Mercurion analysis: ‘The Capital Game’

Mercurion analysis: ‘The Capital Game’

January 2023
Are banks the best partners in trade finance?

Following the financial crisis in 2008 and its aftermath, bank regulations were tightened in a major way; at least this is what the authorities had in mind in order to avoid another crisis caused by a shortage of capital in the banking system. Not quite a Glass-Steagall effort (the Act of 1932 separating investment banking from commercial banking, which also created the FDIC), but still a severe re-jigging of the bank capital rules, including an obligation for banks to hold much larger liquidity reserves, in particular when making loans to ‘unrated’ borrowers.

The years leading up to the financial crisis were dominated by a desire to leverage every dollar of capital as efficiently as possible. This meant that banks drove down the volume of assets held on-balance sheet against which (regulatory) capital had to be set aside in all sorts of clever ways, predominantly by arbitrating the rating agency driven guidelines as laid out in the Basel 2 capital accord. In addition, banks made serious attempts to shift exposures off-balance sheet. Loans and guarantees with maturities of less than 365 days could, for example, be issued with virtually no reserving requirements. By rolling over 365-day facilities on a continuous basis, economic commitments were in fact longer than the regulatory dividing line, but could be booked as ‘zero capital’ positions. As the economic leverage of the banks’ balance sheets became a multiple of the (overall) reported leverage, capital positions were in fact much weaker than what regulators thought they were.

When it all ended in ‘tears’ the rules were overhauled. The stable doors were shut drastically after the horse had bolted. One of the things that was scrutinised was the leverage factor. The newly proposed rules were now overestimating economic exposure. The pendulum had swung the other way. The asset position on a bank’s balance sheet was under the new guidelines crudely arrived at by only sporadically taking into account netting of opposite and equal positions and to keep things simple risk adjustment was no longer applied. A larger balance sheet demands much more capital. Banks were given a few years to comply with the new guidelines stating the minimum amount of capital required.

Another area that was scrutinised was ‘contingent liabilities’, such as guarantees and stand-by letters of credit. Where these did not require much or any capital before, causing any fee income earned on this basis to yield an infinite return on equity, the new accord would treat the contingent exposure as 100% drawn. In particular the leverage ratio of a bank would be calculated by using a 100% CCF (Credit Conversion Factor) weighting. Balance leverage drives the bank’s core equity tier 1 capital requirement (CET1). The effect of the new rules was that trade finance products became a lot less profitable from a return on equity point of view. Bank capital was a ‘scarce commodity’ in the days after the financial crisis. For this reason banks were not keen on extending credit through LoCs. As synthetic, i.e. unfunded, instruments no funding charge could be charged, either, making this type of exposure compare unfavourable with plain vanilla lending. In addition, banks had to set aside a liquidity reserve in respect of unrated borrowers, exacerbating the deteriorating economics of holding contingent liabilities, such as LoCs. To mitigate the impact on capital and liquidity the banks would start to ask for highly liquid collateral; mostly cash.

So, apart from the much extended compliance effort banks had to engage in (money laundering checks, etc.) – which was causing a drag on profitability in its own right, banks were economically not incentivised to engage in trade finance business with (in particular smaller) unrated companies.

Having considered the changed environment for banks since the last financial crisis, which explains why they have become much less willing business partners, we may wonder whether banks are actually required when the goal is to obtain security when engaging in cross border trade. The answer is ‘no’. In today’s world there are more efficient ways to settle transactions securely. Why should any security have to be rooted through the balance sheet of a bank? In particular if that bank mostly demands cash collateral in return anyway? This does not seem to make much sense. Banks are rarely independent parties, either. By putting their balance sheet in the fray they have their own economic interests at heart. So what if we were to transfer the cash that the bank would like to have as collateral to an independent third party with a solid internationally recognised reputation and strong credit standing (at least as strong as the majority of the major banks)? – and what if all of this could be done through a secure digital platform, whereby the compliance burden (for the first time user) would be settled in merely a few days? – and, in addition, this independent party would only settle against a proof of delivery? So to recap: everything could be organised swiftly from behind one’s desk and the outcome would be a secure settlement of the transaction, whereby both parties are protected.

One may ask: ‘where can I find this alternative?’ Well, at Mercurion we have created just this. The system is based on the principle behind all exchanges: ‘payment against delivery’. Whilst delivery is in progress payment is held securely by the escrow agent (the third party that acts independently to make sure the transaction is settled). Mercurion works with the Baltic Exchange on this. Being part of the Singapore Exchange group (SGX, rated Aa2 by Moody’s), Baltic has been in the business of settling transactions securely for a very long time (the Baltic Exchange was founded in 1744 when ship owners and merchants decided to organise themselves).

By skipping the route through a bank, much of the friction experienced by companies engaged in international trade will disappear. So, why not have a look?

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