CIF - Trade Finance and the Compliance Challenge

Trade finance and the compliance challenge A showcase of international cooperationDisclaimer This publication and any opinions reflected therein are the sole responsibility of the World Trade Organization Secretariat and of International Finance Corporation staff. The opinions expressed and arguments employed herein do not necessarily reflect the official views of International Finance Corporation or its partners, nor of the World Trade Organization or its members. © International Finance Corporation/World Trade Organization 2019.| 1 Foreword by Roberto Azevêdo, WTO Director-General, and Philippe Le Houérou, IFC Chief Executive Officer 3 Co-publishers and contributing institutions 5 Acknowledgements 6 Executive summary 7 Introduction 9 Chapter 1 Reasons for persistent trade finance gaps 13 Chapter 2 De-risking and inter-institutional responses 17 Chapter 3 Showcasing capacity-building in trade finance and regulatory compliance 23 CASE STUDY 1 IFC’s AML/CFT guidance for trade finance (International Finance Corporation) 28 CASE STUDY 2 Joint IFC/World Bank AML/CFT capacity-building programmes (International Finance Corporation, World Bank) 30 CASE STUDY 3 Joint IFC/IMF outreach initiatives (International Finance Corporation, International Monetary Fund) 32 CASE STUDY 4 Joint IFC/BAFT capacity-building programme (International Finance Corporation, Bankers Association for Finance and Trade) 33 ContentsCASE STUDY 5 EBRD framework to build capacity in trade finance compliance (European Bank for Reconstruction and Development) 34 CASE STUDY 6 ADB’s Trade Finance Program and AML/CFT initiative (Asian Development Bank) 37 CASE STUDY 7 ITFC trade finance technical assistance event in Tashkent, Uzbekistan (The International Islamic Trade Finance Corporation) 41 Conclusions 43 Bibliography 44 Abbreviations 46| 3 In 2017, an IFC report1 pinpointed the reductions in the network of correspondent banks in emerging markets. In emerging markets, correspondent banking stress and compliance challenges drove some respondent banks

Conclusions 43 Bibliography 44 Abbreviations 46| 3 In 2017, an IFC report1 pinpointed the reductions in the network of correspondent banks in emerging markets. In emerging markets, correspondent banking stress and compliance challenges drove some respondent banks to retrench their own businesses. At the time, the trade finance gap was estimated at around US$1.5 trillion.2 It has likely widened since. Global correspondent banks are reassessing their emerging market strategies. In recent years, both compliance costs and potential regulatory risks have grown exponentially, making it more challenging to stay engaged. Smaller countries, with lower business potential, are particularly vulnerable. Trade finance shortages have been chronic and persistent in the developing world. Stepping up cooperation in this area is vital to boost global trade, lift economic activity, create jobs and achieve the UN’s Sustainable Development Goals. WTO, IFC, other development banks and the Financial Stability Board (FSB) have come together to mobilize resources to enhance trade finance programmes and develop risk sharing frameworks. Foreword Roberto Azevêdo, WTO Director-General Philippe Le Houérou, IFC Chief Executive Officer 1 International Finance Corporation, 2017. 2 Asian Development Bank, 2017.4 | Trade finance and the compliance challenge We also have started an unprecedented technical assistance effort to train a new generation of trade finance specialists and to build capacity on antimoney laundering and combating the financing of terrorism in developing countries. We have created a network to disseminate international best practice among the global trade community. In addition, the WTO, IFC and FSB are working together to inform trade finance providers about relevant regulatory requirements, promote tools to make compliance more effective and less costly for local banks, and help them attract new correspondents. This publication, “Trade finance and the compliance challenge: A showcase of international cooperation”, presents the efforts made so far. It provides an explanation of the current global trade finance gaps amid market failures as well as perceived regulatory risk. The publication presents an analysis

and less costly for local banks, and help them attract new correspondents. This publication, “Trade finance and the compliance challenge: A showcase of international cooperation”, presents the efforts made so far. It provides an explanation of the current global trade finance gaps amid market failures as well as perceived regulatory risk. The publication presents an analysis of the recent trends of de-risking and the reasons for falling correspondent banking relationships. It shows how WTO, IFC and FSB have started working together to respond to this issue since the end of 2017. Finally, this publication shares real-life experiences in building capacity on trade finance and compliance through a range of illustrative case studies. We have a long way to go, but we have already made some significant progress. Together, we can ensure that trade finance availability is no longer a barrier but a springboard to trade, economic growth and development.  Roberto Azevêdo WTO Director-General Philippe Le Houérou IFC Chief Executive Officer| 5 Co-publishers The World Trade Organization (WTO) is the only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to help producers of goods and services, exporters, and importers conduct their business. The International Finance Corporation (IFC), a sister organization of the World Bank and member of the World Bank Group, is a global development finance institution focused exclusively on the private sector in developing countries. Contributing institutions The Asian Development Bank (ADB) is an international development financial institution dedicated to reducing poverty and fostering development in Asia and the Pacific through loans and expertise. The European Bank for Reconstruction and Development (EBRD) is an international development finance institution that invests in projects, mostly in the private sector, and in work on policy reform and provides technical advice to promote sustainable growth. The International Islamic Trade Finance Corporation (ITFC) is a specialized institution that promotes the trade of the member countries of the Organization of

is an international development finance institution that invests in projects, mostly in the private sector, and in work on policy reform and provides technical advice to promote sustainable growth. The International Islamic Trade Finance Corporation (ITFC) is a specialized institution that promotes the trade of the member countries of the Organization of Islamic Conference by providing trade finance and engaging in activities, including investment and advisory, that facilitate intra-trade and international trade.6 | Trade finance and the compliance challenge Acknowledgements Many people have contributed to this publication, either directly by providing written contributions or by participating in the design, editing and reviewing process, or more indirectly by actually reporting on the capacity-building activities that they have been organizing in the field. Special acknowledgment should go to the WTO team including, in alphabetical order, Marc Auboin, Anthony Martin, Heather Sapey-Pertin, Helen Swain and David Tinline; the IFC team, including Hyung Ahn, Kuntay Celik (World Bank), Emmanuel Mathias (IMF), Samantha Pelosi (BAFT), Susan Starnes, Alexei Timofti, and Makiko Toyoda; and the EBRD (Kamola Makhmudova, Rudolf Putz), ADB (Steven Beck, Maria Clarissa A. Laysa, Pinky Rose Lustre, Can Sutken) and ITFC (Anisse Terai).| 7 Executive summary • Up to 80 per cent of trade is financed by credit or credit insurance but availability of finance varies across regions. A lack of trade finance is a significant barrier to trade, particularly (but not exclusively) in developing countries. • Small and medium-sized enterprises (SMEs) face the greatest hurdles in accessing affordable financing. The poorer the country in which they are based, the greater the challenges SMEs face in accessing trade finance. Seventy-five per cent of rejected requests for trade finance relate to SMEs. The number of international banks involved in trade finance continues to decline. • The estimated value of unmet demand for trade finance is US$ 1.5 trillion annually. About

face in accessing trade finance. Seventy-five per cent of rejected requests for trade finance relate to SMEs. The number of international banks involved in trade finance continues to decline. • The estimated value of unmet demand for trade finance is US$ 1.5 trillion annually. About 40 per cent of this unmet demand is in developing Asia, and 10 per cent is in Africa. Bridging this gap would unlock the trading potential of many thousands of individuals and small businesses around the world. • Gaps in trade finance provision are widest in developing countries, where opportunities to trade are increasing as global production patterns evolve. • The reluctance of the global financial sector to invest in developing countries after the 2008-09 financial crisis compounds the problem of gaps in trade finance in certain countries because local banks require trade finance transactions to be settled in the currency of the transaction, which requires the participation of banks in the country which issues that currency. Local banks need international correspondent banks to confirm their letters of credit, engage with them in supply chain finance and clear trade-related payments in foreign currency. • Some 200,000 correspondent banking relationships, over about a million in total, have disappeared since the end of the financial crisis. Africa, the Caribbean, Central and Eastern Europe and the Pacific Islands are the regions most affected by the termination of correspondent banking relationships. Flows of trade finance are particularly affected. • In developed countries, there has been a heightened perception of the regulatory risk of operating in developing countries since the adoption of new anti-money-laundering and countering the financing of terrorism (AML/CFT) regulations and other regulations involving sanctions (particularly regulations pertaining to trade and financial sanctions). The adoption of these regulations has played a significant role in the decisions taken by many global banks to terminate certain correspondent banking relationships.• Local banks, in turn, have found themselves faced with varying levels of demand from foreign jurisdictions in terms of complying with regulations, and they are often hardpressed to comply with all of the new requirements. They risk being marginalized within the financial system, with consequences for the economic development of the countries in which they are based.

foreign jurisdictions in terms of complying with regulations, and they are often hardpressed to comply with all of the new requirements. They risk being marginalized within the financial system, with consequences for the economic development of the countries in which they are based. • The international trade, development and financial communities have realised that they must address the challenges facing trade finance. For this reason, the WTO Director-General Roberto Azevêdo and IFC Chief Executive Officer Philippe Le Houérou joined forces with the Chair of the Financial Stability Board (FSB) on an incremental strategy, involving improving local capacity-building, promoting tools to reduce the cost of due diligence, and improving the process for identifying trade finance entities. The WTO and IFC have given strong support to the efforts of multilateral development banks to develop their own repositories of information on customers. • Joint missions in countries affected by trade finance gaps have involved experts from IFC, the WTO, the FSB and multilateral development banks, providing guidance on trade finance and regulatory compliance requirements. The dissemination of such knowledge is key to reconnecting local trade finance providers to the rest of the world’s network of trade finance distribution. • At the annual meetings of the International Monetary Fund and World Bank in October 2018 in Bali, Indonesia, DG Azevêdo and CEO Philippe Le Houérou co-hosted a session on “Financial Inclusion in Trade”, aimed at discussing future inter-institutional steps to reduce the US$ 1.5 trillion global trade finance gap and address the regulatory compliance challenges. Heads or senior officials of the IMF, the EBRD, the Islamic Development Bank, the African Export-Import Bank and the FSB also participated in this event. • More inter-institutional cooperation is needed to address the shortages of trade finance which are hindering the trade opportunities of many developing countries. DG Azevêdo and CEO Le Houérou have supported the publication of this report, which includes a number of case studies on how best to address regulatory compliance in trade finance.| 9 “ Introduction The availability of trade finance has become an increasingly important issue in the past few years. For

Le Houérou have supported the publication of this report, which includes a number of case studies on how best to address regulatory compliance in trade finance.| 9 “ Introduction The availability of trade finance has become an increasingly important issue in the past few years. For merchandise trade flows of over US$ 18 trillion annually to flow smoothly, there needs to be a wellfunctioning trade finance market serving the needs of global traders. However, the supply of trade finance does not meet demand in many regions. Even before the 2008-09 global financial crisis, a significant gap existed between the demand and supply of trade finance in emerging markets; since the crisis, this gap has grown, with some regions affected more than others. A 2014 study by the Bank of International Settlements (BIS, 2014) revealed that a large share of international trade finance was supplied by a relatively small group of about 40 international banks. This group accounted for some 30 per cent of trade finance intermediated by banks, with local and regional banks supplying the remainder. Since the global financial crisis, many of these banks have been downsizing their balance sheets and reducing the network of their correspondent banking relationships with other banks in the world, particularly in developing countries, a phenomenon called “de-risking”. The International Finance Corporation (IFC) found that over one quarter of the more than 300 emerging market banks across over 90 countries reported declines in relationships with correspondent banks, reducing their ability to serve customers (IFC, 2017). The Financial Stability Board (FSB) established a work programme in 2015 to address the reduction of correspondent banking relationships. According to the FSB, 200,000 correspondent banking relationships were terminated from 2011 to 2017, out of a pre-crisis total of roughly 1 million.

established a work programme in 2015 to address the reduction of correspondent banking relationships. According to the FSB, 200,000 correspondent banking relationships were terminated from 2011 to 2017, out of a pre-crisis total of roughly 1 million. The Asian Development Bank (ADB) estimated the global trade finance gap to be close to US$ 1.5 trillion in 2017. This gap represents the amount of trade finance requests that are rejected. In many developing countries, the alternatives to bank financing are scarce. Consequently, when trade transactions are rejected by banks, most of them are abandoned. A little less than half of the US$ 1.5 trillion trade finance gap concerns developing countries in Asia. A significant share of the gap occurs in Africa: the estimated gap of about US$ 100 billion a year accounts for about one third of the trade finance market in the continent. The supply of trade finance does not meet demand in many regions.10 | Trade finance and the compliance challenge “ Globally, 60 per cent of all trade finance requests by small and medium-sized enterprises (SMEs) are rejected, against only 7 per cent for multinational companies. According to the 2016 Global Enabling Trade Report of the World Economic Forum, lack of trade finance is among the top three exporting obstacles for half of the countries in the world. Since 2017, WTO Director-General Roberto Azevêdo and IFC Chief Executive Officer Philippe Le Houérou have worked with other multilateral institutions, meeting on several occasions to discuss this topic and identified effective remedial actions. Further dialogue with the FSB should help to clarify regulatory expectations, reduce the cost of regulatory compliance, build capacity The ADB estimated the global trade finance gap to be close to US$ 1.5 trillion in 2017.

topic and identified effective remedial actions. Further dialogue with the FSB should help to clarify regulatory expectations, reduce the cost of regulatory compliance, build capacity The ADB estimated the global trade finance gap to be close to US$ 1.5 trillion in 2017. CEO Le Houérou and DG Azevêdo co-hosted a session on financial inclusion in trade at the IMF/World Bank Group Annual Meeting in Bali, Indonesia in October 2018.| 11 in smaller local respondent banks and encourage larger correspondent banks to return to markets from which they had withdrawn. Joint technical assistance is needed to build knowledge on both trade finance and compliance requirements. Trade finance support offered by multilateral development banks helps local companies which are having difficulties accessing trade finance and provides risk mitigation for local banks. However, training is required to meet the compliance challenges encountered by financial institutions when supplying trade finance, notably in developing countries. Looking at best practices in capacitybuilding, this publication examines current strategies to respond to these challenges in emerging markets, the work that remains to be done, and the lessons to be learned. Chapter 1 provides background on the persistent trade finance gaps in developing countries. Chapter 2 looks at how trade finance has been vulnerable to international banks reducing their exposure to trade finance, known as de-risking, which has led international organizations in the trade, development and financial fields (the WTO, IFC and FSB in particular) to engage in dialogue and cooperation. Chapter 3 features a number of case studies provided by several international institutions, highlighting examples of trade finance and compliance capacity-building endeavours in many countries affected by de-risking. 13CHAPTER 1 Reasons for persistent trade finance gaps | • Trade finance is a particularly safe form of finance but it is commonly perceived to be subject to high risks. • Smaller traders dependent on trade finance are more likely

capacity-building endeavours in many countries affected by de-risking. 13CHAPTER 1 Reasons for persistent trade finance gaps | • Trade finance is a particularly safe form of finance but it is commonly perceived to be subject to high risks. • Smaller traders dependent on trade finance are more likely to see their requests for trade finance rejected than any other category of firm. • In two-thirds of cases, traders whose requests for trade finance have been rejected do not attempt to seek alternative financing, simply because it is not available. Chapter 1 Reasons for persistent trade finance gaps The disconnect between perceived and actual risk There are various causes for the existing trade finance gaps. Among them are the failures of operators to recognize the low risk associated with trade finance (Asian Development Bank Institute, 2017). While the commercial risks involved in an international trade transaction seem in principle to be larger than those involved in a domestic trade transaction – e.g. non-payment, loss or alteration of the merchandise during shipment, fluctuating exchange rates – trade finance is a particularly safe form of finance, as it is underwritten by strong collateral, is carefully documented by credit operations, tends to have relatively short tenors, and is often self-liquidating. The low-risk nature of short-term trade finance is supported by data collated by the International Chamber of Commerce’s (ICC) Trade Register Report, established in 2011. According to the reports from 2013 to 2017, the average transaction default rate on short-term international trade finance (credit and guarantees) was no more than 0.46 per cent, with a recovery rate of 52 per cent, mostly through the resale of the collateral, the merchandise. Table 1 (see page 14) provides more detailed data across specific categories of short-term trade finance instruments.14 | Trade finance and the compliance challenge As evidenced in ADB’s 2017 Trade

of 52 per cent, mostly through the resale of the collateral, the merchandise. Table 1 (see page 14) provides more detailed data across specific categories of short-term trade finance instruments.14 | Trade finance and the compliance challenge As evidenced in ADB’s 2017 Trade Finance Gaps, Growth, and Jobs Survey, one of the main reasons for the rejection of trade finance, when it is requested in certain regions, is the perception of high risk. Yet, as shown by the Trade Register Reports, the underlying transaction default rates for transactions are very small (0.39 per cent in Africa compared to 0.38 per cent in Europe and 0.5 per cent in Latin America) (ICC, 2016). The gap between the perception and actual level of risk of the transactions is clearly one of the main causes for the lack of trade finance in certain regions. One way to reduce the “confidence” gap is to continue disseminating information regarding the low risk of trade finance and to work at maintaining a strong database supporting this. The latest ICC Trade Register Report (ICC, 2017) is based on data collected from 25 global banks on 20 million trade finance transactions, worth a total of US$ 11 trillion in trade transactions/flows. Small and medium-sized enterprises (SMEs) in developing countries Trade in low-income countries is more likely to be undertaken by SMEs, as the size of trading companies is by and large proportionate to the size of their economies. As reflected in ADB (2017), tradelending to SMEs in developing countries is severely constrained by their lack of credit history, limited knowledge and experience of trade finance, and absence of collateral. SMEs are also likely to be subject to greater selectivity from local banks when providing finance and more reliant on local currency financing to finance their trade. As highlighted by the African

by their lack of credit history, limited knowledge and experience of trade finance, and absence of collateral. SMEs are also likely to be subject to greater selectivity from local banks when providing finance and more reliant on local currency financing to finance their trade. As highlighted by the African Development Bank’s survey on trade Table 1: Risk characteristics of short-term trade finance products, 2008-17 Category Default rate Implied maturity (days) Recovery rate Import and export letters of credit 0.22% 80 71% Loans for import/export 0.8% 120 45% Performance guarantees 0.36% 110 18% Total 0.46% 90 52% SOURCE: WTO, based on the ICC Trade Register Report averages, from 2013 to 2017.15 finance in Africa (AfDB, 2017), bankintermediated finance is concentrated in customers with whom they have a long history. SMEs account for only 15 per cent of banks’ total trade finance portfolio. The relatively low share is attributed to the higher risk perception associated with these clients, despite a default rate on SME loans of less than 3 per cent across the continent. The ADB survey reveals similar findings in Asia. As shown by Figure 1, only a limited share of SMEs uses banking services. Moreover, according to ADB (2017), companies whose requests for trade finance were rejected were likely, in a quarter of such cases, to resort to the informal sector, suggesting that the transaction has sufficient potential value for the firm to be willing to borrow expensively or/and informally. The most recent ADB trade finance gap surveys (ADB, 2016; 2017) confirmed that smaller traders’ requests for trade finance were more likely to be rejected than any other category of firm. While about half of their requests for trade finance were rejected by banks, in two-thirds of cases they sought

gap surveys (ADB, 2016; 2017) confirmed that smaller traders’ requests for trade finance were more likely to be rejected than any other category of firm. While about half of their requests for trade finance were rejected by banks, in two-thirds of cases they sought no alternative financing, simply because it was not available. Thus, persistent gaps in trade finance could mean the exclusion of such firms from the trading system. This is of concern because SMEs are the backbone of many economies and act as major employers. As outlined above, there is no question that access to trade finance represents a significant obstacle to the economies of developing countries.  Figure 1: Low bank density and low SME coverage in selected developing countries, 2014-16 (per cent) NOTE: The share of small enterprises that have financial accounts varies by country but only a very small share obtains loans.

SOURCE: World Bank Enterprise Survey. 0 20 40 60 80 100

Percentage of firms with a bank loan/ line of credit Percentage of firms with a cheque or savings account Cambodia Viet Nam Myanmar Indonesia India CHAPTER 1 Reasons for persistent trade finance gaps |17 • Since the global financial crisis, many international banks have been reducing their trade finance activities, particularly in developing countries. • “De-risking” is driven partly by concerns over complying with regulations related to money-laundering and terrorism financing, but it is also motivated by concerns related to compliance costs. • The WTO, IFC and the Financial Stability Board, along with multilateral development banks, are working with the trade finance community to improve awareness of compliance requirements. Chapter 2 De-risking and inter-institutional responses Trade finance is vulnerable to de-risking Since the 2008-09 global financial crisis, a number of international banks have been de-risking, i.e. reducing their guarantees to banks in developing countries in particular.

De-risking and inter-institutional responses Trade finance is vulnerable to de-risking Since the 2008-09 global financial crisis, a number of international banks have been de-risking, i.e. reducing their guarantees to banks in developing countries in particular. Several publications have debated the extent of the role of retrenchment of correspondent banking and other post-crisis downsizing in limiting access to trade finance for traders (see BIS, 2014; ICC, 2017). Trade finance is particularly vulnerable to de-risking, despite its very small loss history and high recovery rate. Trade finance instruments, intermediated by commercial banks, are premised on an existing credit relationship between counterparty banks. International banks, which are, for example, required to “confirm” the future payment to the exporter, take on the reimbursement risk related to local emerging market banks. Thus, for goods to be shipped, a confirming bank must be willing to take the payment risk of the local bank. This may not be possible if the trade finance transaction causes that international confirming bank to exceed its client or country exposure limits. In many cases, a letter of credit CHAPTER 2 De-risking and inter-institutional responses |18 | Trade finance and the compliance challenge may not be confirmed because the potential return on this exposure does not merit the risk taken. As indicated above, the trade finance market is relatively concentrated (BIS, 2014), although very large banks have been recalibrating their global network as a result of needing to comply with various regulatory and business parameters. These include the new Basel III standards (an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the 2007-09 financial crisis, which aims to strengthen the regulation, supervision and risk management of banks) and KYC (i.e. “Know Your Customer”, a process of regularly

developed by the Basel Committee on Banking Supervision in response to the 2007-09 financial crisis, which aims to strengthen the regulation, supervision and risk management of banks) and KYC (i.e. “Know Your Customer”, a process of regularly verifying a customer’s identity with a view to eliminating bribery, corruption and other illegal financial activities – a requirement of the international antimoney-laundering (AML) regulations). In the compliance process, some business models have been more affected than others. The claim that the termination of correspondent banking relationships has been linked to compliance costs was examined by multilateral institutions following a request by the G20. The BIS (2015) and the World Bank Group (2015) delivered reports to the G20 Summit in Antalya, revealing nuanced views as to what was driving the reduction in correspondent banking relationships. They acknowledged the concerns over possible sanctions relating to anti-money-laundering and countering the financing of terrorism (AML/ CFT) but also recognized that the withdrawal of international banks was motivated by concerns about costs. The FSB designed a four-point action plan to address the decline in corres