Other unique aspects of trade finance, however, may imply greater potential risk, the most obvious being its exclusively international context. Cross border trades face _macro-level risks_ which could impact the value of return (e.g., exchange rate fluctuations, changes to policy) and the likelihood of default (e.g., conflict, political upheaval). In addition, they face specific _counterparty risks_ linked to the greater difficulty of enforcement across borders, exacerbated in many developing countries by poorly functioning institutions, particularly legal systems (Menichini, 2009). Weak cross-border enforcement raises the risk of strategic default on the part of suppliers, creating a problem of “credible commitment” across borders (Ellingsen & Vlachos, 2009). Finally, the cross-border nature of trade financing means that data on which to assess counterparty credit risk is often limited or non-existent (e.g., where there limited public credit registry coverage or public access to accounts or court proceedings). These risks may be compounded in the case of supplier-extended credit, by the fact that most suppliers operate in ”credit chains” – i.e., firms which extend credit to their suppliers in turn have credit extended to them from their suppliers. Inter-firm credit through these chains provides critical working capital to facilitate production and trade. However, they are vulnerable to shocks as they can quickly propagate problems across the chain (Kiyotaki & Moore, 1997; Raddatz, 2008), contributing to systemic risk. This may be particularly acute with the extension in the length and scope of credit chains that has resulted from the recent growth of global production networks (Escaith and Gonguet, 2009).

# 3. <u>The impact of the financial crisis on trade finance</u>

It has become clear that the global economic crisis has many culprits, among which are: a prolonged period of loose monetary conditions in the US, various regulatory failures, a policy-induced mortgage crash in the US, the growth of “shadow banking” and the use of every-more complex financial instruments, and greed and herd-like behavior by investors. The subsequent collapse in confidence in the banking sector can be seen most clearly in the spread of Libor (the interbank reference rate) over T-bills (US Government Treasury bills) in the period that followed the collapse of Lehman Brothers. This spread – which historically was in the range of 10-30 basis points – rose dramatically to over 400 basis points in the second half of 2008. Large-scale government intervention has since brought these spreads down, but they continue to trade at levels well above historical averages.

Although trade finance has neither been a proximate nor ultimate cause of the financial crisis, it quickly became a collateral damage. As the financial crisis unfolded, the availability of trade finance tightened and its cost rose because of growing liquidity pressure in mature markets and a perception of heightened country and counterparty risks. The contraction in trade finance was also fuelled by the loss of critical market participants, such as Lehman Brothers, a drying up of the secondary market for short-term exposure (as banks and other financial institutions deleveraged), and the volatility of commodity prices.<sup>8</sup> The implementation of the Basel II Accord on banking laws and regulations, with its increased risk sensitivity of capital requirements, in an environment of global recession is also generally considered to have put additional pressure on banks to hold back on trade finance. Regardless of the impact of Basel II, as companies have been downgraded, higher risk premiums have increased capital requirements, further reducing access to trade credit, especially for SMEs and banks in emerging markets.

> 8 The secondary market plays a key role in helping banks undertake transactions that are larger than their current credit and cross-border limits.

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