According to the famous Austrian school of economics, financial market regulation has always caused two main problems, both of which can be said to apply to the new Basel III capital adequacy regime:
- Regulation disrupts market processes, making markets less efficient.
- It inevitably leads to even more regulation (and even less market efficiency) as new regulations are needed to correct the flaws in the original legislation.
The incoming Basel III regime can legitimately be taken to task on both counts. The new regulations will certainly disrupt market processes, by raising the cost of capital for banks and making many banking activities, including lending and derivatives trading, more expensive for corporate treasury end users. In addition, Basel III has helped spawn a whole new generation of regulation, especially with respect to the trading and reporting of over-the-counter (OTC) derivatives, before it has even been fully implemented – and certain aspects of its implementation have incidentally already been delayed.
In regard to the OTC requirements, allied to wider post-crash rules insisted upon by the G20 to effectively force derivatives ‘on exchange’ via the use of central counterparty (CCP) clearinghouses and increased transparency, there may be some unintended consequences under the new regime. Indeed, a cynic might argue that the estimated 0.15% drag on gross domestic product (GDP) growth estimated to result from the implementation of the Basel III regulations will be more than off-set by the fees charged by OTC derivatives lawyers in order to help banks and their clients navigate their way through this new regulatory jungle.
However, proponents of financial market regulation might counter that no statute is perfect from the outset; even the US constitution has required 27 amendments. Basel III is no exception, and 2013 has witnessed the beginning of its inevitable evolution, with two key improvements which will directly benefit corporate treasurers, as well as the banks themselves and the wider finance sector.
Improvement One: LCR Revision
The first Basel III improvement is the revision to the Liquidity Coverage Ratio (LCR). The purpose of the LCR is to insist that banks maintain an adequate supply of “high-quality, unencumbered assets” to ensure they are able to weather a 30-day period of financial stress. Under the original proposal, the stress-testing would require banks to assume that their corporate clients would draw down 100% of their available credit lines; this has now been revised downward to 30% for liquidity facilities – for example, commercial paper revolvers – and 10% for general loan facilities.
This LCR amendment, together with a broader list of assets which a bank can hold against these credit lines (e.g. corporate bonds and equities), and an extended implementation period (banks now have until 2019 to comply, instead of 2015) is great news for both the banks and their corporate clients. By making the liquidity requirements associated with the corporate lending business less onerous, the bank’s cost base will be reduced, which should ultimately reduce the cost of credit for the corporate borrower –or at the very least ensure that it does not go up.
Improvement Two: CVA Charge To Go in Europe?
The second Basel III improvement to benefit corporate end users (for European corporates at least) is the expected decision, under the CRD IV implementation legislation in Europe, to remove the requirement for European banks to apply a credit value adjustment (CVA) capital charge to derivatives transactions with corporate clients. Such a charge would have inevitably increased the cost of hedging for many companies, as banks would have passed this charge on to their clients. Some estimates have placed the impact of CVA on the cost of hedging at 300-400% or more, depending on the type of derivative used. For instance, long duration trades such as cross-currency foreign exchange (FX) swaps, would have been particularly hard hit.
The other likely consequence of the CVA charge would have been an increase to the liquidity risk or counterparty risk facing non-financial firms – namely, corporates and their treasurers and supply chain partners. Due to the fact that posting collateral – often in the form of cash deposits, or trading on margin, rather than through credit lines – offers a way to reduce the CVA charge, corporates may have been tempted to substitute market risk with either liquidity or credit risk. While such an approach can often make sense, especially using bilateral margining agreements, it is certainly preferable for corporate treasurers to have a choice in this regard. The revisions provide this choice.
It should be noted, however, that the European CVA exemption has still not been formally announced yet, but it is widely expected to be agreed by the European Commission (EC), the European Parliament (EP) and the Council of the European Union shortly; perhaps as early as this month. Clearly, this will create a divide with other jurisdictions and major trading blocs, such as Australasia, Japan, China, and possibly the US, where the CVA charge will still apply unless local revisions are made there. As one of the objectives of the Basel III capital adequacy regime is to ensure a global level playing field within the global banking industry and finance more generally, however, it will be interesting to see the repercussions of this European move and if it causes any unravelling. There is a fear that this could put non-European banks at a large competitive disadvantage compared to their European competitors in terms of pricing OTC derivative transactions for corporate clients.
As the famous Austrian economists from last century rightly point out, financial regulation does impede market activity. In fact, impeding certain types of activity is really the main job of regulation. However, this does not mean that regulation is always a bad thing.
An analogy might be drawn to the referee of a football match. While frequent interference in the match can certainly be frustrating (and sometimes it might even be unjust), it is hard to imagine a match running smoothly without the referee’s involvement. As such, the costs of having a referee – from the slowing down of play, to bad decisions and so forth – are outweighed by the benefits, such as the impartial enforcement of the rules, disciplining of dangerous play, etc. And the higher the stakes, the more valuable, and necessary the role of such an impartial arbiter is; whether that is on the field of play or in the financial markets.
Perhaps the most important lesson of the global financial crisis is that, when it comes to the international banking system, the stakes are astronomically high. As such, the value of ensuring a robust regulatory framework, which ensures than banks are well capitalised and that risk is priced appropriately, is surely worth a relatively high price, in terms of the impact on market efficiency. It also means a more transparent and ultimately useful system for corporate clients and others. Basel III is not perfect, but it is all we have for now; and at least it is getting better.
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