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Small firms suffer as strict compliance rules hit world trade finance hard

The biggest barrier to financing world commerce is not the threat of trade wars, volatile commodity markets or digital disruption, but — rather more prosaically — compliance.

Banking rules introduced following the global financial crisis, along with regulations aimed at countering terrorism, are cited by banks worldwide as the biggest obstacle to future trade finance growth, according to the recently published 2018 worldwide survey of trade finance from the International Chamber of Commerce.

Trade finance facilitates 80% or more of annual merchandise trade flows, according to the ICC, which surveyed 251 banks in 91 countries responsible for $9 trillion of trade finance for its report published in May.

For 93% of those surveyed, the biggest obstacle to future trade finance growth was regulation and compliance. A close second was compliance associated with rules to counter terrorism and enforce international sanctions, with 87% of banks citing this as a reason for trade finance restraint.

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"Trade finance used to be like electricity. Now it is hard to get," said Kamola Makhmudova, a senior banker on the European Bank for Reconstruction and Development's trade facilitation program, speaking at the London Institute of Banking & Finance's annual Trade Finance Compliance Conference on May 31.

Closer scrutiny

Banks offer trade finance through the provision of working capital, loans, bank guarantees and letters of credit. Trade finance revenues at the 10 largest transaction banks totaled $5.8 billion in 2017, down from $7.4 billion in 2013, according to figures from Coalition, part of CRISIL, an S&P Global company.

Regulators have focused more closely on this field in recent years since it is a system that can be used for nefarious purposes, like funding terrorism and laundering money, rather than for the more innocent pursuit of funding trade. This scrutiny has caused problems for small firms, in particular.

"The sanctions process can become very generic — if a single name from a sanctions list appears, like John Smith, say, it can trigger a requirement for a full review,' said Peadar MacCanna, trade finance head at Citigroup Inc., the biggest bank in the sector.

"The transaction value itself might be very small, just $100, but the cost of compliance can quickly become not much different to the cost for a $100 million transaction. So the costs almost deselect the banks from supporting this trade."

The biggest gap is with sole traders or small and medium-sized enterprises whose transactions are mostly low value, he said.

The result is a gap between demand for trade finance and supply, a gap which last year the Asian Development Bank said had reached $1.5 trillion annually. This has serious implications for economic growth, according to Mike Rake, chairman of Worldpay Inc. and a director of S&P Global Inc., parent company of S&P Global Market Intelligence.

"It has never made sense to regulate low-risk trade finance the same way as higher-risk investment finance," Rake said in the ICC survey. "What is more, trade finance provides valuable short-term working capital for small and medium-sized businesses and plays a critical role in financing export opportunities."

Trade finance should be regulated differently from other forms of finance, he said, because it is low-risk — short-term credits in trade finance have a default rate of less than 1% — while in a globalized economy supply chains are integrated and span multiple markets across developed and emerging regions.

Instead, new Know Your Customer requirements, brought in as part of anti-money-laundering changes, have imposed almost impossible burdens on banks, said Vincent O'Brien, adviser on trade intelligence and innovation at China Systems Corporation, speaking at the LIBF conference.

"Now the expectation is that banks will do due diligence on a small business in Mongolia," he said. "That is what is killing trade."

The rules mean fewer small and midsize businesses are able to access trade finance to grow their businesses as a result of the regulatory regime, and that fewer banks in emerging markets are able to access capital markets in places like London, Rake said.

Two kinds of costs

MacCanna said banks face two kinds of costs for trade finance — transactional expenses associated with compliance requirements and the extra capital costs associated with trade finance that have appeared in recent years. Basel III regulations increased the amount of equity funding that trade finance requires, leading to an increase in funding costs.

"There are additional capital requirement for trade finance and these are quite strenuous," he said. "But the risks in trade finance are very different to those associated with long-term capex investment, for instance. The last thing someone will want to do is default on their trade finance, because trade is why they are in business in the first place."

Bankers involved in trade finance suggest there is further scope for improvement including simplifying the Know Your Customer requirement, creating credit information bureaus and exchanges for supply chain finance.

Technology can also play a part, although trade finance remains largely paper-based.

Citigroup's MacCanna said it could not be a one-size-fits-all solution, noting that different parts of the world have different financial ecosystems.

"You can't expect them all to digitize at the same speed," he said. "But you can find key players in a certain commodity field, for instance, who operate to a certain digital protocol. We have worked to digitize our core systems so we can interface with these different protocols. There may still be paper at the end of the trail but any time paper reaches us it gets scanned."

There is an opportunity for the fintech industry to increase digitization in this area, he said.