Systemic Risk, Contagion and Trade Finance – Back to the Bad Old Days

Back in the old days (pre-1980s), the term systemic risk did not refer to contagion of illiquidity within the financial sector alone.  Back then, when the real economy was much more important than low margin, unglamorous banking, it was understood that the really scary systemic risk was the risk of contagion of illiquidity from the financial sector to the real economy of trade in real goods and real services.

If you think of it, every single non-cash commercial transaction requires the intermediation of banks on behalf of – at the very least – the buyer and the seller.  If you lengthen the supply chain to producers, exporters and importers and allow for agents along the way, the chain of banks involved becomes quite long and complex.

When central bankers back in the old days argued that banks were “special” – and therefore demanded higher capital, strict limits on leverage, tight constraints on business activity, and superior integrity of management – it was because they appreciated the harm that a bank failure would have in undermining the supply chain for business in the real economy for real people causing real joblessness and real hunger if any bank along the chain should be unable to perform.

As the “specialness” of banks eroded with the decline of the real economy (and the migration globally of many of those real jobs making real goods and providing real added-value services to real people), the nature of systemic risk was adjusted to become self-referencing to the financial elite.  Central bankers of the current generation only understand systemic risk as referring to contagion of illiquidity among financial institutions.

They and we all are about to learn the lessons of the past anew.

We are now starting to see the contagion effects of the current liquidity crisis feed through to the real economy.  We are about to go back to the bad old days.  Whether the zombie banks are kept on life support by the central banks and taxpayers of the world is highly relevant to whether the zombie bank executives pay themselves outsize bonuses and their zombie shareholders outsize dividends with taxpayer money.  It appears sadly irrelevant to whether the banks perform their function of intermediating credit and commercial transactions in the real economy along the supply chain.  The bailout cash and executive and shareholder priorities do not seem to reach so far.

The recent 93 percent collapse of the obscure Baltic Dry Index – an index of the cost of chartering bulk cargo vessels for goods like ore, cotton, grain or similar dry tonnage – has caused a bit of a stir among the financial cognoscenti.  What is less discussed amidst the alarm is the reason for the collapse of the index – the collapse of trade credit based on the venerable letter of credit.

Letters of credit have financed trade for over 400 years.  They are considered one of the more stable and secure means of finance as the cargo is secures the credit extended to import it.  The letter of credit irrevocably advises an exporter and his bank that payment will be made by the importer’s issuing bank if the proper documentation confirming a shipment is presented.  This was seen as low risk as the issuing bank could seize and sell the cargo if its client defaulted after payment was made.  Like so much else in this topsy turvy financial crisis, however, the verities of the ages have been discarded in favour of new and unpleasant realities.

The combination of the global interbank lending freeze with the collapse of the speculative, leveraged commodity price bubble have undermined both the confidence of banks in the ability of a far-flung peer bank to pay an obligation when due and confidence in the value of the dry cargo as security for the credit if liquidated on default.  The result is that those with goods to export and those with goods to import, no matter how worthy and well capitalised, are left standing quayside without bank finance for trade.

Adding to the difficulties, letters of credit are so short term that they become an easy target for scaling back credit as liquidity tightens around bank operations globally.  Longer term “assets” – like mortgage-back securities, CDOs and CDSs – can’t be easily renegotiated, and banks are loathe to default to one another on them because of cross-default provisions.  Short term credit like trade finance can be cut with the flick of an executive wrist.

Further adding to the difficulties, many bulk cargoes are financed in dollars.  Non-US banks have been progressively starved of dollar credit because US banks hoarded it as the funding crisis intensified.  Recent currency swaps between central banks should be seen in this light, noting the allocation of Federal Reserve dollar liquidity to key trading partners Brazil, Mexico, South Korea and Singapore in particular.

Fixing this problem shouldn’t be left to the Fed.  They aren’t going to make it a priority.  Indeed, their determination to accelerate the payment of interest on reserves and then to raise that rate to match the Fed Funds target rate indicates that the Fed are more likely to constrain trade finance liquidity rather than improve it.  Furthermore, the Fed may be highly selective in its allocation of dollar liquidity abroad, prejudicing the economic prospects of a large part of the world that is either indifferent or hostile to the continuation of American dollar hegemony.

. If cargo trade stops, a whole lot of supply chain disruption starts.  If the ore doesn’t go to the refinery, there is no plate steel.  If the plate steel doesn’t get shipped, there is nothing to fabricate into components.  If there are no components, there is nothing to assemble in the factory.  If the factory closes the assembly line, there are no finished goods.  If there are no finished goods, there is nothing to restock the shelves of the shops.  If there is nothing in the shops, the consumers don’t buy.  If the consumers don’t buy, there is no Christmas.

Everyone along the supply chain should worry about their jobs.  Many will lose their jobs sooner rather than later.

If cargo trade stops, the wheat doesn’t get exported.  If the wheat doesn’t get exported, the mill has nothing to grind into flour.  If there is no flour, the bakeries and food processors can’t produce bread and pasta and other foods.  If there are no foods shipped from the bakeries and factories, there are no foods in the shops.  If there are no foods in the shops, people go hungry.  If people go hungry their children go hungry.  When children go hungry, people riot and governments fall.

Everyone along the supply chain should worry about their children going hungry.

When that happens, everyone in governments should worry about the riots.

Controlling access to trade finance determines who loses their jobs, whose children go hungry, who riots, which governments fall.  Without dedicated focus on the issue of trade finance and liquidity from those in the emerging world most interested in sustaining the growth of recent years, little progress can be expected.Trade finance is rapidly communicating the stress on bank liquidity to the real economy.  It presents a systemic risk much more frightening than the collapsing value of bits of paper traded electronically in London and New York.  It could collapse the employment, the well being and the political stability of most of the world’s population.

The World Trade Organisation hosted a meeting on trade credit in Washington Wednesday to highlight the rapid and accelerating deterioration in trade finance as an urgent priority for public policy.

I look at the precipitous collapse of the Baltic Dry Index and I wish them Godspeed.

Further reading:

WTP warns of trade finance ‘deteriorating’ amid financial crisis

Cost of some trade finance deals up sixfold – WTO

Shipping holed beneath the water line

Shipowners idle 20 percent of bulk vessels as rates collapse

16 Responses to "Systemic Risk, Contagion and Trade Finance – Back to the Bad Old Days"

  1. Mark   November 14, 2008 at 4:53 am

    A perfect 20,000 ft view… But, I have to wonder this: are we witnessing a paradigm shift, one that is pulling away from long-term unsustainable global markets and toward (more) sustainable local markets?The death of the SUV is here, with the death of the private auto not far behind, notwithstanding bailouts, which could only delay the inevitable.Coincident with this is the rise in alternative, sustainable energy. NOTE: I believe that alternative energies will be rife with scams and that they will only ever be able to produce a fraction of what conventional fuels have been able to produce (but something will most likely be better than nothing).I do see the Baltic Dry Index as a telling indicator, but in the end I don’t see letters of credit as being the real underlying force driving its downward trend.BTW – Am I first?

    • Mark   November 14, 2008 at 5:03 am

      A slight clarification… It’s all about energy. Without increases in energy (and natural resources) there can be no growth. We’re most likely witnessing global contraction that will retrace the global economic model back to the local/regional until we find a more sustainable level: after this point, human nature being what it is, we’re likely to try expanding/growing again (with perhaps some improved means of energy extraction), though never again to see the levels of growth that we have witnessed over the course of the last 100 years (corresponding to widespread use of fossil fuels).

      • Guest   November 14, 2008 at 9:08 am

        isnt the global economy a defintion of waste of energy. apples from new zealand and the goodness, we don’t need more energy that bad -lets use a bit less and trade on a more regional basis. needs will be met, jobs will be created for those of whom supply the region with needs and wants and on and on it goes. there’s your growth. explosive growth on the regional level. and on and on it will go until we reach this point again.

  2. Sam Dimond   November 14, 2008 at 10:28 am

    I always like reading london banker’s posts. I feel the answer to most of our problems lies in knowing the difference between wants and needs. Most people don’t comprehend how most of their basic needs are met. Where and how is your food made? Could you regulate your body temp without your home being wired to the grid? Can you get and purify water without the help of the city? Of all the crap that currently surrounds you in the room you are in, how much is truly useful and needed? I mean really needed.We waste more as a people than any in history.We deserve this utter collapse that is all but assured.Plant a garden. Connect with your family and friends and nature. Become as self sustaining as possible. Do it when you can and not when you have to…

  3. Anonymous   November 14, 2008 at 10:31 am

    The luddites were right. The essentials – food, housing, transportation – can be produced by less than 5% of the population. That’s hidden in good times (during bubbles) but becomes obvious in bad times.If Malthus and Darwin were also right – and I think they were – then there’s only one solution to our problems; kill the poor and weak.

    • Michael   November 15, 2008 at 1:10 pm

      interesting: you suggest returning to an earlier (“more innocent”?) paradigm, praise the luddites and then issue a call to do away with the useless eaters.i’m sorry- is this progress? has any real fundamental lesson been learned? or shall we allow the dark age of the moneylenders to go on another two thousand years?”kill the poor and the weak?” the problem with your statement, o anonymous one, is that in the transformation that looms for all humanity you will likely qualify for both.

      • Guest   November 16, 2008 at 9:31 am

        Thank you, Michael. It is disheartening for me to continue to read opinions on how we can adjust our living downward to accommodate plunder, tyranny and corrupt totalitarian government. Where are the Samuel Adamses, the Patrick Henrys, the George Washingtons, the Tom Jeffersons…the men who will stand… the men who will die for freedom??Are none left to hear and understand the words of President John Quincy Adams: “Think of your forefathers! Think of your posterity!”?Are we to give up our birthright for a bowl of potage and bondage? Are we to live like Gulliver – a giant tied to the ground by thousands of tiny Lilliputians who have wormed their way into our government and banking system?Then how fitting Vladimir Lenin’s words: Despair is typical of those who do not understand the causes of evil, see no way out, and are incapable of struggle

        • Anonymous   November 19, 2008 at 11:12 am

          The Americans you quoted spent most of their lives plundering Indians and Africans or fighting other plunderers for the spoils. Lenin was followed by Stalin.Realism is not equivalent to despair.

          • Guest   December 18, 2008 at 8:35 am

            Thank you for pointing that out. Look at history not national mythology.

  4. Anonymous   November 14, 2008 at 11:09 am

    In respect of letters of credit both exporters and importers should arrange for these to be opened and negotiated via branches of the same(international)banksuch as Barclays or HSBC.

  5. Detlef Guertler   November 14, 2008 at 3:52 pm

    Maybe letters of credit are some 400 years old – trade is some 10.000 years older. Trade is older than banks are (some 800 years), even older than money (some 2500 years). If banks stop to facilitate trade, someone else will do it. In the long run, that`s a problem for the bank: it won`t survive such a failure. In the short run, it`s a problem for the rest of us to survive the interregnum.But that`s exactly what states are made for: to secure the survival of citizens and society. They should prevent hunger riots and secure the life of bankers. If they are too weak for one of these two tasks, they will be too weak for the other one, too.

  6. Jim   November 15, 2008 at 9:35 am

    No letters of credit no oil for the U.S. Prices spike, long gas lines, buisiness’ shutdown.No letters of credit no wheat and soybeans from the U.S. for the countries that need them like China. People starve. Business in the U.S. deteriorates further.Lovely future

  7. jessWilder   November 15, 2008 at 10:11 am

    They better hurry up and do something before its too

  8. Jim   November 15, 2008 at 1:04 pm

    Prof Roubini; How about a plan? We can’t just watch this thing happenWe need revenue, products as a country.The fastest way I see that happening is become a Saudia Arabia.Ethanol is our way out of this mess.Using only 5% of unusable farmland and nonfood crops ethanol could provide all our transport needs.Use 30% of unusable farmland and we are Saudia Arabia.Trade deficit gone, Budget deficits gone, Americans wealthy again, Millions of jobs for the price of the 700b bank bailout. Real investment not bonuses.Plus its quick unlike solar,wind,nuclear. In 6 months you have 1000 gals per acre. Not Years like solar,nuclear,drilling.So how about it Professor Roubini what do we have to lose?More See YouTube Alcoholcanbeagas Part1 by a 30 year ethanol expert. Ethanol Now!

    • Guest   November 16, 2008 at 1:47 am

      Excellent alternative, to become informed about no-carbon footprint fuel sourcing via ethanol produced from semi arable land. keep up the good work and network David Blume’s permaculture revolution for the future of tis planet and the dismantling of the planet destroying oiligarchy that is is in final throes of autonomic suicide… and taking us with it if we don’t make the effort to change.Politikalyogi

    • Mark   November 16, 2008 at 2:52 am

      Where are you getting these numbers from?Ever hear of the term “soil mining?” Do you understand soil biology?Much of this is debunked here:“”and here:“”