Many of the final detailed rules – as defined within the latest Capital Requirements Directive (CRD IV); the EU implementation – that support the principles were thrashed out by the regulators in Basel back in 2010, but are only now being implemented. They are lengthy and complex, so what do a bank’s corporate clients need to be aware of as the new regulations begin to bite?
Higher capital requirements and tighter liquidity metrics mean that the cost of bank credit extension must rise, as must the cost of providing liquidity. Specifically, the liquidity rules will generate a real shift in the returns curve for bank deposits, which means that corporates will be paid significantly less for shorter-term deposits and comparatively more for investing their money for longer.
They also mean that finance directors and treasurers will have to be more creative, as the management of corporate liquidity becomes progressively more complicated.
Changes to the regulatory landscape mean that corporations are already evidencing changes to their buying behaviour – investing in a broader range of products that meet both their immediate and strategic needs.
Limits on Liquidity
There are two key strands to the regulations: firstly the capital adequacy ratios (risk capital ratio and leverage ratio), which define the minimum amount of capital banks must hold to cushion against losses; secondly, the liquidity coverage ratio (LCR), and net stable funding ratio (NSFR) which control how banks manage their liquidity and funding risk.
The credit crunch of the late 2000s was initially a liquidity crisis before it became a solvency event.
The key element of the CRD IV liquidity requirement is that banks will have to hold enough highly liquid assets to enable them to manage for at least 30 days in times of financial stress.
The LCR was therefore developed as the key metric to control how banks manage their short term liquidity risk, protecting against a liquidity shock by requiring differing levels of liquid asset reserves against different tenors and sources of deposits and other borrowings.
It ensures that banks hold a sufficient liquid asset buffer to survive a worst-case liquidity disruption lasting up to 30 days, similar to the September 2007 run on Northern Rock that ultimately led to the UK bank’s nationalisation by the government in 2008.
Banks now need to prove they are able to manage through a liquidity event when depositors withdraw or do not rollover their cash and the markets are closed to raising fresh funds.
Banks need to be holding sufficient high quality liquid assets (HQLA), such as cash, government securities and certain liquid asset-backed and corporate bonds, to ride out such a liquidity crisis.
In practice a typical bank would probably have to hold 10% to 12% of its asset base in HQLA from.
The final list of what qualifies as a HQLA is still being fine-tuned by the regulators, but the knock-on effect on corporate customers of the LCR is already clear. When compounded by shrinking European bank balance sheets caused by risk capital and leverage ratios there will be lower demand for short dated deposits and consequent lower returns.
Evergreen Accounts to Bloom
The 30-day horizon point, below which, depending on the source and type, some or all of the deposit will have to be held in very low return HQLA, crimps maturity transformation and returns.
Banks will therefore be strongly incentivised to take deposits for significantly longer than one month, so that these funds can be used to support lending or other longer term assets.
So they will offer relatively lower interest rates on funds deposited for periods of one month or less.
This will lead banks to introduce new products designed to reward longer-term deposits, meeting the regulatory aim of reducing the banks’ liquidity risk.
An example is the recent proliferation of so-called ‘evergreen’ deposit accounts, where clients can benefit from both a higher return and floating interest rate by having a minimum 30+ day notice on the account.
Risk-averse corporates have been growing their cash balances over the past few years, but as confidence and underlying economic conditions improve, businesses may look at different avenues in which to invest. However, corporates are expected to continue holding significant cash and/or financial investment balances.
Investing in money market funds (MMFs) has historically been a popular alternative to bank deposits for corporates to place their surplus cash, but proposed new regulations look set to change their habits considerably.
The European Commission (EC) is proposing that MMFs be required to hold a capital buffer equal to 3% of liabilities if the fund offers a constant net asset value (NAV), a move that will make funds safer but significantly more expensive to run.
Fund managers will undoubtedly look to pass that increased cost on to investors, while the other key proposal – that fund managers or sponsors should no longer be able to pay for funds to be rated, will also make them much less attractive.
These proposals are currently in draft form and would be unlikely to come into effect before late 2015 or early 2016, but European MMFs have already begun to see outflows.
A challenge for corporates will be finding convenient alternatives to a rated constant net asset value (CNAV) fund without having to undertake significant ‘in-house’ credit work. This is an area for banks to be thoughtful on how best to support their clients
A New Landscape
From a corporate perspective the Basel bank regulatory changes, unlike regulations such as the European Market Infrastructure Regulation (EMIR), do not require direct compliance and may not lead immediately to requirements for costly investment in new infrastructure or administration. However, ultimately they are more strategic in their impact.
Managing liquidity is one of the core requirements for business success. As part of that, it’s crucial for treasurers and other financial professionals to make sure their funds are safe, available when they actually need them and that they are working as hard as is consistent with the first two objectives.
Regulators are changing the landscape and corporations will have to change their buying behaviours to invest in a broader range of products that suit both their immediate and strategic aims.
A bank that can be trusted to offer the right balance of return and security on your deposits is a crucial ally during these changing times.
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