The era of regulation – part two

Why do concerns on the future of export finance become apparent in the leverage ratio (LR)?

There is little doubt about the stabilising function of Export Credit Agency-backed export finance for exports during crisis times as the post-2008 renaissance illustrates. Since then we have been living in uncertain times with political instability and volatility in currency exchange rates, interest rates and raw material prices. Good reasons for an ongoing momentum and a bright future for ECA-backed financing. In addition, European industries are facing huge competition worldwide with Asian economies and emerging markets also seeking to participate in global markets. Consequently, trade and exports should be promoted further.

But why then do we observe a decline in ECA volumes under the OECD arrangement when Asian ECAs are still on the rise? In 2015 it was estimated that more than 50% of worldwide ECA business was covered by Asian ECAs. In parallel, the ECA deals reported to tagmydeals declined in 2016 by almost 50% in comparison to 2014.

ECA growth is mainly in countries with less regulation

What are the potential reasons for this change? It would be too simple to refer to regulation only. In some economies and industrial sectors, the investment climate is so depressed that even ECA support is ineffective in convincing investors to go for capital expenditure (CapEx). There are also strong indicators that the adoption of Basel III regulation within banks can be seen as a negative catalyst especially for ECA backedexport credits. The ECA business in Asia is dominated by public banks and not bound to regulation. Other major growing ECAs located in non-OECD countries, e.g. India, Brazil, Russia with supporting public banks, are also exempt from harsh banking regulations.

Commercial banks, subject to the Basel rules on the other hand, have to team up more often to source bigger deals and seek off-balance sheet solutions to pass equity tests for stressed scenarios. A number of banks have already reduced their export finance capacity or have shut down this section completely.

Whilst the greater reluctance for SME transactions today is mainly based on the results of much stricter governance (risk analysis + know your customer, anti-money laundering etc.), and the need to reduce costs allocated to the management of smaller operations, the drop in capacity for bigger deals is further due to the most critical element in regulation for export finance: the leverage ratio. Consequently, banks are in the midst of a transitional process from a book-and-hold approach to the originate-todistribute model and ECAs start (or continue) to focus on direct lending options. Why is the leverage ratio so fundamental to the future of long-term export finance solutions for the industry?

Leverage ratio, a valid approach to regulate banks?

After a period of ultra-liberal banking supervision and regulation during the 1980s and 1990s, the financial crisis of 2008 has shown the disadvantages of excessive leverage in the banking system. Basel I categorised five buckets of bank assets with different capital requirements. From this period of time 8% is still known as some sort of general equity, underlying and 0% government risk, as well as for ECAs.

Basel II was an attempt to limit economic leverage and required advanced banks to estimate the risk of their positions and allocate capital respectively. Nonetheless, the results as evidenced by the financial crisis were a disaster for the reputation of banks’ ability to calibrate their own risk models in order to avoid major losses.

As a result, the Basel committee for banking supervision (BCBS) proposed the implementation of a leverage ratio as a simple, transparent, non-risk sensitive measure and backstop to the risk-based methods/requirements (BIS: Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010). In 2013, the European Union transferred the project of the leverage ratio into European law, i.e. CRR/CRD IV.

The leverage ratio is defined as the ratio of Tier 1 capital (numerator) and an exposure measure (denominator): 

 

 

 

After a period of observation and testing, the leverage ratio is expected to come into force on 1 January 2018. In January 2016 the oversight body of the BCBS announced an in-principle agreement to apply for a minimum level of 3% based on Tier 1 capital.

Fundamental to assessing the impact of such a leverage ratio on ECA-backed export finance, is understanding the changes in relation to what was practised previously. In contrast to short-term trade, the gap between the current approach in export finance indicates a substantial increase in underlying capital, especially for ECAs, backed by favourable sovereign ratings, independently of whether banks use the standard approach (KSA) or the internal rating-based approach (IRBA), see Graph 2.

The European Banking Authority (EBA) admitted that: “by design, the non-risk-based leverage ratio may incentivise financial institutions with low-risk business to diversify asset portfolios into high-risk business, in particular when applied on a stand-alone basis”. This is true, especially if the management of a bank has to decide between a 15-year transaction (ECA) and (riskier) business with much shorter time periods. In times when predictability of sufficient underlying capital is jeopardised by steady stress tests, it is unlikely that a 15-year ECA-backed transaction will prevail in comparison to a much riskier transaction with a three-year tenor.

It is also wishful thinking to expect margins for ECA-backed business to be easily raised in order to convince the bank’s management of higher profitability. ECA business is already profitable due to a low-risk profile (as confirmed by the International Chamber of Commerce (ICC) Medium-to Long-term trade (MLT) register report). Pricing for ECAbacked export credits is mainly based on costs of funds, costs of capital, overhead costs and risk-related costs derived from PDs of the borrower and the risk mitigant (sovereign backing the respective ECA). And it has still to be attractive enough to support exporters in global competition. Taking into consideration that export finance business worldwide is mainly executed by Global Systemically Important Institutions (GSIIs) the leverage ratio might be even higher than 3% in the future.

One of the major suspicions of the EBA during the discussions and hearings was a potential excessive growth in business which would be exempted from the leverage ratio or otherwise preferably treated. We argued the ECA-backed export finance is limited by nature as a counter-cyclical instrument to overcome market gaps in crisis times, so growth is restricted. In addition, the OECD arrangement prevents ECAs and banks from too aggressive an offering.

What is more, based on a closer look at the various stages of a specific ECA transaction, the challenges of a simple leverage ratio are evident (see Graph 3).

                                

Phase 1: commitment to final ECA approval

Depending on the procedure of the respective ECAs there is sometimes a period of several weeks/months from an initial commitment to a final ECA approval. During this period the bank’s commitment is always subject to final ECA cover, i.e. conditional. For such a period a lower Credit Conversion Factor (CCFL) than 50% should apply.

Phase 2: ECA approval to disbursement

Similar to phase 1, a CCFL of 50 % ignores that an ECA-backed export credit is not easily disbursed in a stress scenario. Disbursements are always linked to the presentation of shipping documents/service certificates. Therefore, a natural hurdle is raised to prevent parties from receiving instant disbursement. Such period may last two to three years, even on some occasions, up to five years.

Phase 3: disbursement to final repayment

During the lifetime of the loan (up to 18 years according to OECD sector understandings) the LR will be applicable. At present, the additional equity consumption resulting from such a leverage ratio seems to be the major threat to more accurate business predictability. Any a hurdle will be seen as a potential showstopper for a deal.

The EBA has opened a door for ECAbacked export credits in Europe

In early August, the EBA published its long awaited report on the impact of the leverage ratio on the finance industry (“EBA report on the leverage ratio requirements under article 511 of the CRR”). Even if it is not that easy for practitioners to obtain the substance of the comprehensive report, it can be seen as an important milestone on the way to implementing a leverage ratio in Europe and for improved understanding of how resilient the various business segments of financial institutions are in light of the new regulation. The EBA's assessment is based on various discussions with industry experts, business associations and on statistics and quantitative analysis. In order to share this assessment with the industry the above were invited to a public hearing in April 2016 where over a 100 participants from all areas of the financial sector, including representatives of the ICC, Berne Union, ECAs and EBF, attended.

During the hearing many issues were brought to the attention of the EBA. It was argued that the consequences of the implementation of the leverage ratio should be carefully assessed in the context of product specifics, validation of collaterals/guarantees, support for SMEs and also for trade and export finance.

The report will now form the basis of further work by the European Commission on a potential legislative recommendation for a leverage ratio minimum requirement in the European Union. It is not considered surprising that the EBA deems the potential impact of introducing a leverage ratio requirement of 3% on the provision of financing by credit institutions, as a whole, to be relatively moderate. From an EBA perspective such a leverage ratio should lead to more stable credit institutions and help mitigate the risk of excessive leverage.

The EBA comments that “the results of the quantitative analysis performed, suggest that a 3% level of calibration for the LR is, generally consistent with the objective of a backstop measure which supplements riskbased capital requirements.”

At the same time, “the results of a simulation-based analysis, estimating the impact of potential adjustment actions […] suggest a high sensitivity to changes in the calibration of the LR and estimate that the potential reduction of exposures would increase significantly beyond a LR level of 3.5%.”*

Based on the EBA report it can be expected that a 3% leverage ratio will be introduced into Europe. And yet the acute concern of the industry that a more restrictive ratio might be determined at a higher level of 4% or 5% is still there and will still be a further potential threat for the Global Systemically Important Institutions (GSIIs).

In order to understand the EBA’s view on the mechanism of such a leverage ratio it is interesting to refer to the report again: “Hence, the LR and the risk-based capital requirements should function in a complementary manner, with the LR defining a minimum capital to total exposure requirement and the risk-based capital ratios limiting risk-taking. In order to achieve this, and considering the role of the LR as a supplementary measure to risk-based capital requirements, calibration needs to be determined in a manner which ensures that both approaches to capital regulation remain relevant.”**

From an EBA perspective the leverage ratio serves as the minimum level for a bank’s source to cover losses. For riskier business additional equity is needed but the major concern of the EBA is related to low-risk profile business with a higher leverage.

As a result, it is of major importance that the EBA report came to the conclusion that “an exception may be ECA-backed exposures, which may, in some cases, have a risk weight as low as 0%. Given the lack of data on these exposures, it cannot be excluded that if some institutions are specifically constrained or bound by the LR, an incentive may be created not to expand/reduce their exposure to this category.”***

Not only have ECA-backed export credits arrived on the radar of EBA, they have also been acknowledged as a potentially constrained business (see Graph 5).

The EBA comes to the overall conclusion that “one exemption may be ECA-backed exposures, which typically attract a very lowrisk profile”****. From my perspective this conclusion opens the door to further discussions, supported, I would hope, by the export-oriented industry in Europe as well. I am confident that other regulators (BCBS, WTO, EU COM, ECB) will rapidly realise the situation and understand the need to protect trade and export finance (and high-profile jobs) during turbulent times.

The way ahead

The EBA expressed the critical need to exempt a certain business segment from the leverage ratio on several occasions. What is more, market participants admitted that the ratio should be kept as simple as possible and the envisaged regime of a 3% minimum leverage ratio appears reasonable. Given the overall impression of regulators (and citizens at large) that leverage in banks should be restricted, the foreseen ratio of 3% will highly likely become the standard. This said, discussions with the regulators should continue, based on a wider understanding of the transaction specifics of ECA-backed export credits to define which mitigants could be brought to banks willing to offer export credits. One of the lessons learned from previous hearings, meetings and discussions was this: a joint effort by the Berne Union, ICC, EBF and business associations may help to address the major concerns of the export industry. And exporters should be more vocal and active in these discussions, to express their needs for export finance supported by commercial banks.

Ralph Lerch

Chairman of the Export Credit Working Group at The European Banking Federation

 

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Notes

* page 15, EBA report on the leverage ratio requirements under article 511 of the CRR

** page 12, EBA report on the leverage ratio requirements under article 511 of the CRR

*** page 25/26, EBA report on the leverage ratio requirements under article 511 of the CRR

**** page 200, EBA report on the leverage ratio requirements under article 511 of the CRR