After the global financial crisis, there was a strong call to review how banks were regulated. The November 2010 meeting of the G20 heads of government in Seoul, South Korea agreed a series of broad outlines, which have become part of the Basel III capital adequacy proposals. The original framework for Basel III was published in December 2010. Earlier this year the Basel III committee issued the full text of the revised Liquidity Coverage Ratio (LCR) following endorsement by its governing body, the Group of Central Bank Governors and Heads of Supervision (GHOS).
The committee has also said that it will continue to work on the interaction between the LCR and provision of central bank facilities. So while some details still are being worked out – especially around the other liquidity measure of Net Stable Funding Ratio (NSFR) – there is no doubt that the proposals will have a significant impact on the banking industry and its customers.
This article looks at the key proposals and considers some of the impacts these will have on banks and their corporate treasury customers.
Key Proposals within Basel III
The proposals cover both required levels of capital and how the banks will manage liquidity risk. On capital, the proposals firstly increase the required level of Tier 1 capital to 6% (up from 4% in Basel II) of risk-weighted assets (RWAs). They also define Tier 1 in more restricted terms, which will mean that some sorts of capital – such as contingent convertible bonds – will now be excluded.
Beyond this, a ‘capital conservation buffer’ of 2.5% will also be required to absorb losses in periods of financial stress. When the proposed ‘counter-cyclical capital buffer’ is added to this, banks may need capital of between 10.5% to 13% of their RWAs by 2019 to be compliant. Tier 1 capital will also need to be no less than 3% of the banks total absolute exposure rather than risk weighted.
In addition to capital, banks will also need to establish a liquidity risk management framework, which will ensure that the organisation can fund itself through both an institution-specific and a broader market-based stress event.
Key to this will be the LCR, which will measure the bank’s ability to fund itself over a 30-day period without access to the wholesale money markets. To measure the longer-term viability of banks’ liquidity, the net stable funds ratio (NSFR) will look to ensure that longer-terms assets are funded by a solid base of stable liabilities.
Other proposals include a focus on the larger institutions, which are considered systematically important. These Systemically Important Financial Institutions (SIFIs) will be required to have even more capital to pre-empt the possibility of ‘too large to fail’ bailouts.
Figure 1: What Basel III Means to Banks and Corporates.
While implementation of these proposals is set to be progressively introduced between now and 2019, different countries are moving at different paces. Regardless of what regulators are doing, the markets are already starting to measure banks against these standards, thus pushing chief executive officers (CEOs) to drive early compliance.
Impact on Banks
The most obvious impact will be the need to raise significant amounts of additional capital. This will affect some banks more than others. While many banks in Asia already meet or exceed the capital requirements, many banks in the West do not. The measure will more than triple the core capital that US and EU lenders must hold to at least 7% of their assets, weighted for risk. In recent years, as many banks have been generating returns below their cost of capital, this process of becoming capital compliant has not been easy and banks have had to resort to trimming back their balance sheets.
The process of raising additional capital will be further complicated by the impact on margins that the liquidity requirements will have. The need for longer-term stable funding will mean that banks have to focus on building up broad-based diversified sources of funding from their retail and corporate customers.
Wholesale funding will be limited to funding liquid tradeable assets. This will raise the costs of funds for many banks as well as forcing them to invest in cash management and retail banking capabilities. This impact on earnings could be potentially further compounded by the requirement to have capital of 3% of total exposures. This provision could have a significant impact on the profitability of derivatives and other high income streams for banks.
These changes could have a significant impact on the current business models for many banks. The need to boost earnings to raise capital, while working in a more constrained risk environment is likely to mean a significant focus on cost reduction. It is also likely to lead to strong disciplines around capital and the shedding of low-return business. It is also likely to lead to significant shifts in the competitive landscape.
Global banks based in Europe and the US, which have long dominated the international banking scene, are likely to find the new capital requirements a major constraint on their ability to do business. This is likely to be exacerbated by the growing trend of local regulators to require banks to locally incorporate. This requirement means that capital has to be placed in-country, which further reduces the efficient use of what will become a very precious commodity.
This shift in the relative strength of the banks will be further compounded by the relative growth rates of the developing world versus the US and Europe. Weakness in their home bases is likely to erode the capacity of many of the large international banks to invest in the growth markets of Asia, Latin America and the Middle East. This shifting picture will also be reflected in the home country credit ratings that impact banks’ own ratings. The improving rating of the developing versus developed world will start to favour Asian banks against their Europe and US-based counterparts.
This is already starting to be reflected in the relative market capitalisation of the world’s biggest banks. Of the top 15 banks by market capitalisation, currently half are from the developing world. In 2006, the developing world had no representation on this list.
Impact on Corporates
The profound changes unleashed by Basel III will have an impact on the relationship between banks and their corporate customers.
Funding Costs and Deposit Rates: With Basel III, the cost of borrowing for corporates would go up due to banks’ increased capital requirements, reduced net supply of credit and more expensive pool of deposits that can be used to fund bank borrowing. In particular, longer tenor borrowing would see a significant borrowing rate increase as NSFR prevents banks from using wholesale deposits for funding such loans. Borrowers with weaker credit standing would also likely experience a more pronounced cost hike due to their great dependence on bank financing.
As banks seek more ‘stable’ deposits, they would collectively bid-up the rates and these costs would be shared by borrowers. Bonus or penalty interest schemes designed to encourage deposits to stay could also become the norm. For corporates, this means the benefit of efficient working capital management would increase substantially.
Supply Chain: Active working capital management and supply chain financing can provide interesting financing opportunities as an alternative to standard bank financing. Corporates should be keen on their position from a financial and credit standing point of view, relative to other parties in the supply chain. Given the current differentials in cost of credit and the introduction of Basel III, differences in creditworthiness provide opportunities for all parties in the supply chain. When financing costs rise, they go up disproportionately for smaller borrowers. This poses a challenge to corporates dependent on a network of smaller suppliers and distributors.
As banks adjust to Basel III, corporate treasurers are in a position to minimise disruptions to the flow and cost of liquidity for partners in the end-to-end supply chain. Treasurers can leverage their relationship with banks to develop supply chain funding programmes covering their critical supply chain partners. This takes time and effort to build but it could be worth the investment.
Liquidity Management and Notional Pooling: Liquidity management structures deployed by corporates such as notional pooling and zero balancing account (ZBA) sweeping will be affected by Basel III as well. Since undrawn overdraft lines as well as overdrawn accounts in a pool structure will both attract capital requirements under the Basel III guidelines, the costs for providing such facilities go up for banks and as a result corporates. This can make sweeping a more preferred option for liquidity management.
The industry has reached an interesting crossroads, where some banks are retreating due to home economy problems while others are seizing opportunities to expand. While this is similar to the global financial crisis of 2008, the forces driving the trend now look set to persist for some time, and Basel III is reinforcing the trend.
Even with the implementation timeline being pushed back to give some banks a bit more breathing space, Basel III is a reality that is not too far out in the future.
The impact on both banks and corporates will be significant and treasurers should look and plan ahead to ensure they have the right banking relationships to support their businesses into the future.
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