Basel III: Time for Action

In 2011 the average return on equity for the major banks in the G7 economies was around 5%. This is less than half of the cost of equity of these banks. It should therefore be no surprise that the average market to book ratio for the sector is around a half. It should also be no surprise that equity investors are currently wary of putting more equity capital into banks.

The on-going eurozone crisis coupled with economic and regulatory uncertainties are contributing factors. However Basel III is playing its role with:
• A 10-fold increase in the minimum capital ratio (including a surcharge for larger banks).
• A new and expensive liquid assets buffer requirement. 
• A net stable funding ratio which requires banks to seek longer-term (and more expensive) funding.
• A leverage ratio which caps the level of bank gearing. 

With return on equity in the doldrums and tough new regulatory capital ratios, banks are trying to optimise the regulatory treatment of their lending and trading books.

In Europe, these issues are likely to come even more firmly into focus when the final text of the fourth Capital Requirements Directive (CRDIV), which will make Basel III law in the EU, is issued later this year.

What does all this mean for corporate treasurers and the customers of their firms? While the overall consequences of Basel III and other regulatory change will take years to crystallise, some immediate implications include:

The cost of credit is likely to rise. A bank’s willingness to raise prices will depend to a degree on its own financial position and strength and the corresponding positions of its customers and competitors. Even so, this is an area where there is a first-mover disadvantage for the banks. From the bank’s point of view, a ‘plain vanilla’ lending relationship is unlikely to be enough. The new economics dictate that a profitable customer relationship will be built around a range of services.

Trade finance, an innocent bystander in the financial crisis and a low-margin activity, is penalised by Basel III from both capital and liquidity perspectives. Unless the rules are changed (as for example planned in the current draft of CRDIV), certain banks will withdraw from trade finance and some customers will no longer be able to afford it. This could have a major impact on business in emerging markets where trade finance is central to business activity.

Additional capital requirements for derivatives come into force on 1 January 2013. Corporate treasurers, who use these for hedging interest rates, foreign exchange (FX) risk, commodity risk, etc should expect the price to go up. For some banks in some markets the provision of derivatives is likely to become uneconomic, so expect the services provided by banks to change. Note that there are additional rules related to banks’ use of central counterparties (clearing houses) for derivatives that are yet to be finalised. 

Infrastructure and project finance are likely to become more expensive because of the new funding ratio introduced by Basel III. If your business or your customers depend on infrastructure finance, the implications need to be worked through. Assumptions about rolling over of finance may need to be tested.

Banks are in a ‘race for deposits’ to comply with the new liquidity rules. Corporates with cash should, in the long-run, be in a good position despite the fact that the liquidity rules treat corporate deposits less favourably than retail ones. Banks are likely to be keen to lock-in depositors, so corporate treasurers will need to consider what this means in terms of their overall banking relationships and what terms they are willing to accept. 

Undrawn facilities are expensive, both from regulatory capital and liquidity perspectives. Corporate treasurers should expect unused facilities to continue to be reduced in amount and term, to become more expensive or additional collateral required (generally, if a firm can provide additional collateral to its bank, it should be regarded favourably). 

Banks have to avoid concentrations in particular sectors or geographies. This applies to both regulatory liquidity and capital considerations – so corporate treasurers should expect price differentials between banks because their risk profiles vary. Similarly banks have different capital and internal funds pricing models with differing levels of sophistication, so a given transaction may look different depending on the bank’s approach. As ever, it should pay corporate treasurers to shop around.

Shadow banking (finance activities that are not regulated) is likely to grow, enabling bank customers to access financial services more cheaply from non-regulated providers. Corporate bonds issued directly to investors are a well-established option for larger companies to raise finance without a bank. Longer term, it is likely that we will see other financial activities developing outside the regulated sector. New technology means that the options to do so are growing and changing all the time.

In summary, the aim of banking reforms like Basel III is to make the financial system safer and reduce the risk that the taxpayer will have to bail out the banking industry again. However, the removal of the ‘implicit government guarantee’ means that the cost of banking has gone up and that the cost has passed from taxpayers to bank customers.

So, what’s to be done? Corporate treasurers have been long been aware that reform in the banking industry will affect them. It’s clearly important to have a firm grip on the regulatory reforms and their potential implications. It will also be important to continue to monitor regulatory developments closely over the next two to three years as the details are finalised and refinements made. 

In the meantime, to prepare for the Basel III world, corporate treasurers should undertake careful impact assessments and assess their options.

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