Opportunities and Risks Facing Community Lenders That Support International Trade

The role of international trade in the U.S. economy is increasing. And although smaller firms (those with less than 500 employees) accounted for almost one-third of U.S. exports in 2001, they are continually challenged to obtain financing to produce export goods or to finance the sale of exports. This circumstance presents opportunities for community banks that are looking for ways to increase small business fee income and strengthen loan demand. This article looks at those opportunities as well as the risks facing community lenders in supporting small and mid-sized enterprises (SMEs) engaged in international trade.

Small and Mid-Sized Firms Play a Significant Role in U.S. Exports
Although only about 1 percent of the 23 million U.S. small businesses are involved in exporting, these enterprises play a surprisingly large role in U.S. trade.1 As of 2001 (the latest data available), approximately 230,000 SMEs engaging in export operations accounted for about 97 percent of all U.S. exporters. This number reflects a doubling in the prior ten years and an almost two-and-a-half-fold increase over 15 years (1987–2001). California had the highest number of SME exporters (55,000 firms), followed by Florida, New York, Texas, and Illinois.

In 2001, SMEs accounted for $182 billion, or 30 percent, of U.S. export sales, a percentage that has held fairly constant since 1992.2 But in some states the share was notably higher—for instance, SMEs in Wyoming accounted for 80 percent of that state’s exports. In eight other states, including populous New York and Florida, they accounted for 40 percent or more of exports. (See the box entitled “A Regional Look at U.S. Export Activity” for information on merchandise exports.)

Lack of Overseas Affiliates and Foreign Market Expertise Creates Challenges for SMEs
Unlike large firms, SMEs tend to concentrate their business in fewer foreign countries. Nearly two-thirds of U.S. small-business exporters sold to only one foreign country in 2001, while more than half (54 percent) of large firms exporting sold to five or more foreign countries (see Chart 1). Nevertheless, SMEs exported goods worth $1 billion or more to 29 foreign countries and were responsible for at least half of all U.S. exports to 93 countries in 2001.3

Two reasons that explain why smaller businesses choose to export to a single country are the absence of major affiliates abroad and a lack of familiarity with foreign markets.4 SMEs have, in fact, benefited from this concentration when their primary export countries have been the target of U.S. initiatives to reduce foreign barriers to U.S. exports. For example, the 1993 enactment of the North American Free Trade Agreement helped spur growth in U.S. exports to Canada and Mexico, and from 1992 to 2001 the share of U.S. SME exports to Canada and Mexico increased from 24 percent to 33 percent.

A Regional Look at U.S. Export Activity
During 2004, U.S. merchandise exports totaled $818 billion with a growth rate of 13 percent, thanks to the lower value of the dollar and a robust global economy. More than half of these exports (56 percent) came from three of the nine U.S. Census Bureau divisions (see Map 1): the populous Pacific, the rapidly growing West South Central, and the industrial East North Central (see Chart 2). Approximately 25 percent of the exports originated from the South Atlantic and Middle Atlantic states, with the remaining 19 percent coming from the less densely populated New England, East South Central, West North Central, and Mountain Divisions. All except the Mountain Division had double-digit export growth rates last year—the East South Central Division had the fastest growth rate at 20.7 percent and the Mountain Division the slowest at 9.6 percent.

The major 2004 exports for each of the U.S. Census divisions are as follows:

Pacific (Alaska, California, Hawaii, Oregon, and Washington). The Pacific Division’s lead exports were computers and electronics as well as transportation equipment (mainly aircraft). The division’s relatively strong high-technology and aerospace sectors along with their many high-value-added, high-paying jobs generated half of the total value of its exports. In addition, the Pacific Division exported a large dollar volume of crops and processed foods, chemical and machinery manufactures, electrical equipment, and fabricated metals.

West South Central (Arkansas, Louisiana, Oklahoma, and Texas). Because of its location, the West South Central Division is a leading exporter of petroleum and coal products (nearly two-thirds of the nation’s total last year) and chemical manufactures. Agricultural and livestock products were also major exports. As home to several high-tech centers such as Austin, Dallas, and Houston, large-dollar export items included computers, software, and telecommunications equipment.

East North Central (Illinois, Indiana, Michigan, Ohio, and Wisconsin). In the heavily industrialized East North Central Division, transportation equipment (primarily motor vehicles) accounted for nearly a third of total exports. Because of the division’s large industrial base, machinery, electrical equipment, fabricated metals, and plastics and rubber products were also leading exports.

Middle Atlantic (New Jersey, New York, and Pennsylvania). The Middle Atlantic Division’s leading exports were chemical manufactures and computer and electronic products. It also contributed a high share (twice the national average) of printing products and primary metal exports.

South Atlantic (Delaware, District of Columbia, Florida, Georgia, Maryland, North Carolina, South Carolina, Virginia, and West Virginia). The South Atlantic Division is undergoing a major transformation. Traditional export mainstays in nondurable goods manufacturing (apparel and textiles and wood and paper products) are facing mounting pressure from overseas competitors, particularly China. Replacing these exports in importance are the transportation equipment and high-technology industries (computers and electronics), which accounted for over one-third of the division’s total exports.

New England (Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont). Nearly a third of all New England exports were computer and electronic products, and another third of exports consisted of chemical and machinery manufactures and transportation equipment.

East South Central (Alabama, Kentucky, Mississippi, and Tennessee). The East South Central Division exports a broad range of nondurable manufactured goods, including wood and furniture products, apparel and leather products, and printing and paper products. Also, the migration of automobile production from the higher-cost Midwest to the relatively lower-cost Southeast has increased the division’s exports of transportation equipment and plastic and rubber products.

West North Central (Iowa, Kansas, Minnesota, Nebraska, North Dakota, and South Dakota). As it encompasses a large number of farm states, the West North Central Division was a leading exporter of crop production and processed foods. It was also a major exporter of transportation equipment, computers and electronics, machinery, and chemical manufactures.

Mountain (Arizona, Colorado, Idaho, Montana, Nevada, New Mexico, and Wyoming). Although the Mountain Division’s share of total U.S. exports was the smallest (4.1 percent) of the nine Census divisions, it accounted for the highest relative share of computer and electronic product exports than anywhere in the country. In fact, 42 percent of its exports were computers and electronics, followed by transportation equipment (10 percent) and primary metal manufactures (9 percent).

SME Manufacturers Account for More Than One-Third of All SME Exports
SMEs are responsible for a large share of exports from a wide range of industries. According to the U.S. International Trade Administration, which divides exporting SMEs into the categories of manufacturers, wholesalers, and “other companies,” manufacturers comprised slightly more than one-third of the total value of SME exports in 2001.5 Wholesalers, or companies primarily engaged in the distribution of goods to businesses, accounted for another third of exports, and other companies totaled slightly more than one-quarter of all SME exports. SMEs accounted for a large share of total U.S. exports within several manufacturing industries (see Chart 3), which also generally paid below the average manufacturing hourly wage rate. However, when ranked by SME export values, the largest manufacturing industry groups in 2001 were computers and electronic products ($33 billion), machinery manufactures ($22 billion), transportation equipment ($20 billion), chemical manufactures ($17 billion), and processed foods ($11 billion).6 With the exception of the processed foods industry, these industries paid above the average manufacturing hourly wage rate.

Emerging Opportunities for Community Banks
Increased globalization creates intense competition for large and small businesses alike to develop new markets for their products and services. A major concern for these businesses is obtaining adequate trade finance either to produce the goods to be exported (for example, with working-capital loans) or to finance the sale of exports (as with letters of credit). Despite the tremendous opportunities for community banks in small business trade activities, only a small number of community banks actually provide trade financing. The Small Business Administration (SBA) estimated that in 1998, only about 150 to 200 U.S. banks out of approximately 9,000 engaged in any significant amount of trade financing. Although the number of banks engaged in international trade since then may have risen, their numbers are still believed to be quite low, primarily because of a lack of expertise.7 One of the chief complaints among small businesses is the difficulties they face not necessarily in finding buyers for their products, but in helping buyers find financing for their purchases. As such, the growth in worldwide trade may provide innovative community banks an opportunity to generate additional loan demand and increase fee income.

Despite the low number of banks currently involved in global trade, more community banks are becoming interested in pursuing the matter. Some reasons include growth in their potential customer base, a nearby large bank’s departure from the business line, an increase in experienced international managers due to the consolidation of larger institutions, and growing demand for trade finance services. Indeed, smaller institutions are now offering many business lines, services, and products once thought to be in the realm of large banks. In the Pacific Northwest, for example, financial institutions such as Banner Bank, Columbia Banking System, Inc., Washington Trust Bank, and Sterling Financial Corporation are reported to have either started or expanded international banking departments to serve that area’s rapidly growing Asian population.8 Some of the services that community banks are beginning to offer include issuing international letters of credit, providing trade financing loans, and facilitating or executing foreign currency transactions and wire transfers.

Technology Enables SMEs and Smaller Financial Institutions to Enter Global Markets
Advances in technology have facilitated the entry of SMEs and community banks into the international trade arena. For SMEs, the Internet is fast becoming an important tool for locating foreign purchasers of their goods and services. For community banks, the delivery of online services at a reduced cost is enabling them to offer products, such as letters of credit, that were previously available only from larger institutions.9 The Internet can facilitate the exchange of trade data and documentation between cross-border parties and allow community banks to make more cost-efficient trade financing transactions.

Ways for Community Lenders to Gain Global Trade Expertise
There are several ways that community banks can obtain the expertise needed to succeed in global trade. For instance, as a result of ongoing consolidation in the U.S. banking industry, smaller community banks have gained competence quickly by hiring highly skilled bank professionals specializing in international trade finance.10 As an alternative, many small community banks bolster their expertise by establishing a correspondent relationship with a larger institution. Other community banks develop their own proficiency in trade finance and then market their services to other community bankers.

According to a recent report, a few lenders with assets of less than $1 billion are considering offering trade finance services in-house, and several FDIC-insured institutions with assets of between $2.5 billion and $7 billion are already offering international services.11 In fact, banks and thrifts that provide international financing for their customers range in size from small to very large, as illustrated by the asset distribution of financial institutions that participate in the SBA Trade Finance Program (see Chart 4).12 This program helps small businesses enter export markets by providing such services as trade counseling, training, legal assistance, and export information.

The SBA and the Export-Import Bank of the United States offer other programs (for example, the Export Working Capital Program) that provide financing assistance to SMEs and help lower the risks of international banking transactions by guaranteeing commercial loans.13 The SBA also offers an Internet-based service called Export Express to help bankers assess overseas credit risk and structure their loans so that they meet the government approval process.

Immigration Trends Bolster Export Business and Lending Opportunities
One explanation for the rapid growth of SME exports since the 1990s may be the strong role that immigration has played during that period. For example, much of the U.S. trade to and from Latin America is undertaken by Hispanic-American exporters. Similarly, Asian- and European-American immigrants often facilitate U.S. trade to and from their native countries.14 The Asian and Hispanic populations, in particular, have been among the fastest growing in the United States. The U.S. Census Bureau is projecting these two ethnic groups to triple in size over the next half-century—the U.S. Asian population is estimated to increase from 10.7 million in 2000 to 33.4 million in 2050, and the U.S. Hispanic population is estimated to increase from 35.6 million in 2000 to 102.6 million in 2050.15

Community banks are taking notice of these expanding populations and their financial potential. Asia and Latin America are two of the world’s largest emerging markets, and banks that specialize in foreign-trade financing are often located in gateway states that host these large immigrant populations. According to one report, community banks, particularly those in states that trade heavily and cater to Hispanic- and Asian-Americans such as Florida and California, find that “providing working capital or letters of credit is crucial to maintaining relationships with small business customers.”16

The 1997 economic census on minority-owned businesses (the most recent available) showed immigrants to be highly entrepreneurial, with Asian and Hispanic small businesses growing four times faster than the rate of U.S. firms overall. Not surprisingly, then, traditional and new immigrant gateways, where many Asian and Hispanic people live and set up small businesses, often coincide with global gateways, where many of these ethnic small businesses engage in export activity (see Map 2).17

Lending to SMEs Engaged in Global Trade Has Unique Risks
Historically, community banks have been reluctant to lend to SME exporters because of the inherent risks involved. For example, if not familiar with the foreign country’s customs, laws, and regulations, small lenders may be hesitant to extend credit to foreign customers of U.S. exports. Some of the factors that have hindered community bank interest in this line of business are a general lack of expertise in international finance, the complexities of international trade financing, and the belief that the market was too small to devote resources to it.

To successfully conduct international trade-related business, lenders must consider not only traditional credit, operational, and management risks when establishing a relationship with potential customers, but also factors specific to global activity, such as political, foreign exchange, offshore-outsourcing, and import competition risks. And when banking relationships cross international borders, even traditional risk areas can be harder to understand, monitor, and manage. These international banking risks are discussed below.

Credit Risk. Unlike lending to domestic companies, trade finance lenders face legal and cultural issues that make it more difficult to adequately assess the risk of extending credit to foreign borrowers. To some extent, lenders can mitigate this risk by using institutions that will guarantee the loan (e.g., Export-Import Bank). Moreover, smaller community banks tend to rely on correspondent banks that already have the expertise and established relationships in foreign countries, thereby lessening credit risk.

Operational Risk. Contingency plans are crucial to mitigate operational risk for customers who are heavily engaged in trade. If a U.S. firm enters into a joint venture with a foreign firm, legal and other considerations also come into play, such as if a U.S. company’s foreign customers or suppliers abruptly terminate their relationship or fail to deliver per the contract terms. As appropriate, lenders can use covenants, differential loan pricing, and other steps to manage such risks.

Management Risk. Lenders must consider management risk when customers are heavily involved in foreign trade to determine whether they have grown into this line of activity over time and learned lessons along the way or are jumping into a new line of business with little knowledge of local conditions in the foreign country. Along with the risks that accompany any new line of business, firms operating across international borders face legal, shipping and transportation, communication, financing, quality control, marketing, and other challenges that may be significantly more complex than the same issues for domestic firms.

Political Risk. Political risk refers to instabilities in a foreign government that can lead to civil unrest, or a suspension of legal rights and recourse that can result in business disruptions and, occasionally, the seizure of private property. U.S. lenders can reduce this risk by engaging the services of international consulting firms that monitor many countries and provide ongoing assessments of country risk.18

Foreign Exchange Risk. More broadly, political risk can be related to foreign exchange risk. While many countries have freely floating exchange rates that can fluctuate over time, others attempt to peg, or fix, their exchange rate to one or more major currencies. However, even those arrangements can be difficult to sustain during periods of market turmoil, which can result in even more disruptive exchange-rate movements than those experienced by freely floating currencies. An example of a pronounced currency adjustment that negatively affected U.S. exporters occurred in 1997 when the Asian currency crisis caused a sharp realignment of exchange rates between the U.S. dollar and certain Southeast Asian currencies. Because of international financial market pressure and a lack of adequate foreign currency reserves, these Asian nations could not sustain their former currency exchange-rate targets, and, as a result, the value of their currencies fell abruptly. Although this drop proved beneficial to U.S. importers doing business with these countries, it was significantly detrimental to U.S. exporters, as the local cost of their goods and services rose dramatically (see Chart 5). In other examples, crises related to international capital markets (such as Mexico in 1994, Russia in 1998, and Argentina in 1998 and 2000) triggered turmoil in currency markets and, in some cases, limited the ability of businesses to move funds across borders.

Shifts in currency exchange rates need not occur abruptly to affect SME exporters and their lenders, and the shifts need not always have ill effects. For example, between first quarter 2002 and first quarter 2005 the euro appreciated relative to the U.S. dollar by almost 49 percent. This decline in the value of the U.S. dollar relative to the euro had the effect of enhancing the competitive position of U.S. firms that export to the European market. In 2001, nearly 20 percent of SME exports were sold to European Union nations (see Chart 6). And American small businesses making items ranging from forklifts to computer security hardware to toothpaste are reporting gains in overseas sales in response to the declining dollar.19

Offshore-Outsourcing Risk. Often, domestic firms may opt to purchase goods and services from a cheaper foreign source, whether actively engaged in international trade or not. This practice is referred to as “offshoring,” or “offshore outsourcing.” Offshoring can be motivated by shifts in exchange rates that might make certain inputs more costly to acquire in one country than another. Generally, the more dependent a business is on foreign relationships—including U.S. firms that have set up production operations overseas, those that obtain a majority of their inputs from abroad, and those that sell the bulk of their outputs abroad—the more significant the potential impact from international trade and transactions on the firm’s risk profile. In Industrial Distribution’s 58th Annual Survey of Distributor Operations, manufacturers ranked “moving offshore” fifth as a concern, behind “economic conditions,” “price competition,” “customers going out of business,” and “increased operating costs.”20

Import Competition Risk. Finally, community lenders may be exposed to internationally driven credit risk even when lending to SMEs that do not engage in global trade. With today’s trend toward globalization, the reality is that firms that produce and sell only within U.S. borders are not immune to what is happening in the rest of the world. Shifts in the U.S. dollar against other currencies and other economic factors overseas, such as productivity and wage–cost differentials, may significantly affect the competitiveness of domestically oriented SMEs. Several industries in the Southeast—including the apparel, furniture, and cotton industries—are feeling the effects of cheaper imports that are available in the United States. Such import competition can harm sales, profits, and the ability of some SMEs to service existing commercial credit lines.

Recent trends suggest that international trade activity will continue to grow and that more and more SMEs and community banks may be looking to enter this marketplace in some fashion. However, lenders need to individually weigh the costs and benefits associated with offering products and services specifically tailored to their customers involved in international trade. Lending to internationally oriented small and mid-sized businesses carries some unique risks, including political risk and foreign exchange risk, while also changing the nature of more typical concerns, such as credit risk.

While the pace of globalization in coming years remains uncertain, the process itself is unlikely to reverse. Small and mid-sized internationally active firms can provide numerous and rewarding business opportunities for community lenders, including issuing international letters of credit, providing trade financing loans, facilitating or executing foreign currency transactions and wire transfers, and providing direct operating funds through traditional commercial loans. But lenders engaged in these activities also need to be cognizant of the unique risks that arise when their borrower is a small or mid-sized business active in global trade.

Shayna Olesiuk, Regional Economist
Adrian R. Sanchez, Regional Economist
Joan D. Schneider, Regional Economist
Paul S. Vigil, Financial Analyst

1 Doug Barry, “From Appalachia to India: U.S. Small Businesses are Going Global,” Business Credit, June 2000.

2 Office of Trade and Economic Analysis of the International Trade Administration, “Small and Medium-Sized Exporting Companies, A Statistical Handbook: Results from the Exporter Data Base,” October 2003. As more recent data are not available, assuming that the share of SME exports were to remain at 30 percent, 2004 U.S. SME exports are estimated to have totaled close to $245 billion, or 30 percent of total U.S. merchandise exports of $818 billion, based on the U.S. Census Bureau’s origin-of-movement export series.

3 Ibid.

4 Ibid.

5 These three categories are based on the North American Industry Classification System. The category of “other companies” includes resource extraction companies, retailers, freight forwarders, engineering firms, and miscellaneous service companies that often market goods abroad and act as exporters of record.

6 See note 2. The rankings are based on the North American Industry Classification System.

7 Gordon Fairclough and Matt Murray, “Small Banks Expand Their Trade Financing for Exports—Still, Entrepreneurs Going Global Struggle to Get the Services They Need,” Wall Street Journal, February 24, 1998.

8 Katie Keuhner-Herbert, “Small Banks in Northwest Getting Into Trade Finance,” American Banker, April 4, 2005.

9 Ibid.

10 Kuehner-Hebert, “Smaller California Players Gain in Trade Finance,” American Banker, December 19, 2002.

11 Alan Kline, “Small Southern California Bank Selling Trade Services to Its Peers,” American Banker, April 20, 2000.

12 The SBA’s Trade Finance Program Web site (http://www.sba.gov/oit/finance/banks.html) lists banks participating in this program by state. A link on this site to the Office of International Trade homepage has additional information about the program.

13 The Export-Import Bank is a federal agency that extends trade credits to U.S. companies to facilitate the financing of U.S. exports.

14 Tom Coyle, “International Trade Financing, Community Banks Thinking Global: How to Play the World Trade Game,” Community Banker, America’s Community Bankers, June 1999.

15 U.S. Census Bureau, “Census Bureau Projects Tripling of Hispanic and Asian Population in 50 Years; Non-Hispanic Whites May Drop to Half of Total Population,” news release, March 18, 2004.

16 Alan Kline, “Why So Shy about International Trade Finance?” American Banker, January 13, 2004.

17 Audrey Singer, “The Rise of New Immigrant Gateways,” The Brookings Institution, Center on Urban and Metropolitan Policy, February 2004; and Economic Outlook Conference, Economy.com, November 2004.

18 Some of the firms that monitor country risk include: Control Risks Group, http://www.crg.com; Business Monitor International, http://www.businessmonitor.com; Countrydata.com and the International Country Risk Guide (by the PRS Group), http://www.countrydata.com; The Economist Intelligence Unit, http://www.eiu.com; and World Markets Research Centre (by Global Insight), http://www.wmrc.com.

19 Mark A. Stein, “Export Opportunities Aren’t Just for the Big Guy,” New York Times, March 24, 2005.

20 Victoria Fraza Kickham, “Making Inroads Overseas,” Industrial Distribution, March 2005.

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