Mihai Andreoiu assesses the health of the commodity trade finance sector in a boom period and asserts that now is the best time to monetize trust and relationships with resilient banks and new financing partners.
Having attended both TXF and GTR conferences in Geneva over the last few weeks, I could not help a feeling of going back to normality, after over 18 months of virtual events only. What looked even better was to see everybody more concerned about how to secure liquidity and risk appetite for performing commodity-trading businesses rather than manage problem loans. Both commodity traders and their bankers need to cope with increases stemming from both volumes and prices.
In the past, as a banker the biggest business risk I saw was that of persistent low commodity prices, with credit lines utilized at 20-30% and revenue seemingly going nowhere. Couple that with low interest rate environment driving overall limited performance of the transaction banking sector and senior management quickly run their attention to cutting costs. Rather short- term thinking!
An even bigger trigger for banks retrenching was brought about by the pandemic with several commodity trading firms causing billions of losses for the main trade finance banks and some specialized direct lenders. A year ago, some banks were completely exiting the commodity trade finance sector, while others were trimming their portfolio as part of a “flight to quality” (probably one of the most misused sayings in modern finance and banking). Again, this was short-term thinking!
The business boom
Fast-forward 12 months and we are in a booming (musical) world. The commodity traders have learned to play the accordion feature of their syndicated facilities. With commodity prices 50–100% higher than a year ago, liquidity is king again – especially for those traders with the privilege of high margin calls, as driven by the rapid appreciation of various commodity prices. As rising prices go hand-in-hand with increased volumes, line utilization has also doubled – or more – over the past year. Profits are accumulating for trading companies, and they are for banks too, which means they are likely to have their best year in a decade.
But it’s not been an easy journey. Banks have been allocating a lot of risk capital to other businesses, and cut head-count s while still struggling with KYC requirements. As I anticipated a year ago, the resilient banks are now reaping the benefits of the current volume and price boom and have successfully passed the stress tests they’ve been subject to.
The “exiters” have become spectators and are now re-thinking their approach. A leading European investment bank is even considering re-entering commodities trading after exiting the arena eight years ago due to the reputation risk it involved and concerns about return potential. But as a commodity structured finance leader stated, “we don’t like banks that come and go”. That perception has a cost too, it’s not just about switching the lights on again.
Is the current business boom sustainable?
Some analysts believe that despite the economic rebound, inflation is only likely to be transitory. But if the economic recovery and pent-up demand for commodities are sustained, there will be continued pressure on liquidity management for commodity traders. The well-known global trade finance gap, as measured by the Asian Development Bank increased from USD 1.5 trillion to USD 1.7 trillion according to figures released on 12 October. This is worrisome as it witnesses the incapacity of the providers of trade finance solutions to keep up the pace with growing needs. And into 2021 this gap is probably much higher in reality, also with risk appetite for emerging markets remaining scarce.
All this means that commodity traders will have to, both compete for bank liquidity and access new, generally more expensive, sources of capital, such as funds, capital markets, family offices and private equity. The latter represents healthy diversification and a reality check, driving up average cost of borrowing.
Meanwhile, competing for bank liquidity should not mean overpaying for bank financing, especially for established players. No more covid premium. It means understanding who their banks are, the right price for the risk bank are taking, and the way it translates into regulatory capital. Basel IV standards, which are expected in January 2023, are still being formulated, and have the potential to deal further surprises affecting the cost of trade financing (watch out for the credit conversion factors and Loss Given Default levels).
Any bank is the sum of its people and its business model
As I mentioned in an article a few years ago, the better commodity trading firms understands what drives their bankers’ perception of risk, the higher the chance of increasing their credit appetite and reducing the margin charged. As one of my former managers used to say, “perception is reality”. The risk perception of your relationship manager and especially that of his business and risk chain will be the reality when it comes to your liquidity and cost of borrowing.
Are you spending enough time improving that perception, or do you think it’s simply the relationship manager’s job to write all those memos, perform risk analysis and ensure you receive an optimal deal? What drives banks’ risk appetite remains an ever- green topic! (click here for a refresher) Will your banker help you become more profitable, on a risk weighted basis, for the bank and hence be able to provide more credit? Will the structure of your facility result in risk-weighted return improvements?
On a related note, linking loans for commodity traders to ESG KPIs is becoming the new norm, almost similar to compliance. There is still work to be done educating both sides, and especially in terms of how companies should be rewarded or punished via their cost of financing in a meaningful way. One thing is for sure: the malus premium should not be kept by banks. Embracing ESG criteria and related mechanisms may alleviate certain internal pressure within banks on the sector. That explains the need to press forward full- steam ahead, embrace the change and learn along the way. But don’t be afraid to challenge what’s relevant and needed in developing the commodity trade finance sector ESG guidelines.
Conclusion
As the pendulum seems to have swung all the way back in a rather short time frame, CFOs and treasurers of commodity traders need to stick to their long term diligence with the banks! Either way, whether prices keep on surging or demand falls in the new year, NOW is the best time to monetize the trust and increased comfort across relationships with those resilient banks while still investing in newer financing partners.