How Updated Basel III Standards Impact Supply Chain Finance

At a time when the global supply chain finance market is growing rapidly, new regulations for banks under Basel III draw the attention of various stakeholders in supplier financing.

It’s not only banks that are keen to take note of these regulations, but also their corporate clients, who need to understand the implications for their supply chain finance programs. Basel III rules present a regulatory framework designed to strengthen financial institutions by placing guidelines pertaining to leverage ratios, capital requirements and liquidity. Basel III rules were expected to create confidence that some of the mistakes made by banks that caused and contributed to the financial crisis in 2007-2008 would not be repeated.

As a recent article in GTR Magazine points out, the huge demand for supply chain finance over the past several years has caused many banks to start using the syndication market to support the provision for trade-related financing and to minimize their own credit exposures and funding requirements. But, in light of the Basel III regulations, this strategy might prove insufficient.

Supply chain finance provides a unique solution of a win-win proposition for all the parties involved: buyer, supplier, funder and service provider. In terms of capital optimization, the benefits for the banks are the possibility to reduce the consumption of risk-weighted assets, as counter-party risk shifts from suppliers to larger buyers with a better risk profile. This is an important aspect in light of the Basel III regulations as banks can increase profitability thanks to lower capital requirements compared to other trade finance solutions. However, the current discussions on Basel III guidelines might not recognize the short-term self-liquidating nature of supply chain finance, which could result in higher capital costs for banks.

The new global capital and liquidity reforms known as Basel III set a more restrictive interpretation in terms of quality of counter-party risk than previous Basel I and Basel II regulations. Furthermore, Basel III may require banks active in supply chain finance to hold five times more capital than before to fund supply chain finance transactions.

Why Basel III Challenges the Banks’ Role in Supporting Global Trade

The main challenge with Basel III lies in the fact that it considers supply chain finance like all other credits – such as, for example, a classic loan. However, recently, the Basel committee has reflected the fact that in this type of financing the accounts receivable constitutes a collateral for the funder and brings more security in terms of credit risk. Furthermore, supply chain finance has demonstrated that it benefits from very low default rates and high reimbursement ratio of allocated funding.

Overall, the impact of Basel III appears to not be as large as initially anticipated by some market participants. For example, in Australia, one of the first countries implementing Basel III, major local banks had already adopted an advanced internal rating model under Basel II in calculating regulatory capital requirements for transactions. The applied model treated trade transactions as on-balance sheet transactions and used a 100% capital conversion factor. However, actual capital required was adjusted by probability of default related parameters such as credit rating, tenor and transaction security type. This resulted in much lower capital requirement for highly rated, short-term and secured transactions.

Supply chain finance transactions have similar characteristics, thus capital requirements may not be very different from off-balance sheet treatment with 20% capital conversion factor under Basel II.