What Did We Learn About Trade Finance From the Financial Crisis?
Before the crisis, the volume of trade and trade credit steadily increased over the years, driven by better communication, transportation and the advantage of economies of scale. The path to higher annual trade turnover was only interrupted during wars or when certain countries ended trading relations with other countries. Today, trade finance volume is about US$6trillion per annum (status 2009) and is the most important source of short-term financing for companies.
Another dimension of trade finance is the percentage of total assets for companies that it represents: in retail and wholesale industries, the percentage is very high (in 1973 this was about 70%). Even in manufacturing companies, the proportion is about 40% of total assets.
Based on the data, it is fair to say that trade finance has a significant impact on global wealth. This came to the fore during and after the financial crisis in 2008. The central topic of the financial crisis was insolvency risk. That could relate to a market stock, a company or a state.
This kind of crisis was not a new one, but for almost 10 years nearly everyone had stopped thinking about it. However, in a financial crisis trade finance is a key to success for corporates, as it enables them to control their liquidity position and having liquidity avoids insolvency in a crisis.
The financial crisis of 2008 showed that trade volume not only depends on the political situation and market structure of the physical products, but also on the health of the financial markets. Although the physical products did not change, the banks and credit insurers did/could not support trade credit as before. The banks reduced their support funding for the corporate world in general, as well as specifically in trade financing. Credit insurers stopped many credit limits, sometimes even for all customers of a sector, region or country. The non-bank investors also reduced their exposures, which made it very difficult for corporates to obtain new equity, which was crucial for closing the gap due to less credit availability and convincing their banks of their creditworthiness.
From a trade finance perspective, the negative development could not trade finance was unchanged, specially the low default rate in trade finance. In 2010, the International Chamber of Commerce (ICC) found that off-balance sheet trade finance transactions had an average time of just 80 days and an insignificant incidence of default. Even during the global economic downturn, these transactions experienced relatively low levels of default, with fewer than 500 defaults for 2.8 million transactions. For written-off products, recovery rates averaged 60% for all product types.
In addition, the results from credit insurers showed no significant changes during the financial crisis. The biggest global provider had a slightly lower turnover, partially due to the reduced credit limits they offered and also because many buyers ordered less during the crisis. It only becomes critical when the insurer reduces single limits to zero or stops covering a region; for the corporate, this means the end of sales for the time being. Most importantly, the defaults rates did not reach critical with relation to the insolvency of a credit insurer. Finally, corporates did not report any unusual big write-offs during the crisis. A few corporates did publish trade finance defaults, but there were no signs that defaults have dramatically increased due to the financial crisis.
The different view for trade finance in relation to other credit products is that trade finance risk has some specific characteristics in comparison with other bank (credit) products:
The financial standby – letters of credit (LCs) and guarantees – are first used to get the final payment out of the basic trade. Only then does the open position lead to a relevant increase in the bank balance sheet. During the financial crisis, the proven structure, as well as the shape of trade finance, showed that trade finance can sail through all kinds of big waves.
Even trade finance might not be able to survive a tsunami effect but fortunately, in contrast to the impact of a real earthquake in the ocean, the lender of the last resort, the national reserve banks and global financial institutions, could solve many of the problems. They have been so successful that some people now believe that they can solve everything. But they cannot, as it is the condition of the free trade (and capitalism) that the market will finally determine the rules.
The regulators are aware of this and, alongside public bodies, are in open global discussions with the production, trading and financial communities. There is no silo behaviour between the global players (regulators/ICC, for the production and physical side, and the financial community). The end goal is for the situation in trade finance in the long term to be as strong as possible, because trade finance is the economic source for the wealth of nations. The European Commission (EC) has already decided to look deeper in the 2013 default rates of bank guarantees. If the average default rate is as good as predicted, then they will consider this in the equity request for banks in the future.
On the micro-level corporates’ in house management of trade finance must be re-evaluated due to their trade finance experience during the financial crisis. Companies worldwide are missing out on opportunities to maximise cash reserves and reduce borrowing costs because of a failure to analyse and manage customers’ overall credit worthiness and payment history. Nearly half of companies never score or comprehensively analyse their trade receivables portfolios. In addition, less than 20% of corporates perform analysis on a methodical basis.
“Savvy CFOs (chief financial officers) and corporate treasurers look at trade receivables as part of their capital structure of the organisation. But how do you maximise the return on that capital and use trade receivables to generate cash? You have to start with some intelligence, some visibility and transparency as to what’s happening across the portfolio.”1
The internal optimisation of trade receivables can be put under three main headings:
The basic understanding today is that a credit analysis should begin at a specific threshold exposure. As credit giving is a core business of the banks, business-to-business (B2B) analysts might use their procedures. But even then there are not many detailed mathematical methods. One well-known method is from Altman in the 1960s.1 Although this method is not that old, it is not a perfect fit for B2B business, as it does not propose a credit limit. This is something a corporate needs, as trade credit is ‘only’ part of a sales agreement. Therefore, B2B credit analysts look more for a credit limit rather than for a default rate.
Buyers in all regions of the world tend to pay the seller later than agreed. Twenty years ago it was nearly impossible for the seller to prevent this type of behaviour, as paper reminders were sent by post and it difficult to ascertain why payment was late. For example, was it the buyer’s bank that did not transfer the money in time? The economic reason for the buyer’s behaviour is that a late payment is a free source of liquidity (Scandinavia is the only place where this didn’t occur because interest payments are accepted by the market).
Sellers decided to take action to stop late payments. Standard enterprise resource planning (ERP) systems enable sellers to better see their overdues, and trained staff effectively remind late payers by phone. The responsible persons in the selling unit showed the positive effect of chasing late payments on cost and banking credit lines.
The importance of late payments came to the fore with the financial crisis, as bank credit lines were difficult to get even for big producers and wholesalers. It is now clear that every amount received improved the net working capital, thus reducing the need for credit lines, and became an important factor even for CFOs.
On the other hand, optimisation should not lead to a lower profit margin for the seller. The question is how to reach it?
Treasurers, banker and rating agencies should carefully analyse whether in a crisis receivables reducing, as part of the working capital optimisation, is necessary because arguably an active trade finance handling is a better choice in the long run.
In addition, manual handling of credit analysis and credit collection is quite expensive. The inherent accounting procedures to undertake receivables management in accordance with security and legal requirements are also not cheap. The easiest way to avoid these costs is to outsource the process. But easiest does not always mean the best way to fulfil a corporate’s overall targets.
There are many options as to what keep in-house and what to outsource. Best practice will differ for each seller. Risk appetite, size of the company, market in which it operates, customer portfolio, sales strategy, regional structure and outsourcing price will all have an influence. In addition, conditions are not static; market conditions and offers change steadily. New products are coming on to the market and regulatory changes mean best practice may have to change.
These questions need to be deeply analysed. The question as to whether we will see a new split between banks’ and corporates’ core businesses is also on the table.
Trade finance and trade credit are certainly bank businesses, and corporates accept this in order to sell their products. However, corporates have better product knowledge and are better placed to sell a product to another customer, particularly if the buyer failed to fulfil his payment. At the moment there is no proven result as to whether a bank’s or corporate’s trade credit solution is the better. But will this be forever? The markets are already testing new solutions, such as reversed factoring, in which banks offer the producer short payments terms and extend a credit line to the buyer. As said previously, regulators will not be able to fix best practice. Regulators can only avoid short-term overshooting, or they risk limiting profits. Trade finance solutions are ones of continuous improvements, often on a micro level.
How will banks’ trade finance product be handled under Basel III in the future? If it is treated as a risky product, trade volume will have to pay the bill and reserves in trade finance equity calculation will be the basis for the next financial crisis.
Hopefully, trade finance can then avoid following a ‘Schumpeter solution’. (Joseph Schumpeter was an Austrian-American economist and political scientist. He popularised the term ‘creative destruction’ in economics.)
Finally, we need to improve trade finance’s old-fashioned paper handling. The next generation of finance expert will only accept electronic LC versions with a database that easily can store and link all documents with internal data. If this happens, trade finance will have great future.
The views expressed in this article are the author’s only.
1Wimley C.J. 2011
2Altman E.I. 1968