How can banks avoid a credit crunch and accelerate economic growth?
Trade finance is the backbone of the global economy, but concerns remain over the growing gap between bank supply and market demand. Several market factors have shed new light on the issue, including rising commodity costs, which impact credit availability, as well as greater capital restrictions – in particular the upcoming Basel IV requirements .
In an effort to address the impact on trade finance lending, now is the time for banks to refocus on collaborative solutions.
Commodity prices impact credit availability
The current financial climate is undoubtedly quite tense and factors such as financial volatility, disinvestment in sustainability, disruption of global supply chains and rising trade costs have all led to a sharp rise in the cost of raw materials. Many centers of economists, including the United Nations Center for Trade and Distribution (UNCTAD), are most concerned about two essential commodities – food and fuel.
UNCTAD has warned that soaring food and fuel prices will not only affect the most vulnerable in developing countries, but will also have a severe impact on global trade, especially in terms of financing small and medium enterprises.
One of the main impacts of rising commodity prices is on the availability of credit. Many suppliers are now finding that their current lines of credit cannot cover the same volume of goods at their inflated cost. An additional complication arises if companies in the supply chain have lower credit quality and are unable to meet freight costs, resulting in a backlog in the supply chain. Other buyers may even leave areas where credit is limited.
Regulations continue to cause restrictions
Along with rising commodity costs, trade finance also faces regulatory constraints. Basel III has already imposed strict restrictions on banks active in trade finance, and with the implementation of Basel IV scheduled for January 2023, businesses are under pressure. Without proper preparations, the new iteration will make the problem worse.
Regulatory updates have been at the forefront of an ongoing debate among industry stakeholders. The International Chamber of Commerce highlighted the possibility of damage to banks, saying it “could have serious unintended consequences for the provision of profitable trade finance to the real economy”. Various banking associations also weighed in, such as Finance Denmark, which said in a note that the changes “will lead to an overall increase in the capital requirement for EU banks by 23.6%” and that the figures “are in stark contrast to those of the G20”. indication that the final review of Basel III should not lead to a significant increase in overall capital requirements”.
Bridging the Trade Finance Gap
These two challenges pose a problem for the trade finance gap. According to the Asian Development Bank, the gap widened in 2021 to $1.7 trillion – up from $1.5 trillion in 2018 – leaving many businesses unable to access the financing needed to operate. The health of the global trading system depends on the ability to close this gap, but it is a persistent challenge and a worrying symptom of a sector under increasing pressure.
Much of the gap comes from small and medium-sized companies in emerging markets, and when coupled with the impact of Basel IV, it will be difficult to close with additional loans or credit. Solutions have emerged to help overcome these obstacles, such as the possibility of co-financing and greater digitization.
The role of investors
However, banks have adopted an alternative strategy by distributing trade finance instruments to other banks and to the capital market. When lending restrictions have arisen, this method allows for additional funding, since banks can increase net interest income, increase return on equity, and overall do more with less. This benefits all parties involved – banks, investors, companies involved in the supply chain and communities that depend on trade finance.
The problem is that banks have historically distributed only a small percentage of their trade finance portfolios to capital markets. Additionally, access to capital markets for investors has been limited due to the need to repackage portfolio risk and operationally intense reporting requirements. For an investment bank to execute on behalf of an asset manager, the transaction costs for a low-risk, low-return product would routinely exceed the asset allocation of the short-term bank exposure. This limits access to a small portion of riskier assets.
The trade finance infrastructure now exists to enable end-to-end straight-through processing of hundreds of thousands of instruments at lower cost. This gives asset managers and commercial banks direct access to trade finance assets, allowing alternative investors to channel more capital to banks and businesses.
What is clear is that market factors have increased pressure on banks’ already strained lending operations – and this is set to continue. As a result, the distribution of trade finance is now emerging as a lifeline and a necessity, allowing companies to remove debt from their balance sheets and continue lending. Ultimately, this will help boost global trade and ultimately economic growth.