment to keep fueling the movement of goods between countries or be forced to decrease lending capacity, he said. There is still a considerable amount of money under management at institutional investing firms, such as mutual funds or pension funds, that can be invest in trade finance, he said. So while a primary market – that operates like the leveraged loan or high yield bond market, for example – is not an explicit goal of these bankers, it may be a logical conclusion, Wilson said.

The simplest way to market trade finance deals to investors is through securitization – that is, amassing several individual import or export transactions into one large portfolio that a firm can invest in. However, the term securitization still carries a negative connotation in the public and some financial circles, so it may be difficult getting people unfamiliar with trade finance on board, Wilson said.

That is somewhat counterintuitive because trade finance is one of the safest forms of banking in existence, at least according to bankers that arrange those transactions. The industry is definitely an old line of banking. Ask any trade finance banker and they will tell you that it goes back to ancient Greek times when banks financed merchants delivering goods to new markets. At its heart, trade finance fuels the movement of goods across borders.

In the US, trade finance never took off as an active asset class for several reasons, according to bankers present at the conference that chose not to be named. The types of financing can vary widely – from foreign accounts receivable factoring to letters of credit – and each of those financings have specific subclasses and can vary depending on whether it is funding an export or import transaction. So it is not easy to bundle them up into homogenous financial products. Trade finance also tends to comprise smaller transactions because they are financing individual or a small series of sales. This makes it harder to sell on to large money managers, who prefer to have large, “chunky” deals in their portfolios that are easier to keep track of.

Commercial banks’ traditional investor position threatened by Basel III

But most of all, according to several bankers, there was never a real need to sell trade finance to other investors. Commercial banks have been the traditional investors in these types of transactions. However, new regulations threaten this system.

While the Basel III rules have yet to be clearly defined, it is clear that the framework will require banks to have a higher capital allocation on their balance sheet as a ratio to the amount they are lending. In theory, this will make many types of bank loans – including trade finance – more costly to lend. Many banks have been saying that these costs will likely be passed onto the borrowers of the funds.

But a bigger concern is that banks will just stop buying trade finance transactions altogether. And companies will still need financing to export or import goods, so making it easier for other financial institutions to invest is key for the future of trade finance.

Signs of market dislocation are already happening, said John Ahearn, managing director and global head of trade at Citigroup, who spoke on a panel at the conference. Many banks have been offloading entire portfolios of trade finance loans at “fire sale” prices – about 80 cents on the dollar in some cases – because they are determined to be Basel III compliant at the beginning of next year, Ahearn said on the panel. There is a phase-in period for Basel III compliance, but no bank wants to be late to adopt new regulations because of perceived effects of public image and the real effects of increased cost of capital, he said.

This is an especially important issue in the US as many researchers and economists believe the country needs to export more goods in order to emerge from its economic slowdown. President Obama announced in 2009 the administration’s goal of doubling exports in five years’ time and while reports have shown that this goal is on track, the financial tools needed to help achieve it are encountering constraints.

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