Basel is a lovely city of Switzerland situated on the river Rhine where Swiss, French and German borders meet. 'Basel' is famous to the banking community as banks are being guided by the Basel accords namely, Basel I (1998), Basel II (2004) and Basel III (2010) for the last 16 or 17 years. Basel I, Basel II and Basel III guidelines were introduced in Bangladesh in 2002, 2009 and 2014 respectively. The latest version of Basel accord (Basel III) aims at increasing the banking sector's ability to absorb shocks arising from financial and economic stress, improving risk management and risk governance and strengthening banks' transparency and disclosures.
The beauty of Basel III capital accord is, it not only considers strong capital requirements as a tool for financial stability, but also values strong liquidity base and the leverage tax. In other words, the necessary condition for financial stability is to maintain a minimum capital plus capital conservation buffer (12.50 per cent of Risk Weighted Asset), whereas the sufficient conditions for the same are to maintain suggested liquidity ratios (short-term liquidity coverage ratio of minimum 100 per cent and long-term net stable funding ratio of greater than 100 per cent) and a minimum Tier 1 leveraged ratio of 3 per cent.
Discussion will be concentrated on leverage ratio and its impact on trade finance. The Basel Committee on Banking Supervision (BCBS) has stated a succinct description of the rationale of the leverage ratio in its framework on Basel III. One of the underlying features of the 2011 crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still showing strong risk-based capital ratios. During the most severe part of the crisis, the banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital, and contraction in credit availability. Therefore, the Committee agreed to introduce a simple, transparent, non-risk based leverage ratio that is calibrated to act as a credible supplementary measure to the risk-based capital requirements.
Leverage ratio requires that the bank's high quality capital (Tier 1 capital) will be 3 per cent of its total exposure. Exposures include on-and off-balance sheet items. Direct credit substitutes, performance-related contingencies, commitments, short-term self-liquidating trade letters of credit (LC) etc. are components of off-balance sheet items. Calculation of leverage ratio requires that off-balance sheet transactions are to be converted into credit equivalent by multiplying them with credit conversion factor (CCF) of 100 per cent, except for commitments that are unconditionally cancellable at any time by the bank without prior notice. Thus, leverage ratio suggests considering full amount of LC exposure as a component of total exposures unlike minimum regulatory capital requirement calculation, where CCF for LC is only 20 per cent. This means that Basel leverage ratio is measuring both funded and non-funded exposure on the same scale. Is it justifiable? Risk for documentary credit must not be the same as the risk for the funded credit. Moreover, documentary credit is regarded as one of the most secured modes of transaction where default rate is much lower than that of on-balance sheet exposure. That's why the trade specialists around the world raised their concern about justification of taking 100 per cent of LC exposure as funded exposure. Regulation of 100 per cent CCF will hamper trade finance business as banks will have to keep more high quality capital for LC exposure.
The International Chamber of Commerce (ICC) and the Asian Development Bank (ADB)Trade Finance Default Register showed that during 2005-2009, of 5,223,357 million trade finance transactions that occurred at nine international banks, only 1,140 transactions were defaulted, i.e., the default rate was only 0.02 per cent. Side by side, experience shows that defaulted rate for funded exposure is much higher than that of documentary credit. This result is being used by trade professionals as a strong argument against taking 100 per cent LC amount under off-balance sheet business exposure.
Therefore, assigning the same risk weight on funded and funded businesses is not reasonable. To remove the negative consequences of leverage tax on trade business, the BCBS, in its new document on leverage ratio released in January 2014, announced that short-term self-liquidating trade LCs arising from the movement of goods (e.g. documentary credits collateralised by the underlying shipment), now receive a CCF of 20 per cent for both issuing bank and confirming bank.
Like other developing countries, LC is the main mode of trade finance in Bangladesh. If banks have to consider the 100 per cent LC amount as funded exposure, they will have to keep more capital. This will make LC business costlier. LC will lose its attractiveness as a popular mode of trade finance. Thus, recognising the importance of trade finance for business growth, steps have to be taken to reduce the leverage tax on trade finance instrument.
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