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15 October 2004
Under the current capital requirement regime, financial institutions must have
a capital equal to at least 8% of their risk-weighted assets. Generally, such
risk weights range from 0% to100% of an asset. Under Basel II, the 8% rule will
still apply, but no risk weight ceiling will exist and the risk weight of certain
assets could be as high as 250%. Basel II should be implemented by January 1
2007 and it is likely that Switzerland will meet this deadline. Basel II favours
a consolidated supervisory regime, meaning that normally the regulatory authority
in charge of supervising the holding company of a bank group will be almost
exclusively responsible for the capital requirements of the entire group, irrespective
of where the group companies are actually located. For the purposes of the capital
requirements, it is intended that local supervisory authorities should avoid
any undue interference in the local subsidiaries of a foreign bank (a criticism
often made of the current regime, which allows for the duplication of requirements
throughout an international network). It follows that, in the main, the Swiss
legislation implementing Basel II will have the most significant impact on banks
whose ultimate parent company is in Switzerland. The Swiss subsidiaries of foreign
banks should be subject to their parent company supervisory authority as far
as capital requirements are concerned.
Commodities finance has been recognized as a form of specialized finance in Basel II, alongside project finance, object finance (eg, shipping finance), income-producing real estate and high-volatility commercial real estate. The reason for creating these subcategories of exposures is to recognize the danger of analyzing such financing solely as pure corporate exposures, since many borrowers involved in commodities finance represent a weak credit risk which would mean - if analyzed as pure corporate exposures - that the risk weight of loans granted to borrowers would be quite high under Basel II.
The Basel Committee recognized the central role played by the commodity being financed. It follows that for commodities finance, legal and physical control of the commodity is of paramount importance. The tables set out as an annex to Basel II establish four categories (strong, good, satisfactory and weak) for commodities exposure which reflect the importance of the legal and physical control of the financed commodity. Commodities financing arrangements which fall squarely within the structures of traditional documentary credit transactions will involve a perfected security interest over the goods, and are thus unlikely to be affected by Basel II. In contrast, it is most likely that Basel II will significantly affect transactions which do not fall within this category - and which are therefore riskier. For many transactions, the key factor will be to assess whether an asset falls under the commodities finance exposure or is in fact a corporate exposure, albeit generated by a commodities finance business line. It is worth remembering that the traditional documentary credit is supported by a perfected security interest, which effectively enjoys international recognition. While still crucial for international trade, this traditional form of financing is not regarded by many financial institutions as a business line that is as profitable as it should be. However, as a byproduct, many banks enter into riskier transactions, which do provide higher returns, thus enabling the banks to improve substantially the profitability of their commodities finance business. These riskier transactions are typically more structured and do not involve a perfected security interest (or at least not for the entire duration of the financing transaction). Although not a recognized concept in law, it is fair to say that many such transactions are 'imperfectly secured transactions'. In addition, the physical control of the financed commodity is not always certain. For example forwarder's certificate of receipt financing, inland financing, prepayment financing and pre-export financing fall into that riskier and more profitable category. In the context of Basel II, the critical issue will be to ascertain at what point a transaction 'imperfectly' secured with a limited control over the financed commodity should be viewed as a commodities finance exposure or as a pure corporate exposure. The requirement to assign additional capital if an asset is requalified as a corporate exposure rather than a commodity finance exposure will undoubtedly alter the economics of a transaction. It follows that banks, with the help of lawyers, will have to ensure that as many 'imperfectly secured transactions' as possible will not only be categorized as commodities financing exposures, but will also be considered as 'satisfactory' commodities finance exposures. Collateral will become even more central, especially when dealing with clients with a poor credit standing and/or transactions involving emerging countries.
For commodities finance, and especially for 'imperfectly secured transactions' where the well-tried documentary credit structures are not available, lawyers will be called upon to reinforce the legal structures used to mitigate the loss of control by the banks over the financed assets. This opens fairly new opportunities for innovation in the risk sharing of transactions. Insurance companies may be interested in insuring a part of such risk. However, it may be the case that insurance companies will find it difficult to differentiate a trade process risk from a country risk. The major inspection companies would be best placed to assist in collateral management, as well as in eventually guaranteeing certain trade processes. By guaranteeing or insuring certain trade processes, it will be possible to convert a risk against a weak intermediary (eg, forwarders) into a claim against highly rated insurance companies or inspection companies. It is clear that credit enhancement techniques common in the securitization field could easily find their way in the commodities finance business.
It is within this context that SGS, the world-leading inspection company based in Geneva, announced in September 2004 the launch of a ground-breaking programme called the Secured Forwarder's Certificate of Receipt programme. SGS will issue performance guarantees to cover potential performance failures of certain selected forwarders in emerging markets. This scheme will synthetically transform a high-risk asset into a far more palatable risk against a highly rated Organization of Economic Cooperation and Development company such as SGS. This should be the first of many financial innovations dictated by Basel II that will reshape the commodity finance industry. As Switzerland is a world leader in the field, it is set to witness the advent of many such innovations.
For further information on this topic please contact Gilles Thieffry or Emmanuel Genequand at Pestalozzi Lachenal Patry by telephone (+41 22 737 1000) or by fax (+41 22 737 1001) or by email (email@example.com or firstname.lastname@example.org).
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