Are Banks Gaming Capital Rules? – Basel IV & Trade Finance

Capital Management is a serious issue at banks. The overall goal is to ensure banks and their subsidiaries have sufficient capital consistent with each entity’s respective risk profile and all applicable regulatory standards to cushion itself from loan losses.

But the world of trade finance and capital is in flux as the global regulators look to change the rules again and move to what the market is calling Basel IV.

What has initiated this in the trade world is the regulators have been looking at different loan portfolios across the banks and find differences in risk weighted assets. For example, take a large oil & gas exploration company such as Petrobras.  It is rated differently at different banks and therefore the amount of risk weighted assets put up against Petrobras loans is different across banks. The Feds ask how can you have such a wide variance based on Basel, and the reality is everyone has a different approved model.

So the regulators want to reduce inconsistency in capital requirements among big banks that use their own models. Since models that help lower capital requirements give advantages to banks, the Feds believe they need to act to eliminate the banks gaming their balance sheet. That is why they are proposing banks move from the Advanced Approach to the Standard Approach for risk weighted asset calculations.  This puts all banks on the same footing.

This means banks will have less discretion over how much capital to hold against loans booked.

As of now, regulators believe these proposed changes will not significantly increase overall capital requirements,. But in the business of trade finance, a healthy percentage of transactions are emerging market, which are below investment grade ratings. If you compare Advanced vs. Standardized approach, there is a dramatic difference in risk weighted assets.

The key differences between the two approaches is this - the Standardized Approach relies on risk weights based on external rating providers like S&P to calculate capital. Unrated firms are 100%. The Advanced Approach uses ten years of a bank’s internal data to calculate probability of default, loss given default and exposure at default. It is far more advantageous to use for banks since credit risk accounts for 70 percent of a bank's capital buffer calculation.

Talking to several bankers, at the moment for trade deals, there seems to be no correlation of capital when it comes to pricing – it has to do with liquidity. The market is seeing deals being priced based on bank liquidity as opposed to capital.

But if these new capital rules do indeed become Basel IV, we may find banks need even more capital for trade, which does not bode well for the business.

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