Global Finance Proposal Threatens Trade Finance

05/25/2010 11:58 am ET | Updated May 25, 2011

Financial diplomats are right in seeking tougher capital requirements for the world's banks. But they must be careful to keep any new standards from shrinking trade finance.

The Basel Committee on Banking Supervision ― which sets global standards for banking oversight ― is busy at work in Basel, Switzerland, on new proposals intended to strengthen global banking in the aftermath of the worldwide financial crisis. Among the proposals likely to be part of what is commonly called "Basel III" will be a new standard intended to increase the amount of tier-one capital held in reserve on bank books.

Although such standards are not mandatory for regulators in sovereign states, the hope is that, like many Basel standards, they will be followed worldwide, will better prepare banks to deal with future losses, and thus will help prevent another crisis.

Meanwhile, not far from Basel, in Geneva, ambassadors to the World Trade Organization are reflecting on their fears about how the new capital standard in "Basel III" will affect trade finance. There is increasing concern among Members of the WTO that more must be done to stimulate the flow of trade by stimulating the flow of trade finance. And there is increasing apprehension that, in its treatment of trade finance, "Basel III" may hurt, not help.

The volume of world trade in goods and services plummeted 12 percent last year ― the biggest drop since World War II. This was mostly the result of a collapse in global demand, and, to a much lesser extent, an increase in protectionism. However, the World Bank estimates that between 10 and 15 percent of the overall decline in world trade since the second half of 2008 was caused by a decline in the supply of trade finance.

The WTO currently anticipates an increase in world trade of 9.5 percent this year ― a vital ingredient in continued global recovery from the Great Recession. This increase in trade depends largely on continued increases in demand, and on continued resistance to the temptations of protectionism. But it depends also on the availability of trade finance.

Trade finance in the form of credit, insurance, or a guarantee underpins between 80 and 90 percent of the $15 trillion in annual world trade. Without the ready availability of trade finance on reasonable terms, world trade will not bounce back fully from the depths of the global crisis.

A recent survey of 161 banks in 75 countries by the International Chamber of Commerce underscores the centrality of financing to trade. Forty percent of the banks surveyed said they had cut their trade credit last year, and 27 percent said they were unable to meet credit demand.

Recognizing the need for trade finance as a necessary prerequisite to renewed global growth, the Group of 20 economies last year established a $250 billion package of support. These G20 facilities have helped, but, as Victor Fung, the chairman of the ICC, has pointed out, not enough of these new funds is reaching the small companies and the small countries that need more trade finance the most.

There is no evidence whatsoever that the mundane matter of trade finance had anything at all to do with causing the financial crisis. Letters of credit are not exotic financial instruments. They are not leveraged as financial playthings. They are not the fanciful fodder of hedge funds.

Letters of credit and other similar instruments have been used since the Middle Ages, and are among the simplest and safest forms of finance. They provide secure, short-term credit backed by the collateral of a shipment of goods. They are much less risky than long-term corporate lending ― not to mention the subprime junk that seduced Wall Street and spawned the crisis.

As Steve Puig of the Inter-American Development Bank has explained, "Trade overall is the lowest risk activity that banks undertake." For this reason, trade finance should be treated differently from riskier forms of lending where the need for capital reserves is concerned.

Yet, as it stands, the proposed "Basel III" standard would toughen the current treatment of letters of credit under "Basel II." Under the current standard, banks must set aside capital sufficient to cover about 20 percent of the value of letters of credit. Under the current proposal for "Basel III," the required set aside would be 100 percent.

This proposed fivefold increase in the required capital reserves for letters of credit would drive up the cost of trade finance worldwide, and would threaten the current revival of world trade.

Surely countries spending hundreds of billions of dollars to spur world trade by providing more trade finance do not want, at the same time, to smother such financing with needless and counter-productive new financial standards. On this issue, Basel should listen carefully to Geneva.