The collapse of Lehman Brothers in autumn 2008, quickly followed by the rescues of AIG, RBS, Merrill Lynch and numerous other large banking and financial institutions, threatened the world economy with disintegration on the scale of the famous 1929 Wall Street crash, which led to the Great Depression. This fate was only averted by large-scale government interventions and rescues. The consequences are still prevalent today, of course, in terms of large private and public debt piles, an aversion to risky lending, and a renewed focus from corporate treasurers on counterparties and diversified risk programmes. But perhaps the biggest impact is yet to come, as a raft of new post-crash regulations come to fruition for financial institutions which will impact corporations and the future of global finance for years to come.
Prominent among the new regulations is the Basel III capital adequacy rules, which will take effect from 1 January 2013 and progressively be rolled out in all their different elements throughout much of the rest of the decade until 2019.
According to the Bank for International Settlements (BIS) overseer, Basel III is a comprehensive set of reform measures developed by the Basel Committee on Banking Supervision (BCBS) to strengthen the regulation, supervision and risk management of the banking sector.
The Fundamentals of Basel III
The regulatory regime is the successor to Basel II, the second of the Basel Accords, which was introduced in 2004. The purpose of Basel II was to create an international standard for bank regulation, with a specific focus on the necessary level of capital which banks must hold to guard against financial and operational risk. Basel III is, in many ways, an attempt to ‘upgrade’ the guidelines for bank capitalisation, based upon the lessons and conclusions of the recent global financial crisis, where leveraging issues were largely ignored to everyone’s cost. The key regulatory changes that will result from Basel III include:
- Increased capital requirements, with a general 7% figure being outlined, up from just 2% previously. But this figure will rise in certain countries such as Britain where a higher 10% figure is envisaged under its Vickers Report, and for certain large Systemically Important Financial Institutions (SIFIs). Deutsche Bank has itself recently been declared one of only five SIFIs, which is no surprise as its Global Transaction Banking (GTB) unit handles 25% of euro cash flows and is big in trade finance, commensurate with Germany’s strong industrial export and trading sector.
- New liquidity and funding ratios, plus countercyclical buffers, will also come in with the introduction of Basel III.
- The introduction of a leverage ratio is included to try to prevent over-leveraging in future.
It has also been deemed that SIFIs, such as Deutsche Bank, must have higher loss absorbency capacity to reflect the greater risks that their size poses to the financial system. The BCBS has developed a methodology that includes both quantitative indicators and qualitative elements to identify global, systemically important banks (SIBs). The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance.
The aim of all the Basel III measures according to BIS’ own website is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source; improve risk management and governance; and strengthen banks’ transparency and disclosures. While the content of Basel III is largely decided, the precise implications remain unclear for banks and ultimately for treasurers worrying about bank funding or capital market instruments. Most significantly, the regional legislation which will govern the implementation of Basel III – for instance, the Capital Requirements Directive IV (CRD IV) in Europe and Dodd-Frank in the US – has not yet been finalised around the capital adequacy arena so there is still some implementation uncertainty.
The regulation will impact corporate treasurers too, as banks have to keep more money, which could potentially mean funding gets more expensive and there is less around for the least attractive corporations. SIFI-designated banks could, however, theoretically use their special status and implicit state backing to get better funding on the markets, which could be passed on. These SIFI banks have to hold more capital as well, of course, so it is a double-edged sword. Other Basel III treasury impacts could include a more complicated hedging and trade finance arena.
The new liquidity stipulations, for instance, mean that in future some deposits will be worth more than others, which has sparked a battle for corporate accounts. Lots of linking has been happening as any treasurer will be aware, where large steady guaranteed flows are rewarded with good contracts and/or credit facilities. Trade finance may not be as attractive as other instruments under the new regime either, which could lead to a fall in availability or affordability under Basel III. At the moment the traditionally low-risk nature of letters of credit (L/Cs) and other trade finance instruments, which still remained available throughout the financial crisis, are not being recognised and they could become too expensive for practical use if regulators do not relent. Alternatively, treasurers might turn to their own supply chain finance (SCF) options. However, this may risk losing the bank option, which is not in their long-term interest.
Another treasury impact, which Basel III is likely to exacerbate, is the renationalisation trend, whereby banks retreat from providing cross-border services and instead concentrate almost exclusively on their home markets. This move is leading to a fall in competition and services / rates for treasurers, and is similar to what occurred in the market after the 2008 crisis. Renationalisation reduces the benefits from globalisation and is therefore not the right approach, as it could lead to more protectionism.
The core stipulations as they currently exist can best be seen in BIS’ own graph below:
The Basel III changes will be implemented over a five-year timeframe, starting in 2013. However, under the guidelines known as Basel 2.5, implementation of increased capital requirements actually got underway in 2012. The European Banking Authority (EBA) ran stress tests, for instance, on 30 June requiring a 9% core Tier 1 capital ratio which European banks passed by a variety of means, including retaining profits; shrinking balance sheet exposures as RBS and some French banks have been doing for some time; cleaning up data so that capital is recognised faster (as a treasurer would); and in some cases getting a capital injection. The top 20 European banks increased their average core tier 1 capital from 9.1% to 11.5% in 2012, showing that preparations for the tougher capital adequacy requirements under Basel III are underway.
For the purposes of corporate hedging activity, the crucial difference will be the increased capital requirements facing the banks. This impact will result from two separate, but related, factors:
- Capital requirements will generally be bigger, which has a knock-on effect by increasing the cost of credit; an important component in total hedging cost.
- The way that risk-weighted assets will be calculated, the denominator of the capital adequacy ratio, will change. This increases the amount of capital that the banks must hold against over-the-counter (OTC) derivatives. The impact flows mainly from the advent of a credit value adjustment (CVA), which must be added to the default risk capital charge, which already exists under Basel II, to determine the total counterparty credit risk capital charge.
Whether hedging trades involving corporates, which nominally are not profit-seeking, will be exempt from this CVA charge is still up for debate. At the moment, at least under Europe’s trailblazing CRV IV regional implementation, the European Parliament is trying to get a CVA exemption for banks that handle derivative trades for corporate treasurers, as part of a hedge programme. Whether they succeed remains to be seen, and some banks are already beginning to factor the charge into their pricing due to the uncertainty and the length of some contracts which demand caution.
Basel III is still a work in progress and there will likely be many additions and modifications over the coming years of implementation. The general tenor of the regulations is clear, however, and banks are already acting upon it, with some treasurers only now waking up to the potential impact for them. What has not been helpful, however, is the recent announcement of a US delay with the authorities in the country admitting that they will not be ready for the 1 January 2013 start date. With the country being such an important player in the international financial markets – indeed there is an argument that the genesis of this regulation goes back to the subprime securitisation boom and subsequent crash – this was not a welcome move and further adds to the uncertainty in the financial system. [In response, the European Banking Federation (EBF) is lobbying the EC for a year-long European delay – Ed.].
The US is still on Basel I, not even Basel II, in some ways so it is a considerable disadvantage for some US banks to jump ahead towards Basel III compliance now. Conversely, many US institutions might argue that the first EBA stress tests were set so low that many European banks, which have subsequently struggled, sailed through them with a clean bill of health. Whatever the political arguments, corporate treasurers and financiers generally would like certainty from the regulators and agreed universal migration dates where possible. The regulation is needed so it is time now to get on and execute it and ensure that there is a level playing field for everyone.
Questions a Treasurer Should Ask Their Bank
It should be quite clear by now that the Basel III capital adequacy rules will have a big impact on treasurers and the global financial system in the years ahead, even with the uncertainty surrounding some elements of it. The key point for a treasurer is to remember to only focus on the fundamentals for them and what the impact upon corporations might be. For this reason, a hopefully helpful list of key questions that treasurers should ask their banks is outlined below:
- Risk: It is reasonable to ask if your bank can meet the capital, liquidity and leverage hurdles set out in Basel III. The burdens on Tier 2 and Tier 3 banks, in particular, are set to increase, but there are also additional requirements on SIFIs. Find out how well your bank is equipped to meet these requirements.
- Services: Most banks traditionally offer a range of services, covering cash management, trade finance, bonds and so forth, but are they committed to maintaining such a wide-range of services in the future? Crucially, can they offer such services internationally or are they part of the renationalisation trend and is this a problem for you?
- Pricing: As a treasurer it is your duty to ensure that a corporation has good access to the most favourable credit lines you can get and to ensure a diversity of options. This rolls out into hedging programmes as well designed to reduce risk, but as the demands on banks go up so might the prices for you. In a low growth, low interest rate environment, where many banks are exiting structured products, be prepared for some tough negotiations.
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