Article

by Michael F. Quinn

Comedy icons Laurel and Hardy had a way of finding themselves in trouble. "Well, here's another nice mess you've got me into," Hardy would always say. "Another fine mess" is a fair description of our current situation in trade finance.

Since the 2008/9 crisis, challenges and pressures in the business have only intensified. What I categorize as "The Five Cs" - Capital, Credit, Costs, Competencies and Compliance - have converged to make this the most challenging time in trade finance history.

Capital

ICC's Banking Commission and other banking associations around the world have worked with the Basel Committee on Bank Supervision (BCBS) to bring much-needed additional capital into the banking system while preserving the banking community's ability to provide trade finance. This effort was dealt a blow in October, when the BCBS decided to retain the Credit Conversion Factor at 100% for letters of credit and other trade related instruments. Under former regulatory regimes, trade instruments were at 20% to 50% (see the article on Development banks in this issue).

While consistent with the Basel Committee's broader transparency objective, this move from "off balance sheet" to "on balance sheet" transactions penalizes trade transactions, which run an infinitesimal risk of being brought onto the lender's balance sheet due to default.

To reduce systemic risk and discourage interbank lending, the BCBS has added a capital premium to credit exposure for financial institutions with balance sheets of over $100 billion. Some exposures between banks can grow toxic in times of economic upheaval, but L/C confirmations and short-term refinancing of trade transactions are not among them. ICC has done two exhaustive studies analyzing the default rates of trade finance transactions. Both studies, which encompass the most severe economic downturn since the Great Depression, confirm that trade as an asset class is the safest form of lending, with defaults of less than 1% over the past six years.

Credit

An unintended consequence of increased capital requirements is the possible reduction of available credit, which may force banks to make tradeoffs among products, customers and transactions. A higher capital allocation for exposure to other banks will, in all probability, reduce the amount of credit extended to that segment. The historic reliance of banks in the developing world upon developed-world banks for trade finance will be challenged by this reallocation. Developing world customers, particularly SMEs, will be denied the credit they need to build their businesses, increase employment and contribute to economic development, essential to raising the country's overall standard of living. When regulators implement new capital standards in order to improve control over the financial markets, the ironic result may be that credit-challenged banks and companies are driven to seek financing from unregulated entities.

Costs

For the past 20 years, industries, including banking, have been reducing unit costs by moving labor-intensive, redundant activities to low-cost countries. This has proven to be mutually beneficial, with industries maintaining their competitiveness while host countries create jobs and the opportunity for broad economic development. As labour cost differentials have diminished, however, competition for resources has increased, with the result that industries have moved their offshore processes to the next low-cost country.

Enabled by imaging technology, the trade finance industry has done its best to capitalize on this phenomenon, moving its most costly component of production - documents examination - to countries with low-cost, trainable labour. By making the process binary - "Does the document comply or not?" - trade providers have been able to isolate potential discrepancies and escalate them to subject matter experts in the "sending" country for honour or rejection.

Eventually, like other cost-cutting businesses, trade finance processors have migrated to the next low-cost country. But there are now few, if any, "next" countries. There may be one or two more stops on the unit cost benefits train, but the ride may no longer be worth continuing.

Competencies

Historically, trade finance professionals have viewed their jobs as a vocation, striving to deepen their knowledge through years of experience. In the new low-cost model, they have kept their critical analysis and decision-making responsibilities, but do not control the end-to-end review. The experts' lack of ownership of the process and narrowing of responsibilities has made it more difficult for trade finance providers to retain them.

The pipeline of trade professionals has also dried up. Our predecessors were weaned on the understanding that in all likelihood they could develop on a career path similar to the guild system of moving from apprentice to journeyman to master. The current crop of candidates expects to check the box at each level of the process, quickly rising to mastery (or familiarity, at least), and then move on to another product or activity without being "typed" as a trade finance expert over a career of twenty years.

There is another problem related to finding new talent: the technology component in traditional trade processes is low, providing no stimulus for children of the Internet. Because of their near instant access to information, younger finance professionals lack the curiosity and sense of discovery needed to work effectively with trade transactions. Before the world was connected as it is today, you could use your imagination to understand the marvels of international commerce and marvel at the intricate processes that brought materials and goods from one end of the world to the other. Today, there is no need to imagine these things. You can view the same processes in real time on a number of web sites or even YouTube.

Compliance

Already made costly enough by labour, trade finance has been made more so by compliance. Compliance was once the diligent examination of documents integral to completion of a cross border transaction: keeping an eye out for boycott language, for the involvement of just four embargoed countries and for a relatively short list of "bad guys." Nowadays, the examination of documents requires extensive screening (against multiple-country lists) of numerous data elements embedded in ancillary documents, regardless of their role in the letter of credit process.

As database technologies advance, software will execute this screening, but most data elements will need to be transferred manually. Mis-keying of data can result in a false hit - or worse yet, conceal a valid hit. Of even greater concern is the lack of consistency amongst the various country requirements. What may be permissible in one country turns out to be illegal in another, making banks vulnerable to massive fines or even criminal proceedings.

Compliance challenges go beyond transaction processing. Know Your Customer standards vary from country to country, causing disruptions to the free flow of cross-border transactions. A party from one jurisdiction may not be not be vetted appropriately within the counterparty's jurisdiction. Until remediation is completed, the transaction is delayed and supply chain disruption is the likely result.

Meeting "the Five Cs"

Given these five challenges and their historic convergence, what are the next steps for trade finance?

Here are a few: the banking community must move its lobbying effort from Basel to local regulators who will be implementing the new rules. It is even more important to sound the alarm amongst customers who will be facing higher costs for their trade finance, if it is available to them at all. In order to raise the next crop of trade professionals, the industry must find a way to restore the critical aspects of "vocation" without creating an even costlier environment. One way of doing this is to leverage major trade finance providers to reduce competition for resources in what are considered to be "best" locations.

We must also continue to work to make trade finance simpler and cheaper to provide through automation and streamlined, harmonized processes. The industry should do what is needed to speed the migration from paper document checking by promoting the use of new tools like SWIFT's Trade Services Utility (TSU) and Bank Payment Obligation (BPO). As new moves to offshore processing make less sense, the industry should instead get serious about capturing cost savings through continued technological innovation, better training and acknowledgment that slow cost increases are tolerable when we are improving quality and stability.

Finally, in these very volatile times the ICC membership and other trade finance stakeholders must do what is necessary to ensure that multilateral agencies such as the International Finance Corporation (IFC) and the Asian Development Bank (ADB) stand ready to help developing world banks provide trade finance in the event of a major constriction.

In the 1930s, movie audiences were always delighted to see Laurel and Hardy in one more mess. Trade finance customers cannot be expected to feel the same way about seeing us in our current situation. It is up to the community to do everything possible to ensure that the world's oldest commercial activity continues to receive the funding and expert support it so desperately needs - and has every right to expect of us. l

Michael F. Quinn is Managing Director of J.P. Morgan Global Trade in New York. His e-mail is Michael.f.quinn@jpmchase.com