A heated lobbying effort is underway to change the way that the new comprehensive banking regulations, known as Basel II, propose to deal with trade finance. It’s being led by Asia-centric banks like Standard Chartered and HSBC, for whom this sort of relatively low-risk lending has been a staple for a long time.
Under present rules, banks have to provide reserves against trade credit advanced to customers that are equal to 20% of the outstanding amount. Basel III proposes to up that to 100%.
This is an important issue. Globalization and the resulting growth in trade have been main pillars of the increase in worldwide prosperity of the past several decades. Standard Chartered says the new rules, if implemented in their present form, would depress world trade by 2%, and clip a half-percent from global GDP. Presumably things would be considerably worse for HSBC and Standard Chartered.
how trade credit works
Let’s say Very Big Department Store of San Francisco orders 50,000 pairs of blue jeans at $5 each from Great Wall Blue Jeans of Shanghai.
When the contract is signed, Great Wall asks Very Big to have VB’s bank send a letter of credit to GW’s bank, the Hong Kong branch of the Bank of China. VB goes to its bank, Bank of America, to have BA issue the letter.
The letter is normally irrevocable. In it, BA tells the Bank of China to pay GW $250,000 when GW presents proof specified in the letter–usually a bill of lading from the shipping company handling transport of the order–that the order is complete and the goods are under way. BA also promises to reimburse GW immediately.
Based on the signed contract or on the letter of credit, Bank of China will most likely be willing to make a working capital loan to Great Wall, if needed, to finance the manufacture of the jeans.
So, BA and BC both collect fees associated with the letter of credit. Both may also make working capital loans to their customers, to finance, respectively, the purchasing and the making of the jeans. The banks’ risk exposure is of short duration. Assuming that both Great Wall and Very Big are well-known customers, the chance of anything going wrong with the transaction is remote. This is plain vanilla, everyday low-risk business (other than at times of historically high stress, like the recent financial crisis, when this business completely dried up). But it’s also very profitable.
It seems to me that the Basel III rules have to change. But it’s something to keep an eye on. The obvious losers were the proposed rules to stay as they are now are the trade finance-oriented banks. But I don’t think this is the main issue. If China or Brazil go from 8% growth to 7.5%, no one will really notice. But neither the US nor (especially) the EU are likely to have enough extra economic energy that they can shrug off the loss of .5% in expansion.