The impact of Basel III on trade finance: the potential unintended consequences of the leverage ratio

The treatment of trade finance, particularly in the form of short-term letters of credit, has been subject to policy discussions during the making of Basel III rules. International public institutions representing the trade and development communities requested that the relatively light regulatory treatment accorded to such instruments under previous versions of the Basel framework be by and large preserved to avoid penalizing developing countries’ trade, which relied to a large extent on such instruments. Trade finance private lobbies requested an even more favorable treatment. In the end, the Basel Committee on Banking Supervision (BCBS) made relatively limited concessions, closer to the demands of international organizations. The discussion focused on the imposition of a leverage tax on letters of credit, as part of the leverage ratio to be applied to all off-balance sheet instruments. This paper focuses on this particular aspect of the inter-institutional dialogue. Most of this discussion was based on principles and empirics. This paper offers a relatively simple model approach showing the conditions under which the 100% leverage tax on assets such as letters of credit would reduce their natural attractiveness relative to higher-risk ones, which stand in the balance sheet of banks. The conclusions of the model are consistent with the final approach selected by the Basel Committee in the final version of Basel III, which are different than its original proposals. It offers, perhaps ex-post, an analytical confirmation of the right choice made by policy-makers on empirical grounds.