Coastline newsletter / 2009 edition

ISSUE 26 May2009

Rethinking Trade Finance 2009

By Gary Collyer


As many of you who read these Newsletters will be aware, earlier this year, in the backdrop of the global financial and economic crisis, the ICC commissioned a global Survey of banks to assess the impact of the current financial crisis on trade finance products.

Coastline Solutions conducted the online Survey which included participants from the ICC Banking Commission, the International Financial Services Association (IFSA), the European Bank for Reconstruction and Development (EBRD), the International Finance Corporation (IFC), the Asian Development Bank (ADB) and the Inter-American Development Bank (IDB).

The World Bank and the Society for Worldwide Interbank Financial Telecommunications (SWIFT) also provided recent and historical trade flow data (volume and value) for contextual and comparative purposes.

The Survey received responses from 122 Banks in 59 countries. The resulting Report entitled 'Rethinking Trade Finance 2009: An ICC Global Survey' was presented to Gordon Brown (UK Prime Minister) and the G20 delegates, and is available to you here.

I was invited to provide the foreword for the Report. The following is the text that appears in the report. I hope that the content of this Report and the results of the Survey prove of interest to you and provide food for thought in your own trade finance activity.

"Foreword

It is extremely unfortunate that this kind of Survey should have to be conducted in the circumstances the world is facing today. The uniqueness of its information, details on trends in volume and value of transactions, coupled with insights into operational structures and issues, is something that would also have been of immense benefit to the trade finance community under normal trading and economic conditions.

This Survey, responded to by representatives of 122 banks in 59 countries, provides some graphic, and sometimes dramatic illustrations of the trends seen by banks in the last quarter of 2008 compared with the same period in 2007. Admittedly, these responses may be considered an individual's perception or recollection of the business at that time, but it is known that a large number of the banks collected data internally and provided a collective response reflecting their global or regional perspectives. In this respect, it should be noted that 53% of respondents indicated that their trade finance operations were globally situated.

The one anomaly that stands out in the findings relates to the percentage of open account transactions banks are handling. Most source documents available today indicate that the percentage of open account transactions is usually around 80% of world trade. The Survey, by contrast, shows that 13% of export transaction volume and 12% of import transaction volume handled by the banks surveyed is open account. The low figures in this Survey may reflect the trend found in banks that have become more involved in the open account sphere, e.g., via usage of the SWIFT Trade Service Utility, in processing these transactions separately from traditional trade products such as letters of credit (L/Cs), guarantees and collections. It also reflects the fact that traditionally banks only process the payment instructions of the customer that arise as a result of an open account transaction and may not track the actual volumes processed. The respondents to the Survey were predominantly those working in the departments handling traditional trade products.

Over the past few years, there has been a perceived movement to outsourcing of trade finance processing; however, the Survey shows that 83% of the banks currently process all of their transactions in-house. Having said this, over 10% of these banks appear to be actively considering outsourcing some of their trade finance processing between now and 2011. The decision to outsource some or all of this processing has often been predicated on the simple mathematics of costs versus revenue, coupled with the need for enhanced customer service and the inability of the outsourcing bank to control fluctuating volumes. With volumes of traditional trade products decreasing in most markets, as evidenced by the Survey, the figure of 10% may grow significantly during the next 12 months as banks look to reduce costs even further.

When reviewing the volume percentages of trade finance products serviced in the various regions, it is not surprising to find that letters of credit feature prominently as the most commonly used product in each of the three regions providing the main feedback (North America, Europe and Asia). However, the fact that respondents in Europe indicate that 37% of import transactions involved letters of credit seems to go against the perceived movement of European importers from L/Cs to open account settlement and may evidence the increased demands being made by exporters to secure their shipments. For Asia, the data provided by SWIFT clearly indicate that a large percentage of the import L/C transactions issued in Asia are advised to banks in the same region.

It is also not surprising that standby letters of credit feature heavily for North America, whilst guarantees have the same impact for Europe. The most surprising statistic, from my perspective, is the high volume of documentary collections handled and the consistent percentage of their use across the three regions - around 20%. This may be the result of exporters looking for more security in the transaction, as opposed to their handling transactions under open account, as well as a desire for the banks to act as "custodians" of the documents until payment or acceptance is made.

Values of trade finance products have closely matched volumes on both the import and export side. As one would expect, over 50% of the value of import trade transactions handled in North America relates to standby letters of credit, whilst a similar figure applies to issuance of L/Cs in Asia. The North America statistics are a little surprising, as values of standby letters of credit are often significant and disproportionate to the volume of transactions issued. Historically, the average value of a letter of credit is not that significant. Whilst there are numerous transactions covering projects or commodity shipments, which are therefore of a significant value, the more traditional form of L/C covering the supply of basic goods does not amount to great sums of money.

Part of the problems being faced by banks today is the need for increased capital requirements under Basle II for their trade assets. Suffice to say that the Survey results paint a clear picture showing that the vast majority of respondents (86%) consider the risk rating of traditional trade products to be the same or lower than that of general banking facilities. This reflects the structure of the transactions and the desire of one party to buy and another to sell. The results also highlight the divergence of views that exist globally concerning the rating of risks for these products - even within the same region. This is clearly an issue that needs to be resolved in order that banks can operate with a similar consistent threshold and structure.

The views expressed on the risk rating of traditional trade products is borne out by the statistic that 66% of the respondents considered their trade finance losses to be significantly less than those experienced under general banking facilities, and the overwhelming figure of 91% that consider this level to be slightly less, moderately less or significantly less. This is a clear message to regulators highlighting the need to reform the current guidelines in order to stimulate the marketplace and encourage banks to actively participate so that the level of traditional trade product volume seen prior to the fourth quarter of 2007 can be restored.

Despite the very low level of losses for traditional trade products, when compared to general banking products, banks have continued to cut trade credit lines for corporates and financial institutions. With regard to the latter, 51% of respondents indicated that lines had been reduced or withdrawn in the last quarter of 2008 compared with the same period in 2007. This reduction has occurred in the face of increased demand for the issuance of bank undertakings such as letters of credit, guarantees and standby letters of credit. Various reasons have been cited for the decline, but for financial institutions it generally comes down to exiting a market or banking relationship due to perceived higher levels of risk. This has often happened even when financial institutions have perfectly good payment records.

We now have markets with the capability to handle more trade finance business, but limited counterparties willing to undertake confirmation or offer trade finance services to the exporter. Potential issuing banks for letters of credit are signaling their willingness to issue, but are finding their credit line reduced or their requests for increases being held up. One banker commented that, in the past, requests for increases in a credit line (temporary or permanent) were usually handled within days; now it is a question of weeks or months. At the end of the day, there is an underlying transaction between two parties ready to buy and sell. But in the midst of all these developments, suddenly banks are seen as inhibitors of trade finance transactions.

On a more practical level, the financial constraints being experienced have other serious implications for the trade finance business. At a time when exporters, and often importers, are moving from open account to letters of credit (contrary to the trend of the last 10-15 years), the future for the L/C would not seem to be more positive. However, there is a down side. In addition to the reduction in trade credit lines, which impedes the ability of banks to confirm letters of credit, transactions that are being processed are coming under greater scrutiny than ever before. Nominated banks do not wish to give an issuing bank any reason to refuse, and issuing banks do not want their applicants to reject an honoured presentation based on the fact that the product has seen its unit price fall in the commodity or local market.

The result of all this is an increase in the number of refusals of documents (the Survey indicates that 30% of respondents have seen such an increase.) This can be accepted if the discrepancies have some validity but, more disturbingly, 48% of respondents reveal that, as nominated banks, they had experienced an increase in the number of spurious or dubious discrepancies. At the other end of the transaction, 20% noted that, as issuing banks, they were coming under increased pressure from applicants to "find" discrepancies, with falling commodity prices being the main reason. In short, on the one hand there is an increased demand for letters of credit but, on the other, where the demand is met, the exporter and/or the nominated bank is subjected to practices that call into question the working processes of the issuing bank.

Banks should seize this opportunity of growth in letter of credit demand and, where it can be serviced, be true to the principles of UCP 600. This may require that the underlying L/C be better structured to protect the applicant, but this extra care and attention to detail can also serve to remove any ambiguities in the wording for a beneficiary. The concern I have is that the corporates will look at this period as one in which banks can come to the fore with their letter of credit offerings and, if they fail to deliver according to expectations, the demand will remain short-lived once the financial crisis is over.

On a positive note, the Survey indicated that 71% of respondents expected to see an increase in demand for traditional trade products. This may be optimistic, but it demonstrates the willingness of banks to listen to the needs of their customers and hopefully to satisfy those needs.

It is my hope that the results of this Survey will demonstrate the need for reform of the capital adequacy requirements under the Basle II regime and will support proper recognition of the trade finance product suite. The optimism shown by many respondents who foresee increased business in 2009 will only come to fruition through the concerted efforts of all of us and our respective governments."

The Report, whilst issued in difficult times and mainly covering issues that pertain to the financial crisis, also contains some valuable information on product splits within banks and the percentages in respect of the products offered and serviced.

As noted in the foreword, the open account percentages are lower than you would expect to see but that is probably due to the department or (role of the) person who completed the survey.

There will surely be a further Survey or Surveys in the future to test the impact of the measures proposed by the G20 and how banks have reacted to a, hopefully, favourable changing marketplace.

'Rethinking Trade Finance 2009: An ICC Global Survey' is available to you here.

Trainees who complete ISP Master qualify for 12 PDUs towards recertification for the Certified Documentary Credit Specialist (CDCS) accreditation offered by BAFT-IFSA and IFS.

ISP Master is an advanced online training service in ISP98 and Standby Credits.

The course content is written Professor James Byrne of The Institute of International Banking Law & Practice in association with Gary Collyer, Technical Adviser to the ICC Banking Commission.

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