How can the role of alternative credit providers help prevent a Trade Finance crunch post pandemic? What lessons can be taken away from the last Global Financial Crisis (GFC)?
In the years following the 2008 Financial Crisis, regulators introduced rules to promote stability in the international financial system. While these new regulations have been largely successful in limiting the exuberant risk-taking that helped send the global economy into recession, some of these broader changes – originally introduced to prevent another credit crisis – are now negatively affecting other segments of the financial markets. In banking, new capital requirements have meant much less credit is now available to finance global trade, which (according to Asia Development Bank, ADB) created a supply gap of roughly $1.5 trillion a year in 2019 (source). A recent paper from Standard Chartered using research from the ICC in 2020 estimates that the additional strain from the COVID-19 crisis has exacerbated these long standing constraints in Trade Finance. They estimate the existing $1.8 trillion gap has been compounded to a shortfall of $3.4 trillion needed in order to achieve the UN’s Sustainable Development Goals (SDG):(source)
As we stare down the barrel at the end of an 13-year-old expansion – due to concerns in the market of tail end risks following the coronavirus outbreak – maintaining access to capital is even more crucial. This is because the gap in Trade Finance has the potential to damage the global economy just as badly as non-performing loans did in 2008, if for very different reasons. We believe that a measured rethinking of financial regulations is needed to encourage capital providers to lend more and support Trade Finance. At the same time, new entrants, such as credit funds and private equity, can keep money flowing towards commodity trade deals.
Our perspective is not intended as a criticism of regulators whose job is incredibly tough – a balancing act of encouraging innovation and growth, while reining in systemic risk-taking. The suffering that the financial crisis created rightly demanded robust rulemaking to drive better risk management within financial institutions. The Dodd-Frank legislation in the U.S. and the European Basel Accords cleaned up banks’ balance sheets, boosted liquidity, and, most importantly, made financiers think harder about probabilities.
Over time, these post-financial crisis banking rules have had a profound effect on the availability of certain types of credit. Despite low default rates and a favourable credit risk profile relative to comparable asset classes, Trade Finance has found itself particularly affected as banks have changed their lending practices in response to regulatory frameworks, increased due diligence requirements and enhanced risk assessments that were never intended to limit trade.
This signals cause for concern – Trade Finance is the backbone of the real economy. It facilitates the trading of manufactured goods and also the raw materials of life, such as food, textiles, energy, chemicals, and more. Up to 90 percent of all global trade relies on trade and supply-chain finance (source). If access to credit dries up, there would be an immediate disruption in the trade of critical commodities, such as fuels, sugar and cotton. This would have a sizable impact on the economic inclusion of the developing economies the goods are coming from as well as an effect on daily life for many. In recent months we saw Coronavirus swiftly damage the global supply chain, causing shortages of components and raw materials affecting the supply of foodstuffs and fuel for our cars.
As banks have pulled back, small and medium-sized businesses, especially in developing countries, have been hit hardest. The International Finance Corporation (IFC) estimates that approximately “forty percent of formal micro, small and medium enterprises (MSMEs) in developing countries, have an unmet financing need of $5.2 trillion every year” (source). These very companies are the engines behind most economic growth, investment and development. According to the World Bank, SMEs contribute up to 50 percent of global employment and up to 40 percent of GDP in emerging economies (source). Thus, this gap presents a very real threat to the global economy – one that, like the housing crisis in 2008, could be a trigger for broader economic turbulence.
To be clear, we are not advocating the unwinding of the regulations that helped banks become more stable since the financial crisis. But in learning lessons from the past, we believe it is essential for regulators to pay close attention to the early warning indicators associated with the shortage of credit for Trade Finance. The canary in the coal mine may not have expired just yet, but its prognosis is certainly dire under the next rollout of Basel standards, not to mention a potential global recession on the horizon following the strains of the COVID-19 crisis.
Currently, the EU Commission intends to push forward plans to implement Basel IV (so called after additions were made to the Basel III Framework in 2017), into law in January 2023, having extended the date due to the pandemic. Further revisions to Basel IV include significant changes to the way banks calculate their minimum capital requirements for market risk and aims to make outcomes more comparable across banks globally. Within Trade Finance, these changes impact banks’ portfolios significantly due to the increased economics of lending and the requirements of additional capital outlay. With this increased capital shortfall Trade Finance banks will find they simply cannot provide financing economically to the physical trading community.
These concerns stretch far beyond the Trade Finance industry to all European lenders. A 2019 study by Copenhagen Economics warned that “European banks could need as much as €400 billion in capital to comply with new rules” (source) and that private investments stand to decrease by €70 billion per year in the 10 years following implementation (source). This does not bode well as financial institutions brace for a potential crisis following a year of unprecedented stress to the global financial system. If loans and interest rates continue to drop, banks will only tighten their lending practices. And soon many banks may need support in extending credit to companies in industries upended by the virus.
Amid this market stress, it may well be time to find other ways of financing trade. As the economy battles volatile market adjustments, we see an opportunity for more non-bank players, such as alternative credit providers, to enter the fray, providing lenders and investors with secure opportunities.
Alternative lenders can work within the banking system to create new sources of capital that can facilitate funding. Risk-adjusted funds that do not have the same pressures on their balance sheets as established banks can distribute risk across the wider institutional investor base and provide the collateral required that banks are not willing to lend. Harnessing external financing to participate alongside Trade Finance banks would keep the cost of capital down for SMEs while protecting consumers from the inflated prices that come with higher costs of capital.
Additionally, alternative strategies, such as Commodity Finance, can offer better protection for investors’ capital, should a recession hit. Trade Finance’s risk profile is actually better than investment grade corporate bonds – with overall defaults between 0.04% – 0.21% – and the recovery rates are far superior due to the liquid nature of vital raw materials. These statistics remained virtually unchanged during the financial crisis of 2008, where the financial markets collapsed at the same time as the world commodity prices collapsed.
As national authorities begin to enforce the Basel IV framework, it is important that regulators and legislators examine how risk management reforms affect all facets of the financial industry – including those with a wide range of risk profiles, such as Trade Finance – and adjust the rules accordingly to ensure there are limited negative effects on the real economy.
Audentia Global, an alternative credit manager