Tradeteq: How technology could help banks avoid the Basel IV lending crisis

Rising capital requirements threaten to restrict banks’ ability to fund trade finance deals and further limit economic growth.

Christophe Gugelman

In this guest author article for The fintech Time, Christopher Gugelmann argues that distributing trade finance assets to investors appears to be a practical solution to a looming lending crisis

Gugelmann is the CEO of Tradeteq, a trading platform that allows banks and financial institutions to connect, interact and transact. The company’s AI-based credit scoring, advanced analytics and investment management engine provide risk transparency and informed decisions.

Likewise, its simplified securitization tools reduce complexity and seek to make trade finance investments efficient, liquid and transparent.

The increased capital requirements outlined in Basel IV are expected to restrict banks’ ability to lend, as many companies already lack the funding they need. Here, Gugelmann explains that banking distribution of trade finance assets is key to freeing up balance sheets:

Implementation of Basel IV is set to begin in January 2023 and, with time running out, companies are grappling with their plans. However, Basel III has already imposed strict restrictions on banks active in trade finance lending and so the concern is that, without adequate preparations, Basel IV will further magnify the problem.

The evolution of Basel IV began in 2017 when amendments to address credit risk calculations emerged to complement Basel III. Dubbed Basel IV, the amendments were to be implemented initially in March 2022 before the 2023 start date at the latest. However, there are some regional variations. The European Commission and the bank of england then pushed back EU and UK deadlines to 2025 amid fears banks’ ability to lend was crucial to post-pandemic recovery, so it took longer to prepare.

The updates continued to be the subject of concern and debate among industry stakeholders. The International Chamber of Commerce highlighted how they could cause damage to banks, saying they “could have serious unintended consequences for the provision of profitable trade finance to the real economy”.

Various banking associations intervened, in particular Finance Denmarkwhich said in a note that the changes “will lead to an overall increase in capital requirements for EU banks of 23.6%” and that the figures “contrast sharply with the G20 indication that the final revision of Basel III should not lead to a significant increase in overall capital requirements.

The Growing Trade Finance Gap

The problem is that there is a looming crisis for businesses, many of which are already struggling to secure commercial financing from banks. This is a persistent problem that has led to the widening of the trade finance gap – the gap between supply and demand. Research from the Asian Development Bank estimates the gap to be $1.7 trillion.

Basel’s capital constraints are at the heart of the problem. The regulation requires banks to set aside more capital for trade finance transactions, which means they have had to increase capital requirements and reduce their standardized risk weights.

The higher Basel IV thresholds will further restrict the ability of banks to lend and therefore have a major impact on the availability of funding. Without a solution, the trade finance gap will continue to widen – and the World Economic Forum expects it to grow to $2.5 trillion by 2025.

Distribution of trade finance

Much of the gap comes from SMEs in emerging markets and given the impact of Basel IV, it will be difficult to fill it with additional loans or credit. In the absence of increased funding, solutions have emerged, such as the possibility of co-funding and greater digitization.

An alternative, however, is the distribution of trade finance instruments to other banks and capital markets. Banks recognize that by adopting a source-and-distribute model for their commercial portfolios, they can increase net interest income, increase return on equity and open up additional sources of funding. This not only benefits banks but also their investors and the businesses and communities that rely on trade finance.

All of this, however, depends on investors’ ability to access this asset class – and currently they are constrained 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 bank’s short-term exposure. This limits access to a small portion of riskier assets. Commercial banks that distribute trade finance through investment banks face similar cost barriers due to the need to repackage the instruments from a legal and regulatory perspective.

What is needed is a more cost-effective approach to making trade finance an acceptable investment proposition. As a result, we are beginning to see the steady dismantling of old, complex and convoluted processes with little transparency and standardization.

Technology is now opening the door to this huge opportunity, making it possible to buy and sell assets through private distribution networks. In particular, an infrastructure exists to enable straight through end-to-end processing of hundreds of thousands of instruments at low 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.

At a time when banks must do more with less, practical approaches are needed to help mitigate the negative and unintended consequences of Basel IV. With investors able to access trade finance as an asset class, banks have more options to generate larger volumes.

As such, the distribution of trade finance appears as a lifeline and a necessity, allowing companies to remove debt from their balance sheets and continue to lend. With geopolitical events, supply chain disruptions and currency volatility rocking the markets, efforts like this will be critical to driving future economic growth.

Janet E. Fishburn