Expected trade finance disruptions create opportunities for alternative providers

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Trade finance firms are scrambling for position as the business of funding companies’ imports and exports is expected to face significant disruption over the next few years.

With new banking regulations coming into place and the credit quality of foreign trade partners improving, traditional trade finance instruments such as letters of credit (LOC) are falling out of favor. A number of industry experts interviewed for this article have observed that in an increasing number of situations banks are exiting the business of processing LOCs as companies gravitate toward alternative means of financing. Tim House, a Wells Fargo banker who published an article on this subject earlier this year, noted that large retail importers are shifting their suppliers to open account trade terms instead of letters of credit. He noted that many banks are evolving from traditional trade financiers into complete supply chain information managers in order to deal with these changes. Meanwhile, other service providers and financial firms are looking for ways to fill the void.

UPS Capital is witnessing these changes first hand. Boutique investment and trade finance firms have been approaching the company about potential partnerships aimed at making it easier for companies to export goods, said Chris Vukas, senior managing director at UPS Capital, which is the financing arm of the global logistics company UPS.

Such a partnership would make sense for all parties involved. The expertise and on-the-ground information that UPS brings would help lenders better understand credit risks associated with funding companies, Vukas said. In turn, partnering with a dedicated finance firm would allow UPS Capital to fund more companies conducting international trade, he said. As for the customers, they would be able to solve logistics and shipping problems as well as their financing needs in one place.

While UPS Capital has not determined any exclusive partnerships with financial firms, Vukas said the company could pair up with as many as 10 to 15 different firms, each dedicated to a specific financial instrument such as credit insurance or receivables factoring. This type of turn-key solution for companies selling goods abroad will be the pattern for years to come, Vukas added.

“Trade finance in the future won’t be different silos of one company doing insurance, one doing shipping, one doing financing,” Vukas said. “It’s all going to come together to support trade.”

Bank of the West also sees opportunities in the trade finance field and is working on streamlining its supply chain finance platforms for small and medium sized enterprises, said Stephen Herrick, senior trade manager for the BNP Paribas-owned bank.

Supply chain finance is an umbrella term many banks use for services that allow companies to track the movement and payment of goods through its various suppliers and customers. The service is usually done on a web-based platform where companies can track goods in real time. The banks plugged into this system will offer a discounted upfront payment for shipped goods.

The system has worked well for large corporations with a vast network of suppliers and customers, but is not cost efficient for smaller companies, said Herrick. The upfront costs of inking all the legal agreements and contracts to set up the system can be overwhelming for smaller companies, he said. Bank of the West has been working on simplifying a process that large corporations have long-since adopted.

“Many of these systems work for companies with a large volume of transactions,” Herrick said. “We’re working on standardizing the documentation of these programs in such a way that smaller and mid-sized companies can easily participate.”

While the turn-key services that UPS Capital and Bank of the West envisions are only starting to develop, specialized trade finance firms are still seeing business boom.

Commercial banks reined in credit availability after the financial crisis hit in 2008. That left a lot of opportunities for smaller firms to help fund exports.

“There’s virtually no competition for us,” said Richard Lopez, managing partner of the Miami-based trade lender Drake Finance. “Banks are doing less and less trade finance for small and middle market companies.”

Drake Finance’s trade finance business specializes in financing the foreign receivables of small and medium sized enterprises, with most of its customers exporting to Latin American and Caribbean countries. Many times these companies cannot find financing from local commercial banks because the transactions they do are not big enough or the company does not meet the banks’ internal credit criteria. The firm chooses the companies that have insurance policies from the U.S. Export-Import Bank or helps them obtain that insurance and extends financing. To manage its own capital, the firm then usually sells that paper in the secondary market to non-commercial banks that buy Ex-Im Bank insured paper, said Lopez.

The firm launched its receivables financing business as an experiment about a year ago and has already lent out about USD 10m in loans to companies doing business abroad, Lopez said. The firm originally started as an equipment and agriculture financing firm in 2003, but the foreign receivables financing has proven a more successful and profitable business, Lopez said.

The firm is planning to expand its operations to Southern California, near the ports of Los Angeles and Long Beach. Gaining a presence on the West Coast would make the firm better suited to deal with companies exporting to Asian countries as well as access to two of the busiest ports in the U.S.

The company wants to open an office in the Santa Monica area in the next year or two, said Lopez.

The decline of letters of credit

One of the major causes of this changing landscape is the new Basel III framework, which is a set of reform measures and regulations on the global banking sector set by the Basel Committee on Banking Supervision, a group created by the central banks of G-10 nations. Banks from the major financial centers around the world begin adopting the new standards in 2013, but the transition process begins this year.

An oft-cited consequence of the new framework is the negative effect it will have on the availability of traditional trade financing instruments, such as letters of credit. The new standards will require banks to dedicate more capital against letter of credit commitments and other types of financing. The purpose of the changes is to force banks to deleverage their balance sheets to prevent future banking crises. At the same time, banks stand to face a five-fold increase in the cost of providing traditional trade financing, according to an October 2010 report from D&B, a business research firm.

Payment methods based on letters of credit used to be the gold standard in conducting business with foreign customers. As usually used in international trade, an exporter of goods who is wary of the credit quality of the buyer will ask the buyer to issue a letter of credit. The buyer will ask its bank to issue the letter of credit, which is essentially that bank’s promise that it will make the payment for the goods instead of the buyer. The seller of goods reduces the risks associated with the trade by basically replacing the questionable credit of the buyer with the more trustworthy bank. Sometimes the seller’s bank or other intermediary banks will step in to negotiate and verify credit agreements and related documents. The whole process is labor intensive and costly for companies and requires meticulous documentation.

More and more companies are eschewing doing business overseas on a letter of credit basis. A large part of this is due to banks slowly pulling back on issuing LOCs in anticipation of the new banking regulations coming into effect.

Another reason is that companies in the U.S. are becoming more comfortable with doing business with overseas trading partners. For example, companies exporting goods to China and Brazil, two major trade partners with the U.S., have for years relied on letters of credit. The two countries only received investment-grade status by Standard & Poor’s in 2008, which improved the credit quality of the companies based in those countries. The trend in recent years has seen companies move toward other types of financing when doing business with Chinese or Brazilian firms.

“There is a built in prejudice against letters of credit because it’s a mechanism used when you don’t have a lot of faith in the credit quality of the company on the other side of the transaction,” said Bank of the West’s Herrick.

“But as you get to know your customers better, you work your way down to other types of financing,” Herrick added.

That is not to say that letters of credit will fall out of favor completely, Herrick said. It is still a valuable tool for companies doing business with foreign organizations with questionable credit quality or in countries where there is a high political risk, he added. For instance, many companies exporting to Middle Eastern countries still conduct most business on a letter of credit basis, he said.

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