Published: August 01, 2012
As I write this the day before the Opening Ceremony for the Olympic Games, it is hard to believe the transformation that has occurred in east London and in the venues around the UK in only seven years since London was awarded the Games. The banking sector is engaging in a similar transformation. Over the next five years, the regulatory and market environment for banks, and the institutional customers with whom they work, will become barely recognisable compared with the conditions that existed before the 2008-9 crisis. Many have argued that this is either a good or bad thing respectively, but change is inevitable and inexorable.
One of the most substantial new regulations is known as Basel III (or the Third Accord of the Basel Committee of Banking Supervision) which will have far-reaching implications for banks and their customers. Although Basel III is mentioned a great deal, primarily in the context that ‘things will change’, what this means in practice is less clear. This problem is exacerbated in that the details of Basel III have yet to be determined. However, with new capital adequacy requirements rolling out from January 2013 (with a deadline of 2019 that seems long but is unlikely to prove to be) Basel III is now an immediate consideration for banks and their customers.
The requirements of Basel III cover capital requirements, leverage ratios liquidity and systemic risk issues, but for the purposes of this article, we will focus on capital requirements and in particular, liquidity, which will have the greatest impact on the way that banks engage with their corporate customers. As Greg Kavanaugh, Managing Director, Head of Global Liquidity and North America Product Solutions, Bank of America Merrill Lynch summarises,
“Most large multinational corporations are aware of regulations such as Basel III, and they know that the intention is to make the banks safer. However, they have varying degrees of knowledge about the likely implications, such as how the cost of assets will increase, and liabilities become less generic, which will result in banks becoming more discerning about the business they conduct.”
Andrew Bailey, Director: UK Banks and Building Societies Division, Financial Services Authority (FSA) summarised in a recent speech,
“Why are we undertaking such wide-ranging reforms? he simple answer, because we have had a major crisis, is not good enough as an explanation – it explains the timing of the reforms, but the substance of them requires more explanation… First, achieving a stable financial system will in turn enable the development of a strong, competitive system, and likewise will foster the strength of financial centres. Financial stability and competitiveness are not fundamentally in conflict; rather, the former is a necessary but not sufficient condition of the latter, much as stable low inflation is a condition of sustainable economic growth. The key point here is that our respective objectives of stability and competitiveness are fundamentally not at odds.” [[[PAGE]]]
i) Capital ratios
According to Basel III’s predecessor, Basel II, which is the current regulation governing capital adequacy, banks should hold 2.5% of risk weighted assets in common equity, and 4% of tier one capital (now defined as shares, retained earnings and some forms of hybrid capital). Under Basel III, the common equity ratio is increased to 7% (including a mandatory buffer of 2.5% so that in the event that a bank’s capital ratio falls within the buffer zone, it will be restricted in the payment of dividends and discretionary bonuses) and 6% of tier one capital.
The risk weightings that are applied to different asset classes are being revised with the aim of reflecting a bank’s true exposure to counterpart, trading and securitisation risk. At present, the most controversial aspect of this change is trade finance instruments such as letters of credit, which will typically be weighted at 100% of their value, although as the International Chamber of Commerce has demonstrated, the default rate for trade finance instruments is negligible. Under Basel II, letters of credit are weighted at 20% and standby letters of credit, guarantees and performance bonds at 50%. Many corporates and banks fear that this change will constrain banks from offering their customers the solutions to manage international trade risks cost-effectively.
ii) Leverage ratio
Over recent years, banks’ balance sheets have increased considerably in size, a trend which Basel III aims to restrict or even reverse. The new regulation will cap banks’ total assets at 33 times their equity capital. To many banks’ (and their corporate customers’) concern, trade finance instruments are included in this ratio.
iii) Liquidity
Basel III introduces a liquidity ratio to enforce equilibrium in a bank’s assets and liabilities over a period. This is one of the most significant elements of Basel III for banks, and also for their corporate customers. All banks will be required to perform stress testing that assesses their ability to weather a period of 30 days of ‘stressed’ market conditions according to a common definition.
The assumption is that under ‘normal’ market conditions, a bank can expect a high proportion of loans to be repaid, whereas under stressed conditions, this could reduce to around 50%. Ordinarily, a bank may cover defaults through deposits and by reissuing new loans, but this may not be possible during a market crisis. Furthermore, a bank could expect to lose deposits during a period of crisis. The new regulations assume that a bank could lose 75% of deposits from corporates with whom they do not have an operational relationship, and 25% of deposits from corporates with whom they have such a relationship.
In theory, the rollout of Basel III starts in January 2013, with effectively an end date of 2019. However, particularly in an environment of on-going volatility and poor press for the banking community, many banks believe there are competitive advantages in being able to announce Basel III well ahead of time. No bank wishes to be considered a ‘laggard’ in regulatory adoption, so we are seeing strong momentum amongst banks towards compliance. Effectively, once the first banks announce compliance, others will be obliged to follow quickly, so the 2019 end date is likely to be largely irrelevant.
It is clear that each one of these aspects of Basel III will have a significant impact on the way that banks interact with their corporate customers:
i) Cost and availability of credit
Firstly, on-going credit constraints will inevitably continue or even exacerbate the current trend so that banks will need to be even more selective in whom they lend to. This will come as no surprise, and inevitably, certain customer groups will become less attractive to banks, as we have seen since the crisis. Robert Pehrson, Global Head of Product Management, Corporate Segment, Global Transaction Services, Merchant Banking, SEB indicates that the change in funding terms is not only driven by regulation,
“It is not only Basel III that is changing the way that banks and their corporate customers work together, but also the condition of the funding market. Spreads have been growing since 2007, which greatly exacerbates the effects of regulations such as Basel III.” [[[PAGE]]]
Just as significant as the reduced availability of credit overall is the change to risk weighting, particularly for trade finance instruments. This is an area in particular in which corporates could be significantly adversely impacted. There have been some ‘tweaks’ to the regulations to try to reduce the effects on trade with the world’s poorest nations, but these changes are relatively minor and do not alleviate the effects for the majority of corporates. Furthermore, it is not only Basel III that is affecting banks’ ability to do business. As Greg Kavanaugh, Bank of America Merrill Lynch outlines,
“The impact of Basel III on capital is, in general, quite well understood, although there is still considerable uncertainty about how lending under trade finance instruments will be affected. There are also a number of questions, however, around liabilities. It is important to recognise that banks are not only required to implement Basel III, but myriad regulations, which will affect capitalisation, product distribution and pricing, and accounting for financial instruments, all of which add to the cost of the regulatory burden.”
ii) Pricing
It is not only the cost of capital that is likely to increase. Trade finance and other services that now have a higher risk weighting will also increase in cost, but the cost of any individual product or service still needs to remain competitive. Banks themselves will need to establish a clear view of what it costs to deliver each product. However, these costs may be offset when looking at the overall amount of business that they do with each customer, such as deposits that a customer places, and ancillary services such as cash management. This leads in turn to the growing importance of relationship banking as opposed to transaction banking, a shift that we are already witnessing, which is described further later in this article.
iii) Deposits
While Basel III may appear to be rather doom-ridden for corporates from the discussion so far, there are some upsides, particularly for corporates with surplus cash available for short-term investment. Robert Pehrson, SEB explains,
“Banks are keen to attract certain types of deposits, so they will sometimes need to offer favourable terms; on the other hand, overdraft pricing will tend to be higher due to increased spreads in the funding markets."
Greg Kavanaugh, Bank of America Merrill Lynch continues,
“The combination of Basel III together with shadow banking regulations such as those surrounding 2a7 funds, could result in reserve cash becoming less valuable to banks, compared with operating cash. Consequently, there will be more competition for operating cash. Alongside this, the possible move towards funds with floating net asset value (NAV) and/or capital buffers could change the dynamics of bank deposit alternatives.”
Once again, the need to attract deposits is a factor contributing to the evolution of a relationship banking model, which is a positive development for most large, highly rated corporate customers.
iv) Relationship banking
Greg Kavanaugh, Bank of America Merrill Lynch outlines,
“Banks will do more portfolio and market analysis to identify the customer market segments that are most valuable to them. They will then focus on long-term, end-to-end relationships with these customers, both to deliver the best possible services to them, and balance the costs of delivering one product with the value of another. Inevitably, some industries will experience a disproportionate impact, particularly financial institutions.”
The combination of capital adequacy changes, and the introduction of new liquidity requirement are likely to result in a decline in banks’ return on assets, making ancillary business such as cash management and alternative financing even more important. Robert Pehrson, SEB illustrates,
“There remains a lack of clarity about the detailed requirements and timescales for Basel III, but there are undoubtedly implications for corporates, such as in the relationship with their banking partners. Banks need reconsider the way that they price different products, and engage in a close dialogue with customers to determine how best to optimise working capital and long-term financing.”
Effectively, cross-selling becomes essential. This may sound cynical but it is not necessarily a bad thing. For example, one of the important ways in which banks are aiming to strengthen their key corporate relationships is to take a more holistic view of working capital, enabling them to deliver services across the financial supply chain, and increase value from doing so whilst reducing the use of credit facilities.[[[PAGE]]]
There are clearly advantages to this approach for corporates as well as their banks. Robert Pehrson, SEB describes,
“For customers of SEB, this approach is not new, as we made the strategic decision some years ago to expand our customer dialogue from pure cash management to a wider exploration of working capital, including solutions such as trade finance, factoring and supply chain finance. Achieving a balance between uncommitted financing and collateralised financing is valuable for both bank and corporate: banks can manage their balance sheets more effectively, while customers can reduce funding costs and increase flexibility. For example, we work with customers to minimise unused overdrafts, and build up alternative ‘rainy day’ funding solutions.”
The focus on relationship banking brings other benefits too, as Greg Kavanaugh, Bank of America Merrill Lynch suggests,
“The improved depth and quality of relationships between corporates and their banks has a number of very positive implications. Firstly, the bank has a far greater insight into a customer’s business and can therefore provide solutions and support that specifically address each company’s cash flow, risk management, financing and investment needs. Secondly, banks are motivated to become more efficient and innovative in order to reduce costs and improve services. Similarly, with customers expanding their relationship with their bank, they are in a stronger position to receive more value from their bank.”
Basel III will bring challenges and tensions between banks and their customers, particularly those that do not have the ability to offer their banks the more profitable business that they need to offset the higher cost of delivering finance solutions. It is not yet clear, however, how material the impact on pricing will be, but small and medium-sized enterprises, and some industries such as financial services are likely to see the most substantial negative effects. Timing and implementation of Basel III are also uncertain. As Greg Kavanaugh, Bank of America Merrill Lynch discusses,
“Although Basel III is a global regulation, it requires local execution – regulators country by country will implement particular rules on timelines that best fit their local needs and concerns. Given this, and the long lead time for its introduction, banks have built up a good level of knowledge and are actively engaged with regulators, even though they may be at different stages of decision-making about how they will implement the regulation, and how this will impact on their business mix, funding and pricing models.”
It is likely to take months if not yet years for these uncertainties to be resolved, but banks are already proactively moving towards adoption of the key elements of Basel III, which is becoming evident in new cash investment solutions, financing initiatives and a stronger move towards relationship banking.
Corporate treasurers need to ensure they remain abreast of the changes and refinements, as Robert Pehrson, SEB explains,
“Corporate treasurers’ awareness of Basel III is good, particularly amongst large, multinational corporates, and we continue to have a very positive dialogue about the implications of both the regulatory environment and funding situation. These treasurers are frequently engaging in a similar dialogue with their own business units in situations where treasury acts as an in-house bank. Smaller corporates and regional or local treasurers are typically less familiar with Basel III, so banks need to educate their sales teams and customers to facilitate discussion on how to manage the new market situation.”
Greg Kavanaugh, Bank of America Merrill Lynch concurs,
“Our customers tell us that they want to be kept updated with new developments and progress towards Basel III, particularly as these relate to the downstream effects. There will be changes to trade services, financing and investment, but with the implementation of Basel III still a dynamic process, a number of variables still remain. Treasurers need to stay informed by working with their banks, and influence the course of regulation by participating in industry groups.” [[[PAGE]]]
In addition to maintaining an awareness of on-going developments, it is essential that treasurers anticipate the effects of Basel III (and other regulations) as part of their business and treasury strategy. Robert Pehrson, SEB advises,
“Corporate treasurers that have not already engaged with their core banks should do so, with a view to planning how they can work together to build an optimised working capital and long-term finance model that reflects the current funding market and requirements of Basel III. No longer is it sufficient simply to ensure that an overdraft facility is available, but corporates should also be exploring other funding sources such as the area of receivables financing. In the past, these techniques may sometimes have been considered a last resort when all other funding sources had been exhausted, but they are now an integral part of a well-balanced funding portfolio.”
Just as London anticipates a new era of regeneration following the Olympics and Paralympics this summer, the banking sector is going through a similar transformation. Yes, there will be highs and lows, and some decisions will undoubtedly be adjusted, but the focus is on strengthening the banking sector and increasing the security of its customers, which is an ambition we can all share.
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