Transaction Services

Trade Finance — Protecting the Engine of Global GrowthOctober 2012

Trade Finance — Protecting the Engine of Global Growth | Contents 1

Welcome 02

Foreword 03

Executive Summary: Trade Finance — protecting the engine of global growth 04

Introduction: Trade Finance today and tomorrow 06

Key trends and considerations for the Trade Finance space 08

Basel III and how it impacts Trade Finance 10

Protecting Trade: Key Recommendations 15

Conclusion 17

About the Author 18

Contents

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We have immense intellectual capital across our global network at Citi, and are committed to harnessing this resource for our clients and the communities in which we operate. One key way in which we are leveraging our network is by enabling the growth of world Trade and prosperity. In this context, I am pleased to present the third paper in our series: Trade Finance: protecting the engine of global growth.

In this paper Citi’s policy expert explores the implications of Basel III on global Trade. In collaboration with our Trade Finance business, the practical challenges of the proposed Basel III prudential framework on the provision of Trade Finance solutions, including impacts on cost and competition, are analyzed in detail with a view to highlighting alternative approaches to ensure that Trade Finance will not be negatively impacted by the changes in the global prudential regime.

Citi has been doing business in the world for more than 200 years now. We have a strong vested interest in the international financial system, and have been working in close coordination with other market participants to ensure we maintain a robust and competitive Trade Finance offering around the globe.

We hope that this paper will encourage dialogue and debate among governments and businesses today about our collective responsibility in support of global Trade and growth.

Naveed Sultan Global Head of Treasury and Trade Solutions Citi Transaction Services

Welcome

Trade Finance — Protecting the Engine of Global Growth | Foreword 3

John Ahearn Global Head of Trade Citi Transaction Services

The combined forces of globalization, consolidation, and regulation are dramatically changing the nature of global Trade.

Basel III, which is designed to improve the resilience of the banking sector, will have an impact on Trade Finance – including the proposed changes in capital requirements and the potential adverse affect on companies involved in the import/export business, particularly in emerging markets. Profound changes in global Trade are also forcing financial institutions to reassess their Trade Finance business models. Many may have to alter their current risk diversification, operating and over arching partnership strategies in order to serve their clients in new Trade markets.

As the implications of these forces play out, financial institutions, and their corporate clients, will have to make a number of strategic decisions about how they do business.

This paper provides a deeper insight into the world of Trade Finance, highlights the challenges currently observed in the market, and presents the risks to global Trade if the Basel III regime as proposed in 2010 is not amended. We also propose key policy initiatives and provide insights we have gained as a leading provider of Trade services and industry advocate for a collaborative approach to change in coordination with the national and international regulatory bodies.

Foreword

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It is commonly agreed that Trade is a key pillar of the global economy. In response to the global crisis, Trade experienced a contraction of 23% in 2009. In order to support global trade’s essential growth trajectory in a sustainable way going forward, the impact of a future financial crisis needed to be assessed and steps taken to reduce the risks associated with such an event.

The Basel Committee for Banking Supervision (BCBS) delivered a set of key measures developed for this purpose when it proposed a revised framework in 2010, known as Basel III, defining measures across a plethora of areas to stabilize the prudential regime of the banking sector. However, the nature of Trade Finance transactions - short-term, self-liquidating or long-term government backed - was not sufficiently taken into account within these proposed measures, resulting in a rather unfavourable set of outcomes that could constrain the growth of the real economy as a consequence.

Citi, as a leading provider of Trade Finance, strongly supports the development of emerging markets and operates in over 100 countries. With a view to providing a deeper insight into the area of Trade Finance, this paper aims to highlight the challenges currently observed in the market and the risks posed to the future of Trade Finance, and hence to Trade itself, if the Basel III regime as proposed in 2010 is not amended. We also identify and analyze key trends that can shape global Trade and Trade Finance in the coming years. Additionally, we highlight examples of key policy initiatives and principles that we believe are particularly important in achieving a balanced regulatory response that would limit unintended consequences to the area of Trade Finance.

Our recommendations to the Basel Committee as well as all national regulators are focused around seven key areas:

1. In relation to the additional capital requirements for global systemically important banks (G-SIBs) regulators should focus closely on maintaining a competitive level-playing field across participating banks in the Trade Finance space, in particular in the context of the different capital treatment of G-SIB and non-G-SIB banks.

2. In the context of the leverage ratio regime, the Basel Committee and national regulators should re-instate the Basel II credit conversion factors of 0% - 50% for Trade Finance transactions in order to take into account the specific nature of Trade Finance transactions, which is predominantly short-term and self-liquidating. This would limit potential negative impacts on global Trade growth. In addition, the Basel Committee should consider the embedded credit agency guarantees as relevant risk mitigating measures in relation to long-term Export Credit Agency Trade transactions.

3. Regulators should include short-term Trade instruments as liquid assets (with appropriate haircuts) in the calculation of the Liquidity Coverage Ratio. Also, regulators should apply a reduction in the deposit run-off factors for transaction banking (especially for FI transaction balances) and permit the use of advanced internal modelling methodology to establish run-off and stable funding factors to better reflect the reality in the market. From an international perspective, at the level of the Basel Committee, clarity around concepts and definitions is needed and an elimination of extraordinary draws from Trade Finance facilities (e.g. unutilized Trade facilities) is strongly recommended.

Executive Summary: Trade Finance — protecting the engine of global growth

Trade Finance — Protecting the Engine of Global Growth | Executive Summary: Trade Finance 5

4. Regarding inter-bank exposures, the Basel Committee should refrain from applying the 1.25 Asset Value Correlation (AVC) multiplier for the specific area of Trade Finance related inter-bank exposures and hence align with the limited risk of these exposures.

5. Furthermore, the Basel Committee is urged to establish a harmonised approach in relation to all types of Trade Finance transactions by requiring the use of actual tenor in place of the one-year floor, enabling the appropriate treatment of these transactions and limiting geographic arbitrage between banks.

6. More broadly, all regulators should work jointly on promoting an international level playing field and consistency of Basel III implementation across the globe in order to limit unintended consequence of arbitrage and risk concentration in unregulated jurisdictions.

7. And finally, regulators should be vigilant to ensure that their actions do not translate into unintended risk concentration with non-regulated providers.

Above all, our objective with this paper is to stimulate debate in this key subject area. We remain keen to share our ideas and insights with regulators and policy makers across the globe as part of our overall efforts to support global Trade.

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World Trade experienced a significant contraction of 23% in 2009 and even though growth rates picked up again in 2010 with 14.5% growth according to the World Trade Organization , figures show a decline in growth rate to 5% in 2011. The 2012 forecast indicates a further downward trend in the growth rate to 3.7%. The mixture of the US economy slowdown and the European sovereign debt crisis is taking its toll on global Trade. And, as WTO Director General Pascale Lamy recently put it, “we are not yet out of the woods.” At the same time banks have started to prepare for the forthcoming Basel III framework, leading to balance sheet contraction, including a reduction of Trade Finance assets in many instances.

It is worth remembering that the nature of Trade transactions is inextricably linked to the real underlying economy. In the wake of Basel III reform proposals, the industry has collectively joined forces to try to capture as much data on Trade Finance as possible in order to demonstrate to regulators that the risk and associated default rates of these types of transactions are, in reality, very very low, because of the direct link to real economic activity. In that regard, the International Chamber of Commerce Trade Finance Register is the most comprehensive dataset now available on the market and reveals that a minimum of 60-65% of traditional global Trade Finance activity is based on assets (or about USD2.2-2.5 trillion). The data has been pooled across 18 leading Trade banks globally, including Citi, and shows, for example, that the average of transactions in the market is short tenor (ranging from less than 80 days to an average of 147 days). The dataset of 11.4 million transactions recorded displays less than 3000 defaults. In this regard the default rates for off-balance sheet Trade products were particularly low, showing 947 defaults in a sampling of 5.2 million transactions. The overall default rate for Trade Finance amounts to a mere 0.022% and the loss given default to no more than 40% over the 2005-2009 horizon measured in this study. It appears though that banks are unable to utilize this data. Despite low industry

defaults most IRB ratings have increased capital for all but the most highly rated.

Above and beyond this general challenge of not being able to use empirical data to prove the low risk nature of Trade Finance, European banks in particular have far bigger issues on their plate in the context of the on-going sovereign debt crisis and the increased levels of cost associated with bank debt, which is challenging their ability to provide Trade Finance. CDS for European banks have spiked, indicating a perception of increased credit risk. The impact of credit rating agencies downgrades of a number of banks and sovereigns has further impacted the cost of capital and continues to do so.

The European sovereign debt crisis is continuing to be felt by those institutions that have large exposures to GIIPS countries. This cumulative effect has resulted in a scarcity of USD liquidity for European banks, directly impairing their ability to participate in Trade and the FX market, both areas dominated by USD.

Recent interventions by the European Central bank have increased Euro liquidity; however USD liquidity remains a challenge for European banks, resulting in banks more carefully reviewing their Trade portfolios. One reason for the rather desolate conditions experienced by the European banks is the EU bank stress-testing process. Whilst the US focused on the amount and composition of capital, testing the bank’s Tier 1 risk-based capital ratios and specifically looking at the proportion of Tier 1 common equity as the most important protection in comparison to more senior parts of the capital structure, the EU considered Tier 1 capital without any specific focus on the proportion of common equity. At the level of bank asset valuation, the US included all assets whilst the EU looked at assets with the exception of those that could be sensitive to a sovereign debt shock. Consequently, the potential risk of a sovereign shock remained largely understated across Europe. Additionally, the US process required banks that failed stress tests to immediately recapitalize, whereas the

Introduction: Trade Finance today and tomorrow

Trade Finance — Protecting the Engine of Global Growth | Introduction: Trade Finance today and tomorrow 7

EU, which identified a number of failed banks in round one of the stress tests, did not require immediate recapitalization. With the latest round of European stress tests, this has now been remedied and European banks had to raise EUR 115 billion in new capital by June 30, 2012.

Even though the situation across the European banking sector remains challenging, Trade Finance at a global level will continue its growth course as long as unintended regulatory consequences in this area are limited.

In the future, Citi economists expect world Trade to expand at an average rate of 6.1% per annum (pa) between 2010 and 2030 and by 4.4% pa between 2030 and 2050, compared to a growth rate of 5.4% pa between 1990 and 2010. In figures, world Trade would rise from $37trn in 2010 to $122trn in 2030 to $287trn in 2050.

The key message is that growth in Trade is not expected to follow the ‘old’ patterns seen over the last two centuries. Instead, expectation over the next forty years will be transformational. What is new, at least since the industrial revolution of the late eighteenth century, is the prominence of today’s emerging market economies in world Trade. Emerging Asia is set to overtake Western Europe to become the world’s largest trading region by 2015. We expect China, already the world’s largest exporter in 2010, to be the world’s largest trading nation by 2015, overtaking the US. Emerging Asia is positioned to become the largest region by Trade in 2025 and India, currently not even on the list of the 10 largest nations by Trade, is to overtake the US and Germany to become the world’s second largest country by Trade in 2050. We also expect Africa, a continent mainly notable for its absence in the first two waves of globalization, to more than double its share of world Trade from 3% in 2010 to 7% in 2050. Latin America is another key geography braced for accelerated growth. With the rise of emerging markets the intra emerging market Trade has already increased significantly from the 6% of world Trade in 2000 to 15% in 2010 and is set to account for 27% of world Trade in 2030

and 38% in 2050. These transformations will change Trade relationships around the world with implications for investors, supply chain managers and policy makers.

With the continuing rise of China and India becoming strategically important, it is likely that the focus on the US, the EU and Japan as export destinations will diminish. A number of factors will determine the strength of emerging regional trading hubs, such as the scope and quality of transport infrastructure (roads, railways, airports, seaports) and the efficiency of infrastructural services (logistics, communications, transport, etc). But, above all, the legal and regulatory environment is going to be a key element in the likelihood of a country developing into a major trading hub. If the western world wants to continue to play a leading role in this space, the policy approach would need to align with this objective. There is a significant risk that a number of ongoing developments, in addition to the future outlook, will re-shape this part of the market place in a way that may not be beneficial to the developed world. Harmonised Basel III implementation will be a key ingredient to the creation of global financial stability and effective competition.

1 2011 and 2012 WTO Report

2 http://www.wto.org/english/news_e/pres12_e/pr658_e.htm

3 Global Risks – Trade Finance 2011, ICC Report, http://www.iccwbo.org/uploadedFiles/ICC-Register_Report_26_October_2011.pdf

4 It is estimated that 60% of international financial transactions are dominated in USD and 86% of FX transaction volumes (FED 2010).

3 From 2011 and 2012 WTO reports

5 Trade Transformed: the emerging corridors of trade power, Willem Buiter and Ebrahim Rahbari, October 2011, http://willembuiter.com/trade.pdf

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Regulatory change impacting Globalization The existence of the Basel III recommendations is already having an impact on the markets. With banks looking to increase quality capital and plan their portfolios in anticipation of Basel III, financial support is dwindling in many sectors, most of which are reliant on this support and hence also the most vulnerable. Governments are starting to react with measures intended to protect national markets and national taxpayers from potential risk of bank failures. This is translating into a more concerning consequence on globalization as it translates to what we could call ‘regulatory nationalism’.

By creating a situation where international financial institutions may see their liquidity trapped in each of the jurisdictions in which they operate, consequences on the global economy are going to be an unwelcomed side effect. Limiting the ability to move money will translate into inefficiencies and contribute to de-globalization. Restricting the ability of international financial institution to net off their exposures reduces their ability to price competitively and hence will result in a general increase of price levels in all areas of financial products, Trade Finance included.

The impact of these measures on companies needs to be equally considered. Where businesses are today on an ongoing journey of expansion and globalization, their global banking partners play a key role in enabling them to leap-frog and cross-pollinate. Both company and financial institution learn from each other. Global banks such as Citi are a key building block to enable expansion of businesses into new territories. Knowledge transfers help the business navigate a country’s market,

regulatory and infrastructure dimensions, allowing faster time to market and support on the financial transaction side. It would be detrimental if global banking partners were to be put in a situation where they were effectively forced to de-globalize, hence being unable to provide their services across the globe to where their clients are.

Extra capital charges foreseen under the Basel III regime for global systemically important financial institutions (G-SIFIs) can be considered a clear indication of the fact that the global banking model is being dis-incentivized. This, however, will also have significant negative impacts on the competitiveness of local markets. By creating a barrier around local markets these markets will become less efficient and more insular. The need for competition and value added will be more limited and even recourse to efficient outsourced solutions from international providers will not be necessary as competition will reduce overall.

A final element to consider is the potential fragmentation of Basel III implementation. If a number of economically important countries and regions were to implement Basel III along differing timelines and in ways which deviate from the global standards, this could trigger capital arbitrage across the banking spectrum and counter the objective of increasing global consistency and integration to the benefit of trade. It can already be observed that countries that have begun Basel III regulatory developments – in particular Europe and more recently the US – are following different approaches for example in relation to the leverage ratio and minimum capital floors.

Key trends and considerations for the Trade Finance space

Trade Finance — Protecting the Engine of Global Growth | Key trends and considerations for the Trade Finance space 9

Challenges to efficient capital allocationThe incentive for banks to invest in productive systems development with a view to improving efficiency for clients and saving cost is being continuously reduced. Rather, banks’ technology development investments are designed to meet the increasing number of regulatory requirements. These investments are significant and the increasing costs can hamper the ability to deliver value-add solutions to clients. Basel III will require significant investments in liquidity buffers. Today, this cash is utilized to deliver solutions and services to clients. Tomorrow, these funds will be put ‘out of use’. In the same vein, the objective regulators had in mind with the liquidity regime appear to be counterproductive in practice. Another example of increasingly inefficient capital allocation is illustrated by the recent activities of the European Central Bank (ECB). The fact that banks in Europe are placing the cash they borrow from the ECB back with the ECB as opposed to performing lending to the wider economy, which would in turn boost economic development, shows exactly that. The productive use of capital is reduced and the economy suffers as a consequence.

Concentration versus CompetitionThere is also a paradox that can be observed in relation to one of the regulators’ other core objectives - to create more competition - given that the new rules will not only raise the barrier to entry for new providers of financial services, including Trade Finance, but arguably lead to a concentration in the market place. Fewer players will translate into price concentration and the emergence of a seller’s market whilst more providers

would reflect a buyer’s market where competition is strong. This is an area that clearly demonstrates the benefits of market forces. If, through regulatory intervention, market participants are limited in their ability to choose the risks and amount of leverage they consider appropriate, the overall supply of Trade Finance will significantly reduce but also the level of competition and the degree of diversity in business choices and strategy will gradually fade away, ultimately leading to harmonized behavior on the supplier side, with little choice on the buyer side.

Shadow BankingThe Financial Stability Board has estimated the size of the global ‘shadow banking’ system at ~ EUR 46 trillion in 2010, a sharp increase from EUR 21 trillion in 2002. These figures are significant, representing 25-30% of the total financial system and half the size of bank assets. The emergence of the shadow banking sector has led to increased focus from regulators, e.g. with the EU Commission’s recent consultation in March of this year. While there has not yet been a significant shift of Trade assets to the less regulated non-bank financial institutions it is a potential outcome from Basel III. A more consistent and comprehensive approach by regulators across all financial sectors, including shadow banking, will ensure a level playing field and an appropriate level of regulation going forward. Otherwise there is likely to be a large shift out of Trade assets from regulated banks to other less regulated, and perhaps less capitalized, parts of the financial sector.

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The experience with the earlier Basel regimes showed that quality, consistency and comparability of regulatory capital are key ingredients to a more stable financial market. In the past different forms of capital, including hybrid capital were permissible. Basel III now defines that the predominant form of regulatory capital must be common shares and retained earnings – Tier 1 common equity. Banks are now required to hold a minimum of 4.5% of common equity tier 1 capital (of a bank’s risk-weighted assets), a total of tier 1 capital of at least 6% and total capital of at least 8%.

But that is not the whole story. Two additional capital buffers are also being introduced, which may result in constraints on capital distribution. And for G-SIBs additional capital requirements ranging between 1% and 3.5% have been added within the global framework. To supplement the revised capital framework, Basel III also introduces a non-risk-based leverage ratio of 3%, which unlike the Fed’s current US leverage ratio, that is based on GAAP assets, will also incorporate almost all off-balance sheet items at a 100% conversion factor. And, finally, Basel III establishes global standards for high quality liquidity buffers, introducing the short-term Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) on the longer term sustainable maturity structure of assets and liabilities.

The new capital, leverage and liquidity requirements are already creating a disincentive for some banks to advise and confirm letters of credit or provide financing via ECAs. Coupled with that, the decreased liquidity for Trade Finance, the conditions for Trade Finance and therefore support for growth of the global economy are increasingly challenging. The most vulnerable stakeholders such as SMEs and subsidiaries of multinationals in emerging markets are feeling the effects. A phenomenon which is very much at odds with the G-20’s goals of readily available low cost Trade related funding to boast global growth.

Impacts of Basel III on Trade Finance: key issues and potential solutionsBasel III impacts the area of Trade Finance and therefore the ability to generate global growth and prosperity in several significant ways:

1. Global Systemically Important Banks (G-SIBs)

2. Leverage Ratio

3. Liquidity Regime

4. Counterparty Credit Risk

5. One-Year Floor on Tenor

Each of these is worth examining in more detail.

Global Systemically Important Banks (G-SIBs) A total of eight of the world’s top ten Trade banks have been categorised as G-SIBs. This means that additional capital of up to 3.5% will have to be held by these banks. However, banks not deemed to be G-SIBs would not have a clear advantage in the international Trade Finance space because Trade is predominantly undertaken in USD and with an overwhelming majority in G3 currencies. Even though these banks will not be required to carry the extra capital they will still be significantly exposed to this issue. Trade is predominately undertaken and funded in USD. The major Trade banks, most of which are G-SIBs, provide “wholesale” USD funding to regional/local banks around the world, which then use this USD funding to finance their own USD Trade lending to their corporate clients. G-SIB banks will be forced to raise the pricing on USD Trade funding and, given the list of 29 G-SIBs, banks in need of USD Trade funding will not be able to find other viable alternative sources for USD Trade funding. This will inevitably lead to situations where access to Trade Finance just becomes too expensive for market participants, potentially hurting global Trade as a whole.

Basel III and how it impacts Trade Finance

Trade Finance — Protecting the Engine of Global Growth | Basel III and how it impacts Trade Finance 11

The fact that not all G-SIBs have to hold the same level of additional capital will also lead to some competitive advantages and disadvantages that are likely to play out between participants - a non-level-playing field has been created by regulators.

The expected impacts of Basel III around Trade Finance for non-G3 lending will be quite different, although it would only apply to a small part of the global Trade market. Local banks have ample sources of local currency and do not need to rely on G-SIB banks to fund this type of Trade business. Non G-SIB banks will therefore have a significant competitive advantage versus G-SIB banks for local currency Trade – again reflecting the emergence of a non-level-playing field.

Whilst additional capital is an important ingredient to achieving financial stability, we would like to recommend to regulators to take into account the above considerations with a view to ensuring that no unintended consequences on the growth potential of global Trade are being triggered.

Leverage RegimeThe newly introduced leverage ratio, designed to constrain leverage and supplement the risk based measure, includes assets that today are held off-balance sheet, for example: liquidity commitments, direct credit substitutes, acceptances, standby letters of credit, Trade letters of credit, failed transactions and unsettled securities. In this regard, the Credit Conversion Factor (CCF) was increased from 0%-50% to 100% for Trade increasing capital from 1.6% to 3%. Only for unconditionally cancellable transactions the CCF has been set at 10% (still, however, representing a significant increase from the previous 0%).

Under Basel I and II, Trade-related contingent assets were converted at 0%-50%, which is commensurate with the limited risk of highly documented, short-term and self-liquidating

Trade instruments (agency guarantees, LCs, Standbys, etc.). Trade transactions are typically held off-balance sheet until processing is completed because around 50% fail original submission and many expire unutilized (86% in the case of guarantees and Standbys). Trade transactions are triggered by underlying economic activity, not driven by banks to increase bank leverage. In addition, the proposed 100% CCF fails to properly account for the value of agency guarantee for export agency transactions wherein industry losses are very low.

Whilst we support more stringent requirements in areas where the crisis has shown that risks were underestimated, the concept of a universal Credit Conversion Factor (CCF) for off-balance sheet exposures is not aligned with the actual limited risk of highly documented, short term and self-liquidating Trade instruments.

To protect Trade Finance, it would be most appropriate to reintroduce the CCF that the industry followed under Basel II. Basel II used 0%-50% CCF, not a 100% CCF for all transactions, in order to reflect the small portion of exposures that actually convert into on-balance sheet exposure in this business area.

It is worth noting here that the European Union has proposed to revert to the old CCF formula for Trade transactions in order to calculate the leverage ratio in Basel III under their Credit Requirement Directive (CRD) rules. This favourable treatment of Trade contingent assets is aligned with the risk characteristics of this asset class. However, the European Basel III rules would apply only to banks in Europe, which means that without the same treatment being implemented in other key countries such as the U.S., Trade banks would be at a significant disadvantage versus European competitors. In that context it is worth noting that the US is already moving into that direction,

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by not only proposing the full inclusion of all off-balance sheet items under the proposed 3% leverage ratio of Basel III for sophisticated banks but by also maintaining, in addition, the existing risk adjusted method of a minimum Tier I leverage ratio of 4%, which falls to 3% for the strongest firms. The fact that larger US banks are expected to have to meet both ratios is again an indication of an emerging non-level playing field, which is going against the objective of global competition across the industry.

We urge the Basel Committee, as well as national regulators, to work towards a harmonized implementation of the leverage ratio in a way that avoids detrimental impacts on Trade Finance. Therefore we would recommend the current European approach of re-instating Basel II CCFs for Trade Finance transactions that would allow a risk treatment of those assets that would be more in line with the actual low risk profile of Trade Finance.

Liquidity Ratio The new Liquidity measures do not consider short-term Trade instruments as liquid assets for the purposes of the Liquidity Coverage Ratio calculations (i.e. in the numerator) but instead include draws on off-balance sheet Trade commitments in the calculations as an outflow (i.e. in the denominator) even though commitments cannot be drawn down without verification of underlying client commercial activity unlike commercial revolvers. This means that banks will have to pile up far greater levels of liquid assets for something that is disproportionately less risky.

Under the NSFR the available stable funding ratio must equal or exceed the required stable funding ratio. This means that long-term lending will likely become more expensive because funding will have to be matched. If lenders cannot match long-term loans with long-term funding, they will need to stock up with cash or near cash, which is expensive and inefficient.

These new liquidity ratios do also have a very significant impact on cash management deposits. Under the new LCR measure

100% of financial institutions’ non-operating deposits are assumed to run-off within 30 days and they cannot be used to calculate the NSFR either. The new liquidity ratios will therefore significantly redefine the attractiveness of financial institution deposits. This is relevant in relation to Trade given the fact that it is quite common to cross sell Cash and Trade, especially to financial institutions. In many cases financial institution Trade Advances are offered at attractive pricing to capture a bank’s cash deposits. This FI cross sell model will need to evolve based on new liquidity rules.

To reduce the risk of limiting Trade Finance, the LCR should include short-term Trade instruments as liquid assets (with appropriate haircuts). At the same time a reduction in the deposit run-off factors for transaction banking (especially for FI transaction balances) should be applied and the use of advanced internal modelling methodology to establish run-off and stable funding factors should be permitted. In light of the ongoing calibration efforts of the BCBS in the context of the liquidity regime, it would also be welcomed if the definitions and categories, i.e. correspondent banking, were to be clarified in more detail in order to appropriately differentiate transactional banking from discrete interbank activity. In the same vein, the obvious asymmetry between LCR and NSFR factors should be tackled as part of these further clarifications. Finally, we would also advocate that the extraordinary draws from Trade Finance facilities proposed as part of this regime are eliminated (e.g. unutilized Trade facilities, driven by underlying commercial activity, should not be treated the same as unutilized revolvers).

Counterparty Credit RiskWe observe that the proposed 1.25 asset value correlation (AVC) multiplier for key financial institution exposures (banks over $100 billion assets or unregulated financial institutions) is not correlated with the actual risk of advising/confirming letters of credit. Trade is now given the same treatment as longer-term loans without specific collateral.

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The new AVC does not distinguish amongst FI exposure types. Instead the short-term self-liquidating nature of Trade should be considered in the context of the actual exposure to another financial institution.

As previously highlighted, the majority of Trade is conducted in G3 currencies, and predominately USD. Banks without G3 liquidity, especially in emerging markets, must borrow G3 currencies from major Trade banks to support the G3 denominated Trade flows of their clients. We project that the market will reprice upwards for the cost of this additional capital, which will significantly increase the cost for banks to borrow from other banks. The unintended consequence of this part of Basel III is that it could damage the growth of Trade opportunities in emerging markets.

We strongly recommend that the 1.25 AVC multiplier does not apply to short-term Trade transactions (such as confirmation of letters of credit, trade advances etc.). This would align with the limited risk of these exposures. Furthermore, it would support Emerging Market banks’ USD liquidity for Trade Finance purposes. From a policy perspective this would be an ingredient for supporting balanced global Trade and enabling growth of the developing world.

One-Year Floor on TenorAs per a recent ICC industry study of major Trade Banks, the average Trade transaction has a tenor of 115 days and banks have to carry an additional 20-30% more capital on a 90-day transaction to account for the one-year floor on tenor. Basel II/III originally had a one-year floor on all tenor regardless of actual tenor. This has recently been modified to allow certain types of short-term transactions, including Trade letters of credit to use actual tenor but this exception does not apply to other types of Trade facilities under one year. The one-year floor has a very significant impact on Trade given the short-term nature of Trade transactions.

Basel II/III does allow local regulator discretion to use the actual tenor in place of the one-year floor. To the extent that local

regulators allow this, there will be no impact to Trade from this aspect of Basel II/III. But, if some local regulators use their discretion while others do not it will create geographic arbitrage - banks in some markets will have a key advantage in both off-balance sheet contingent assets as well as Trade Finance. We therefore strongly recommend to the Basel Committee to remove the national discretion aspect and instead require that the actual tenor be applied in the case of all Trade Finance transaction types.

Basel III: the end of long-term Trade Finance?The impact on the medium and long-term finance sector, e.g. export credits, is likely to be highly detrimental to global economic activity. At the peak of the financial crisis in 2009, guarantees brought by export credit agencies (ECA) played a crucial role in keeping world Trade alive, increasing by around 25% compared to the previously highlighted 23% contraction. The latest statistics published by the Berne Union, the association for export credit and investment insurance worldwide, show that the combined exposure of its members to short and medium term export credit insurance amounted to nearly USD 1.6 trillion at the end of 2009, around a third of total world export Trade in that year.

ECAs help protect both exporters and banks against political and commercial risk linked to Trade and investment. However, Basel III does not consider risk-mitigating factors when looking at banks’ exposures in the context of the leverage ratio. This overlooks the fact that ECAs often include backing by the home state of the ECA (e.g. the German Government in relation to an ECA backed by the Hermes Kreditversicherung).

Historically, credit losses from Trade transactions that have been financed via ECA-guarantees have been low. With an historic CCF of 0%, given the government-guaranteed nature of these transactions, the jump to a 100% CCF of ECA assets for inclusion in total assets that are subject to the non-risk based leverage ratio is huge. Given that these trades are also related to the exchange of real goods, similar to letters of credit, there should be no

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reason to treat them as more risky. In fact, there are three levels of potential recourse: first the company that obtained financing via EAF, second the asset value that underlies the transaction and third the sovereign, which has provided a full guarantee of the transaction. Unfortunately Basel III proposes that collateral, guarantees or other risk mitigating instruments shall not reduce on-balance sheet exposure, which therefore makes them more expensive and less attractive for banks, which are therefore likely to respond by either passing the cost on to the exporters or even withdrawing from that market altogether, thus reducing overall access to Trade and export finance. Therefore, there is a very strong argument that ECA guaranteed loans should be exempted from the calculation rule of the Leverage Ratio with 100% uniform credit conversion factor. Furthermore, as such assets are likely to be treated unfavourably under the liquidity constraints (LCR and NSFR – see above), they should not be binding for ECA guaranteed loans before the EBA’s report in 2015.

In addition, the short term liquidity regime does not consider these assets as eligible liquid assets, even though sovereign guaranteed and historically displaying very low loss given default rates – this represents an additional cost as other liquid assets will need to be put in place for the liquidity buffer. When then looking at the NSFR and in light of the long tenor that ECA transactions usually have, matching long-term capital will be required, rather than wholesale funding - again, a significant new cost that will have to be absorbed.

To highlight a real life example, let us take the aircraft industry. Under Basel II Aircraft finance transactions have generally required very low levels of capital, as they are asset-based financings and, as such,

fully secured by the aircraft and operating lease rental stream. At the same time these transactions are guaranteed 100% by certain credit agencies, e.g. the German Hermes Kreditversicherung. These agencies are sovereign backed. Pre-Basel III the ability of banks to lend in this space has been largely dependent on the appraised value of the aircraft and the resulting loan-to-value ratio. Whilst many other asset-based financings landed in default (in part because the quality of the assets turned out to be much less than was anticipated by the financiers), secured aircraft and engine financings, including securitizations, were also – and unfairly – put into the same bucket of ‘financial junk’ (even though the appraised value of the aircraft assets did not change for the worse). Instead of permitting the financiers’ and appraisers’ assessment of the credit-quality of the aviation asset, Basel III uses a one-size-fits-all approach – with the 3% leverage ratio - regardless of the quality of the asset or guarantee. This means that lenders participating in aircraft finance transactions will have to put in more capital in front of “good quality” aviation assets, based on nominal amounts, even if the same have been independently appraised by a third-party appraiser at a much higher level. Additionally, the LCR and NSFR – as explained above - will require significantly more liquidity, hence reducing efficiency and increasing cost in this space. As a result, it is likely that, once Basel III is effective, financiers will be less willing to do 12-year long-term aircraft finance loans – which today are common practice - and, instead, revert to short-term financing. This would create constraints in the way these types of industry manage their production and no alternative – other than trying to find solutions in the shadow banking space – is in sight for them.

Trade Finance — Protecting the Engine of Global Growth | Protecting Trade: Key Recommendations 15

Trade Finance is at the heart of global growth and prosperity. Whilst during the crisis the real issues stemmed from collateralized debt obligations and mortgage securitization products, receivables portfolios used in Trade Finance were not a contributor to the crisis. To support a balanced policy approach with a view to protecting global Trade, we close this paper by summarizing the key areas where policy action or change is important.

We urge regulators around the world, including the Basel Committee on Banking Supervision, to reconsider elements of the Basel III package to support the important role of Trade Finance for global economic growth and recommend the following actions:

1. The additional capital requirements for global systemically important banks (G-SIBs) will have an impact on the global levels of Trade, given the fact that eight out of the world’s ten largest Trade banks are captured under this regime. It will therefore be even more important to align elements of the Basel III framework more closely to the true nature of Trade Finance – as outlined in this paper - in order to balance the higher levels of cost of Trade Finance that stem from the G-SIB framework. We strongly recommend that regulators focus closely on maintaining a competitive level-playing field across participating banks in the Trade Finance space, in particular in the context of the different capital requirements between G-SIB and non-G-SIB banks.

2. With regard to the leverage ratio, the specific nature of Trade Finance transactions – predominantly short-term and self-liquidating - has to be taken into account. This should translate into a reduction of the credit conversion factor – from the proposed 100% for all off-balance sheet transactions to the Basel II levels of 20% and

50%. We would also recommend that the Basel Committee consider the embedded credit agency guarantees as relevant risk mitigating measures in relation to long-term Export Credit Agency Trade transactions.

3. We strongly support the inclusion of short-term Trade instruments as liquid assets (with appropriate haircuts) in the calculation of the Liquidity Coverage Ratio. At the same time a reduction in the deposit run-off factors for transaction banking (especially for FI transaction balances) should be applied and the use of advanced internal modelling methodology to establish run-off and stable funding factors should be permitted. More clarity around concepts and definitions needs to be provided and extraordinary draws from Trade Finance facilities proposed under Basel III should be eliminated (e.g. unutilized Trade facilities).

4. Furthermore, the Basel Committee should, in our view, recommend a harmonised approach in relation to all types of Trade Finance transactions by requiring the use of actual tenor in place of the one-year floor. This will ensure the appropriate treatment of these transactions and limit geographic arbitrage between banks.

5. Regarding inter-bank exposures, the foreseen 1.25 AVC multiplier should be eliminated for the specific area of Trade Finance related to inter-bank exposures and hence align with the limited risk of these exposures.

6. A priority for all governments including the Basel Committee should be the promotion of an international level playing field and consistency of Basel III implementation across the globe in order to limit unintended consequence of arbitrage and risk concentration in unregulated jurisdictions.

Protecting Trade: Key Recommendations

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It is currently unclear how major exporting economies like China will implement the new rules. At the same time the emerging differences between European and US proposed rules compared to the Basel III set of recommendations is very concerning. Differentiated implementation of Basel III rules could severely harm all market participants including Trade Finance banks and depending on the local rules put them at an economic disadvantage with their main competitors in other countries. Citi therefore strongly supports the “Basel III regulatory consistency assessment programme”, which was published by the BIS in April this year. This is the first time that the Basel Committee is going to examine timely adoption and regulatory consistency of the Basel III rules amongst its members and Citi hopes that this process also extends to countries that are not direct members of the Basel Committee.

7. And finally, regulators should be vigilant to ensure that their actions do not translate into unintended risk concentration with non-regulated providers.

The net impact of Basel III on Trade is negative. The increased capital charges will raise the overall cost of Trade Finance. The specific Credit Counterparty risk as well as the new leverage ratio will create a disincentive for banks to confirm and advise letters of credit whilst the new liquidity ratios will eliminate many of the benefits banks currently receive from export credit agencies. Citi continues to support industry wide efforts under the umbrella of BAFT-IFSA to highlight to regulators the challenges and potential unintended consequences for those parts of society that are most reliant on Trade Finance. In collaboration with the International Chamber of Commerce a significant data gathering exercise has been undertaken over the last few years to deliver a coherent register on Trade default rates, which clearly demonstrates the very low risk associated to this type of financial transaction.

To summarize, we have empirical indications that banks are already anticipating the implementation of the measures related to both liquidity and leverage ratios, and indeed to the medium and long term export business and there is an alarm signal that a non-binding observation period is not sufficient as a tool to persuade banks to continue to provide the Trade and export finance instruments to exporters under the same conditions as today. Should these proposed measures not be amended soon, the unintended impact on Trade and export finance will be detrimental to the global economy.

In the absence of fundamental revisions however at this stage it is apparent that nothing will legally apply to banks until governments choose to implement the Basel III regime. Against this background Europe has been the first in proposing a comprehensive revision of their existing Capital Requirements Directive in order to apply Basel III. In their approach specific concessions for Trade Finance have emerged, which will significantly help European Trade banks going forward. We hope that other regions as well as the Basel Committee itself will endorse Europe’s approach as best practice for Basel III when it comes to Trade Finance.

Banks are the financial gateway for all other industries. In Trade the matching of financial and physical logistics is the harmony that brings growth. If the physical chain is being disrupted, e.g. through strikes or natural disasters, goods cannot arrive at their destination and economies/industries suffer. If the financial chain is disrupted, the same phenomenon can be observed. There is no cure for natural disasters, but there is a chance to cure those that are man-made. We should make a case to cure it before it happens.

Conclusion

18 Citi Transaction Services |

Ruth Wandhöfer is the Global Head of Regulatory and Market Strategy with Citi Transaction Services.

Ruth is highly regarded across the international banking industry for her in-depth knowledge of the regulatory, market and competitive landscape, in particular acknowledged as an authority on key initiatives such as the Single Euro Payments Area. She holds a number of influential positions across the banking industry including membership of the EU Commission and European Central Bank Expert Groups.

Ruth is responsible for engaging with the regulatory and market/standards environment on a wide range of topics in the transaction banking space, and for driving and coordinating the business response within Citi Transaction Services.

Ruth is also the author of a well regarded book, EU Payments Integration (2010 Palgrave Macmillan), is a fellow lecturer of the Pallas LL.M. Program in European Business Law and a member of the Editorial Board of the Journal of Payment Strategy & Systems.

About the Author

Citi Transaction Services www.transactionservices.citi.com

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