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The European Banking Authority (EBA) recently issued a consultation paper proposing pivotal changes in the classification of guarantees under banking regulations. 

This development, part of ongoing efforts to refine the Capital Requirements Regulation (CRR3), aims to better align the treatment of off-balance sheet exposures with their actual risk levels. 

The trade finance industry must provide their responses by June 4, 2024.

Overview of the consultation paper 

The EBA scheduled a public hearing in April, providing a crucial platform for stakeholders to present their concerns and insights. 

This event offered trade finance specialists a direct channel to influence regulatory standards that significantly impact their field.

Key proposals on Guarantee classifications

The consultation paper proposes reevaluating certain guarantees that have traditionally been classified under ‘Financial Guarantees’ and suggests reclassifying them as ‘Performance Guarantees.’ 

This reclassification, which includes guarantees such as rental guarantees and M&A bid guarantees, could have significant implications on the regulatory treatment and capital requirements associated with these instruments. 

The International Chamber of Commerce (ICC) has expressed concern that this could lead to a decrease in the availability of trade finance, particularly for small and medium-sized enterprises (SMEs).

Introduction of Bucket 2 for trade finance instruments, and the impact on Article 111(8)

This article provides the legal basis for the new classifications and details how these are to be implemented.

The ICC emphasizes that the EBA’s mandate, according to CRR regulations, is limited to classifying off-balance sheet items not already covered in Annex I.  

They argue that trade finance instruments (currently in Bucket 4) should be excluded from the scope of the RTS due to their inherent low-risk profile.

Understanding Credit Conversion Factors (CCF)

For trade finance specialists, understanding the implications of CCF is crucial. 

CCFs are factors used to convert off-balance sheet exposures to credit exposure amounts that could be at risk in the event of a counterparty default. 

The EBA’s proposal to shift some trade finance guarantees from a 20% CCF to a 50% CCF means that banks will have to hold a larger capital reserve against potential defaults, which could reduce their capacity or willingness to engage in certain trade finance activities. 

The ICC highlights that this could affect the cost and availability of trade finance, potentially increasing transaction costs for corporates and other stakeholders reliant on these financial instruments.

Considerations for the banking sector

The potential reclassification of guarantees and the introduction of new risk weight buckets could necessitate a recalibration of risk management strategies across the industry.

Furthermore, the potential reclassification of trade finance products could reshape the competitive landscape, influencing how banks and financial institutions approach trade finance. 

The ICC recommends that trade finance instruments remain in Bucket 4 with a 20% CCF due to their low default rates (less than 0.3%).

ICC Recommendations

  • Exclude trade finance instruments from reclassification: The ICC believes trade finance instruments should remain in Bucket 4 with a 20% CCF due to their inherent low-risk nature.
  • Refine disqualification factors for unconditionally cancellable commitments (UCCs): The ICC considers the EBA’s proposed factors for disqualifying UCCs (e.g., litigation risk) to be subjective and potentially lead to double counting with the Basel Committee’s 10% CCF justification.
  • Classify unused committed lines under Bucket 5: The ICC suggests classifying the unused portion of committed lines for issuing trade finance guarantees under Bucket 5 (0% CCF) as their issuance doesn’t necessarily increase default risk.

Way Forward

This consultation represents more than just a regulatory update; it is a moment for the industry to influence policies that balance regulatory rigour with the practical realities of trade finance. 

The decisions made and the arguments presented in response to this consultation could set the course for future banking regulations in Europe and beyond. 

Trade finance specialists, along with the ICC, must engage deeply with the consultation process, leveraging their expertise to ensure that the regulatory environment continues to support robust, effective, and fair trade finance practices.