FX International Payments
By Frances Coppola
For countries that are net importers, falling oil and commodity prices are something of a double-edged sword, since the short-term economic boost can be offset by deflationary pressures that may persist for longer. Today’s widespread negative rates are a response to such pressures.2 When people get into the habit of deferring spending in the hopes of lower prices tomorrow, the economy stagnates, prices fall further and a dangerous deflationary feedback loop can develop. This is what central banks fear, and why they are cutting rates – into negative territory in some jurisdictions – in order to encourage spending and investment.3
For businesses dependent on oil and raw material imports, the combination of falling prices and negative rates can give a major boost to production and sales. But for banks that provide trade finance, the combination squeezes their profits from two directions at once.
Demand for trade finance in the oil and commodities sectors has fallen dramatically: when oil is at $50 per barrel instead of $100 per barrel, businesses only need half the financing for the same volume of exports. So simple supply and demand forces trade finance providers to cut the rates they charge on export trade finance as they compete for shrinking business in the oil and commodity sectors.4
In theory, negative rates should enable trade finance providers to cut their funding costs, thus helping them to maintain their margins in the face of severe downwards pressure on trade finance interest rates. But if anything, they make the downwards pressure on interest rates worse. This is because of the way that banks price trade finance.5
Typically, trade finance is priced as a margin over a benchmark rate such as Libor or Euribor. Libor is the average rate at which banks lend to each other on the London market: Euribor is the equivalent for European markets. So a bank will fund itself at or near Libor or Euribor, and price trade finance at a margin over Libor or Euribor. Falling oil and commodity prices force banks to cut that margin to the bone: when, in addition, the benchmark rate itself is negative at shorter maturities as Euribor currently is, the bank may not earn enough to pay its overhead.
So what can banks do about this, and what would be the effect on businesses? Attempts to stop the fall in oil prices by reducing supply have so far had little effect.6 And although some economists have expressed concern about the effect on bank profitability of negative rates,7 the prevailing view appears to be that the short-term benefit to the economy outweighs the longer-term risk to banks
Analysis by Citigroup suggests that banks are withdrawing trade finance facilities from less profitable companies, while simultaneously making it easier for more profitable ones to obtain finance. This could cause concentration in the oil and commodities sector, as marginal producers go out of business. Some banks, too, may exit the trade finance business entirely.8
Some analysts believe that the nature of trade finance will change in the near future. Trade finance could increasingly be provided through the capital markets rather than bank lending, or directly by large cash-rich corporations to their own value chains.9 Accenture says that “this move away from bank intermediated trade finance instruments is posing a real threat to the trade finance revenues of banks, while at the same time leaving corporates with reduced access to financing options.” It notes that the traditional role of banks in trade finance is being challenged by new providers, such as logistics companies, supplier networks and specialist alternative trade finance providers.10
Further, Accenture says, banks that intend to remain in the trade finance business will need to “up their game” – streamlining and digitizing their offering, and providing corporations with full supply chain solutions. This could include changing the way they price trade finance, perhaps to a model that relies more upon fees for services than net interest margin on lending. They might also consider moving away from pricing tied to traditional benchmarks such as Libor towards newer official replacements such as the U.S. Federal Reserve’s Overnight Bank Funding Rate.11
Falling oil and commodity prices coupled with negative rates are squeezing the profit margins of the banks that traditionally provide trade finance. At the same time, technological developments and changes in the attitude of corporations to supply chain management and finance are encouraging new entrants to the trade finance business, challenging traditional providers. In future, success in trade finance may require that banks make radical reforms to the pricing and delivery of their key products and services.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. "Falling oil prices: who are the winners and losers?", BBC; http://www.bbc.co.uk/news/business-29643612.
2. "Introduction of ‘Quantitative and Qualitative Monetary Easing with a Negative Interest Rate'", Bank of Japan; https://www.boj.or.jp/en/announcements/release_2016/k160129a.pdf.
3. "Negative interest rates: less than zero", Bloomberg; https://www.bloomberg.com/quicktake/negative-interest-rates
4. "Trade Finance: The Big Squeeze On Margins", Global Finance Magazine; https://www.gfmag.com/magazine/may-2015/big-squeeze-trade-finance
5. "How Negative Rates Impact Trade Finance And Business Credit", Trade Finance Matters; https://spendmatters.com/tfmatters/negative-rates-impact-trade-finance-business-credit/
6. "Oil prices drop as attention turns toward supply glut", Wall Street Journal; http://www.wsj.com/articles/oil-prices-drop-as-attention-turns-toward-glut-in-stocks-1474021150
7. "The influence of monetary policy on bank profitability", BIS; http://www.bis.org/publ/work514.pdf
8. Commodity prices: The impact on trade finance, Citigroup; https://www.citibank.com/tts/about_us/articles/docs/2016/Commodity_Prices_The_Impact_on_Trade_Finance_Though_Leadership.pdf
9. "Trade Finance: The Big Squeeze On Margins", Global Finance Magazine; https://www.gfmag.com/magazine/may-2015/big-squeeze-trade-finance
10. Trade finance: The landscape is changing – are you?, Accenture; https://www.accenture.com/t20160301T033343__w__/us-en/_acnmedia/Accenture/Conversion-Assets/DotCom/Documents/Global/PDF/Dualpub_21/Accenture-Trade-Finance.pdf
11. "Banks identify possible replacements for US Libor", Reuters; http://www.reuters.com/article/us-usa-libor-idUSKCN0YB2DF