Published: September 01, 2011
The European Union (EU) has a plan for adopting stricter capital requirements and better corporate governance for banks and investment firms (the so-called ‘CDR IV’ project). Despite the fact it only concerns financial institutions, this projected Directive could indirectly heavily impact non-financial corporations. The new rules will have to be translated into national law by the end of 2012. In this new proposal1, it appears that there will be no exemptions for exposures to corporates from Credit Valuation Adjustment (CVA) charges (regulation, part3, title VI, p.56). Should we as European corporate treasurers be worried by this part of the proposal? We certainly should. At the treasury association level, we are really concerned about the potential impact on bilateral derivatives trades, which may become very expensive due to new capital requirements imposed on banks to hold the capital to cover the CVA risk. Banks will be forced to charge more to corporates and therefore hedging may become unaffordable. As for the EMIR discussions on OTC (over-the-counter) derivatives reform, we believe that there is a very strong case for exempting trades with corporates from the CVA charge in the CRD IV.
In the draft of EMIR (European Market Infrastructure Regulation), it was recognised that, in general, transactions with corporates should be exempted from central clearing counterparty (CCP) for hedging commercial risk and under a certain threshold should receive a proportionate capital treatment. In the draft proposal, it is clear that transactions with a CCP and including collaterals will be excluded from the ‘own funds’ requirements for CVA risk (cf. article 270 CVA2 scope p. 380). It is clearly stipulated that all financial institutions must calculate the own funds requirements for CVA risk in accordance with all OTC derivative instruments. The idea is to reflect the counterparty risk run by the bank while dealing with third parties.
When calculating the own funds requirements or CVA risk for a counterparty corporate risk, a bank has to base all inputs into its approved internal model for specific risk associated with traded debt position on specific complex formulae (depending on which model adopted by the financial institution the calculations are based on). Therefore, we can clearly identify an interaction between EMIR and CRD IV on this particular issue. EU regulation on OTC derivatives contains exemptions (which we were claiming and lobbying for) from mandatory clearing for non-financial counterparties using OTC derivatives to cover pure commercial risks and where derivatives exposure does not exceed the clearing threshold (to be further determined in the regulation). [[[PAGE]]]
However, if the capital that banks are now required to hold for non-cleared OTC derivatives transactions (i.e., without collateral) is too large due to the CVA capital charges that the CRD IV Directive would impose, banks will be forced in future to charge more to corporate treasurers. Therefore, hedging transactional risks may become unaffordable for all of us. Such a regulation could effectively block access to risk management products for end-users and limit our ability to hedge the operating business risks we are facing. Even more, it would actually increase volatility and risks on the whole financial market. The obvious risk would be to stop hedging some exposures (especially on longer terms) to reduce financial costs. Eventually it would prove to be exactly the opposite of what the EU was looking for.
The EACT and all treasury associations have lobbied EMIR on OTC derivatives for the same reasons and for avoiding posting collateral which would have been extremely expensive for corporates, specifically when they are structurally ‘short’ (i.e., net borrowers). The EU’s proposal for the regulation of OTC derivatives, central counterparties and trade repositories sets out a number of new rules for OTC derivatives clearing. Some OTC derivative transactions will have to be cleared, while others will be exempted from mandatory clearing. We don’t think posting margin on cleared trades will reduce systemic risk. Furthermore, it would be difficult for some end-users to post margins, because of the indebtedness situation. No one could deny that it would be both operationally complex and costly. If the corporations were required to give collateral, it would inevitably result in treasurers not hedging some exposures, which were previously passed on to bank dealing-rooms. In the USA, rules implementing Dodd-Frank should contain a similar exemption (even if its form may differ slightly from ours).
Commissioner Michel Barnier has to implement Basel III capital rules (under the project called CRD IV). A key principle of Basel regulation is that a financial institution must maintain at all times financial resources as a cushion against potential losses. These potential losses of course include, for example, a non-financial institution counterparty which would not pay back its part of the FX or interest rate deal (e.g., the bank pays the USD bought but is not receiving the EUR sold by the corporate). That is what we commonly call the counterparty risk or delivery risk (i.e., risk of default of the corporate before maturity of the FX deal) or risk of the creditworthiness of the corporation which deteriorates significantly without necessary defaulting (the so-called CVA risk). The former Basel standard already requires banks to hold capital reserves to cover this counterparty default risk. The third revised version of the Basel Accord will add new requirements to hold equity to cover CVA risks. It results in financial institutions being subject to capital charges for potential negative change in mark-to-market valuations and deterioration of counterparty creditworthiness. Banks will be requested to make provision for potential credit risk.
In summary, we all understand that all efforts made for adapting EMIR regulation on OTC derivatives could be killed by the new CRD IV. There is no need for exemptions if at the end of the day, banks are highly motivated to impose clearing. If no clearing is obtained, banks will hugely increase the costs of hedging to compensate capital requirements. The EU may undermine the effectiveness of this exemption we have obtained by ‘fighting’ hard. If dealing hedging instruments becomes prohibitive, corporates will change their hedging approaches and strategies and even start hedging less while monitoring more ‘open’ exposures. It could be a real revolution of risk management strategy.
Again, the objective of the EU has never been to increase the volatility of corporations’ P&L. We believe it could have a negative impact on our activities as a whole. The risk is to be under- or un-hedged or to stop doing business in regions with products implying financial risks (too) expensive to be protected and to be mitigated. Who will be the most penalised? As always, the SMEs which haven’t the capacity to manage this situation. SMEs have lower internal implied (bank) credit ratings that penalise them in terms of counterparty risk. Nonetheless, we understood that the report by Werner Langen on the derivatives markets expressed the intention to provide exemptions and lower capital requirements for SMEs’ bilateral derivatives2. We have the impression that they gave with one hand and took back with the other. Treasurers hope that all these discussions were useful and that the final version of this new Directive will not penalise them. However, we must be realistic and admit that the chances of Basel III and CDR IV being amended are limited. The whole risk management approach will evolve in future to be adapted to this new reality.
Notes
1 http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm
2 see: www.eifr.eu/news0000261.htm
How Thought Leadership Can Reduce the Cost of Sales by Patrik Havander, Havander & Partners A focused attention on the costs incurred by the global sales and marketing processes is becoming increasingly important for corporate banks and their transaction banking departments. While the client/bank relationship remains vital, research has shown that in fact relationship selling […]
