Small and medium-size enterprises (SMEs) play a significant role in the global economy, accounting for a substantial portion of employment and domestic production. According to some estimates, SMEs’ contribution to gross domestic product exceeds 51 percent in high-income countries, consistent with the general consensus that SMEs are “engines” of economic growth. With an increasing number of SMEs engaging in international transactions, their influence on the volume of international trade has increased as well. In the U.S alone, SMEs represented 97 percent of all importers and 98 percent of all exporters, and accounted for 31 percent and 33 percent of imported and exported goods respectively during 2012 (International Trade Administration, 2014).

Previous research shows that despite their important role in the U.S economy, small firms have limited access to external financing, and are particularly dependent on banks for their financing needs. Being small and opaque, SMEs cannot raise funds in the financial market. Instead, they rely on relationship-based financing from small, so-called “community banks.” Although the prior research is helpful in understanding the prominent role of banks in the domestic operations of SMEs, the impact of banks and their trade-financing products on SMEs’ international trade has received little attention in the literature. This is arguably surprising, given that the international operations of SMEs are more dependent on external financing than their domestic operations, due to (1) information asymmetry and lack of trust between overseas trading parties; (2) less room for recourse and higher costs associated with foreign counterparty default risk; (3) upfront fixed costs associated with pursuing export/import opportunities (e.g., regulatory compliance, overseas shipping, freight, and insurance expenses, product customizations, tariffs and customs); and (4) increased working-capital needs as a result of longer execution times in overseas transactions.

Large, well-known firms with a small degree of information asymmetry and long trading history frequently undertake international trade operations via open-account trade by trusting one another and their trading relationships. For SMEs, however, open-account trade is not a viable option. Rather, bank letters of credit have historically been the sole instrument for opaque SMEs to establish trust with foreign trading parties and minimize international trade risks. Through letters of credit, trading firms transfer counterparty risks to banks, receive back-up guarantees, streamline payments, and obtain working capital loans. Hence, banks play a crucial role in export and import operations of SMEs.

Even though historically hesitant and “skittish” about offering international trade financing, a growing number of community banks are reportedly getting involved in international trade financing due to (1) their so-called soft-information advantage in maintaining business relationships with an increasing number of SMEs going global; (2) recent advances in information technologies for processing letters of credit; and (3) guarantee programs offered by the Small Business Administration (SBA) and Export-Import Bank (EXIM). In addition, banks may feel the need to offer trade financing as part of a cross-selling strategy aimed at protecting relationships with the clients that demand a full menu of services. As a result, trade financing is becoming increasingly important for both SMEs and community banks.

In our recent study, available here, we empirically test whether and to what extent trade financing by community banks facilitates U.S. international trade. Using state-level quarterly data for the first quarter of 2008 through the fourth quarter of 2013, we find that commercial letters of credit (CLCs) issued by U.S. community banks are economically and statistically significant factors in state-level international trade. On average, a 10 percent increase in the aggregate CLCs issued by community banks in a given state is associated with a 2.16 percent increase in the annual state-level international trade volume. We conclude that CLCs issued by community banks, although constituting only 10 percent to 15 percent of all CLCs in the U.S. banking industry, play a nontrivial role in U.S. international trade. Community banks’ contribution to state-level international trade volume is particularly evident in the manufacturing industry, where SMEs are heavily dependent on bank financing. Interestingly, the association between CLCs issued by community banks and state-level international trade grew significantly weaker during the financial crisis. This may point to a substantial increase in the market imperfections during the financial turmoil, which in turn severely affected the role of small community banks in intermediating international trade.

Our study has important policy implications. First, the results are driven by the U.S. manufacturing sector, which is known to be capital intensive and bank dependent. Given that imports of manufactured goods are key to the overall productivity growth in the manufacturing sector, possible disruptions in bank financing of SMEs’ international trade due to exogenous shocks may have non-trivial repercussions for the U.S. manufacturing sector and the nation’s productivity. Thus, regulatory initiatives designed to (1)  alleviate community banks’ burden and risk associated with extending trade financing services to SMEs and (2) provide incentives for larger banks to become more involved in SME trade financing may mitigate distortions in markets for trade financing and, as a result, improve availability and stability of trade financing for SMEs.

Second, due to inherent credit risk associated with off-balance sheet trade credits and guarantees, as well as regulatory pressure, bank managers are mindful of bank capital position when making LC decisions. Thus, financial market imperfections, in combination with regulatory guidelines that prescribe the way LCs should be recognized, may have a substantial impact on intermediation of trade financing instruments and, in turn, on the volume of international trade transactions. In January 2010, in response to the recent financial crisis, the Basel Committee on Banking Supervision proposed a set of new measures and policies aimed at strengthening bank stability. Given that all letters of credit are off-balance sheet commitments for banks, according to the risk-based capital regulation, banks are required to convert off-balance sheet commitments to an on-balance sheet credit equivalent amount by using a prescribed “conversion factor.”  While the currently applied conversion factor for commercial contingencies (i.e. CLCs) is 20 percent, it is 50 percent for performance-related guarantees (i.e., PLCs).

One policy suggestion proposed by the Basel Committee is that certain off-balance sheet items, including CLCs and standby LCs, should have a flat 100 percent credit conversion factor. An increase in credit conversion factors may impede community banks’ trade financing credits to SMEs. Market frictions coupled with tightened regulatory capital constraints associated with CLCs may lead small community banks to move equity capital into other activities, become more sensitive and selective in dealing with SMEs, or make trade financing more expensive for SMEs. These measures may result in a sizable decline in the amount of U.S. international trade, particularly in the manufacturing sector, where SMEs largely depend on banks for financing.

This post comes to us from professors Dmytro Holod and Gokhan Torna of the State University of New York at Stonybrook. It is based on their recent paper, “Do Community Banks Contribute to International Trade? Evidence from U.S. Small Business Banking?” available here.