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At the International Trade Forfaiting Association (ITFA) 49th Annual Trade and Forfaiting Conference in Abu Dhabi, TFG’s Deepesh Patel spoke to Silja Calac, Board Member, and head of the ITFA Insurance Committee to learn more about credit risk insurance and its importance for trade, as well as specific aspects of the implementation of the Basel 3.1 Regulation.
The importance of credit risk insurance for trade
Credit risk insurance is a risk mitigation tool used by banks to cover credit risks related to transaction banking.
This means that the bank substitutes the probability of default (PD) and loss given default (LGD) of the original obligor of a transaction by the PD and the LGD of the insurance.
In this way, banks can enhance their credit capacity and reduce risk-weighted assets.
As a result, Calac said, “Credit risk insurance is absolutely crucial for our economic system.”
A survey conducted by ITFA in collaboration with the International Association of Credit Portfolio Managers (IACPM) in 2021 showed that the 40 banks surveyed used $136 billion of insurance cover, i.e., the total insured amount.
This facilitated a total transaction amount of $350 billion. A 2023 survey showed that the amount has increased to $400 billion.
Calac said, “So, insurance contributes $400 billion to the real economy.” This stands as a key demonstration of why credit insurance is so critical for trade.
ITFA’s response to the implementation of Basel 3.1
The IFTA Insurance Committee was actively lobbying for the implementation of Basel 3.1, particularly regarding the Capital Requirements Regulation (CRR).
About two years ago, the Insurance Committee had noticed that the Basel Regulation foresaw that for insurance, the LGD would be set at 45%.
Calac said, “Every time you work with an insurance company, never mind for which kind of business, banks will be in the foundation approach. So, they cannot model their own LGDs any longer; they have to take the LGD which is prescribed by the rules, and these rules say it is 45%.”
The Insurance Committee initially thought that the regulators had overlooked a key point. This stemmed from the understanding that when regulators extend loans to an insurance company, their main objective is to protect especially vulnerable creditors.
These vulnerable creditors are the policyholders who must receive their payouts in the event that the insurance company becomes insolvent.
Working with the EBA to find an efficient solution for insurance for transaction banking
The Committee had raised this oversight with regulators, which led to a successful dialogue.
After the conversation, Article 506 was formulated in response.
Calac felt Article 506 was “quite a success story.” After consulting with all major stakeholders in the European Commission and Parliament, the Commission presented a revised draft that now includes Article 506, which is currently under voting.
Article 506 specifies that within a set timeframe, the European Banking Authority (EBA) is to consult with ITFA and the European Association for Insurers to collaborate on determining a more suitable LGD figure, as an alternative to the current 45%.
Currently, there is not yet provision for a transition period. This concerned ITFA, as the new CRR rules would be implemented in 2025.
Article 506 states that the EBA shall, within a certain period of time, calculate and identify the correct LGD. However, the new CRR rules would be implemented immediately, still containing the LGD of 45%.
This current rule, implemented after 2025, would cause significant issues for banks.
Calac said, “This would have a huge cliff effect because banks would no longer be able to do large amounts of credit risk insurance, which contribute greatly to the real economy.”
This was why ITFA supported the proposal for a transition period until a new, optimal LGD level could be found.
The key focus for ITFA in collaborating with the EBA to develop an effective insurance solution for transaction banking was pinpointing pertinent statistics.
Default statistics are particularly needed.
ITFA was also tasked with elaborating on the details of the recovery process. This responsibility fell to the Insurance Committee, which was reaching out to its members to help provide the necessary information to the EBA.
Progress by cooperation: Industry insights are needed to move the needle
Calac urged the industry to participate in the ITFA surveys.
She noted that the only way that ITFA can make a convincing case to the EBA to lower the LGD from 45% is by providing thorough answers and relevant statistics, which need to come from their partners.
Moving forward, it is clear that there is a critical need to reduce the LGD from 45% to a lower number that the industry agrees on. Without this, the trade finance and credit insurance sector will struggle to fulfil their vital role in the industry.