An Executive Interview with Andrew Linton, Head of Product Development and Jason Straker, Head of Client Portfolio Management, EMEA, J.P. Morgan Global Liquidity Group
Why do corporate treasurers need to know about Basel III, given that it is a banking regulation?
Basel III redefines global standards for bank capital, liquidity and leverage, and will profoundly impact how banks manage their balance sheets. Given that a bank’s balance sheet is made up of loans to customers (its assets) and deposits (its liabilities), changes to a bank’s balance sheet have an impact on its customers, particularly in this case on institutional customers.
What are the key elements of Basel III that corporate treasurers need to be aware?
A key element of Basel III is the liquidity coverage ratio (LCR). This has been designed to ensure that a bank can meet its liquidity needs in a severe stress scenario. Specifically, banks need to hold a sufficient stock of unencumbered assets that can be converted into cash within a day, without a decrease in value to meet all of the bank’s liquidity needs over a 30-day stress scenario.
To achieve this objective, banks must hold more high quality liquid assets (HQLA) than the difference between their calculated net cash outflows and inflows under 30-day stress period. HQLA are categorised in different ways: for example, cash, central bank reserves, central bank assets and sovereign debt are ‘level one’ and must comprise at least 60% of total HQLA.
The net cash outflow figure, which is key to the LCR calculation, reflects assumptions about the proportion of deposits (liabilities) that would leave the bank at a time of systemic stress. This is referred to as the run-off factor. The more stable the source of funding is perceived to be, the lower the run-off factor applied to it. Operating cash is considered the most secure, and therefore has the lowest run-off rate. For example, FDIC-insured retail deposits (and deposits guaranteed under similar schemes in other jurisdictions) are considered to be the most stable. Therefore, the run-off factor is only 3%. Non-operating cash, however, is subject to higher run-off rates. At the furthest extreme, uninsured, wholesale funding from financial institutions is considered the least stable, and is subject to a run-off rate of 100% i.e., the assumption is that 100% of this cash would leave the bank in 30 days.
From a corporate treasurer’s standpoint, a 25% run-off factor is applied to operating accounts not fully guaranteed by the FDIC or similar scheme, and 40% to unsecured wholesale funding from non-financial services corporations that ae similarly not fully covered.
While the LCR addresses short-term liquidity issues, another element of Basel III, the Net Stable Funding Ratio (NSFR), targets longer-term liquidity issues, focusing on reducing banks’ funding risk over a one-year horizon. Specifically, the ratio of stable funding (customer deposits, long-term wholesale funding and equity) to weighted long-term assets must be greater than 100%. Weighted long- term assets include 100% of loans that extend beyond one year, 85% of retail loans of less than one year, 50% of corporate loans within one year to maturity and 20% of government and corporate bonds. The aim is to reduce banks’ dependency on short-term wholesale funding, encourage better assessment of funding risk, promote funding stability and address mismatches between the liquidity profile of a bank’s assets and liabilities.
Basel III also increases the quantity and quality of the regulatory capital that banks need to hold from Basel II, in order to help banks withstand unexpected losses. It also identifies 29 globally systemically important financial institutions that are required to set aside higher levels of capital, from 1% to 3.5%.[[[PAGE]]]
What does this mean in practice for corporate treasurers?
Although Basel III as a whole is fundamentally changing banks’ practices, including changes to risk management and supervision, and market discipline, in addition to the liquidity and capital requirements discussed earlier, the LCR has the most significant day-to-day impact on corporate treasurers. Deposits of non-operating cash will be far less attractive to banks than in the past, as they will have to match them – in some cases up to 100% - with HQLA. Banks will no longer be in a position to accept non-operating cash on to their balance sheets, or will offer dissuasive pricing. Conversely, operating cash will be more attractive. Consequently, treasurers will need to segment their cash into operating and non-operating cash, and make investment decisions accordingly:
Operating cash will be best invested with a corporation’s cash management banks, and these banks are likely to offer incentives to do so. Investors will, however, have to invest non-operating cash in alternative (and potentially more rewarding) investment vehicles, including non-balance sheet products such as money market funds (MMFs) and separately managed accounts (SMAs), or in money market instruments.
How is operating cash distinguished from non-operating cash?
Operating balances are those that have a relationship with an operating account, such as a sweep or custody account, a payment process or another service for which a bank can charge fees. Therefore, the deposit is a by-product of the related transactions. All other cash balances are considered non-operating cash.
When are these changes likely to take effect?
Although Basel III will not be fully implemented until 2019, the timeline differs by bank and jurisdiction. Since 1 January 2015, banks have been required to disclose their LCR and many banks, particularly US banks and banks operating globally, will be seeking to comply with Basel III during the course of 2015.
What should corporates be doing now in preparation for these changes?
There are three key areas on which treasurers should now be focused:
- Firstly, they need to discuss the implications of Basel III with their banks as a matter of urgency to understand the specific impact on their business.
- Secondly, they need to review their investment policies to ensure that there is sufficient scope for investing non-core cash. In some cases, treasurers will need to engage with the board, treasury or investment committees to explain why treasury may need to invest in a wider range of instruments, including off-balance sheet investments. This should not be considered a negative process: rather, regular policy reviews are essential to reflect changes in the market and credit environment, as well as evolution in companies’ risk appetite and financial needs.
- Thirdly, and perhaps most importantly of all, treasurers need to review and refine the way that cash flow forecasting is performed to allow appropriate segmentation of cash. This will allow companies to invest some of their cash for a longer period, therefore increasing yield and gaining access to a wider range of investment instruments.
What options do treasurers have for investing non-operational cash?
There is no shortage of investment solutions that are suitable for corporate investors, from MMFs that are already familiar to many treasurers, through to SMAs and money market instruments. The most important pre-requisites, however, are to ensure that the investment policy (together with systems, processes and reporting) is broad enough to support these investment choices, and to segment cash appropriately. At the shortest end of the spectrum, cash required for working capital needs to be liquid and stable, so government MMFs may be appropriate, as treasurers would not wish to invest this cash in funds with a variable net asset value (NAV). Beyond this, corporate investors need to consider for how long they can invest each portion of cash, and what degree of liquidity is required. For example, cash that can be invested over a 6- to 12- month time horizon, for which same day liquidity is not required, could be invested in SMAs or short bond funds. There could be considerable advantages to this approach, with the potential to pick up additional yield, whilst protecting the principal value.
In addition to investment funds of various types, there is also the potential to invest in money market instruments. There have been a number of discussions about repos (specifically reverse repurchase agreements from the perspective of a corporate investor) and indeed, these present an attractive proposition; however, there is a problem of lack of availability. There have also been issues with the legal framework for repos in the past, but there have been some efforts to simplify and clarify this; however, these are secondary to the availability issue.
Certificates of deposit (CDs) and commercial paper (CP) have always been a feasible investment option for larger corporate investors that are able to take a view on risk. Opportunities in these areas have not changed significantly; however, as most CP is bank debt, corporate treasuries need a specialist analyst for the banking sector to monitor risk, which is only achievable in larger treasury functions.
Increasingly, corporate investors, particularly larger investors, are considering SMAs that are specifically designed to meet their investment requirements, with the ability to stipulate interest rate risk (such as the maturity and duration of assets), credit quality of individual assets and average portfolio, and liquidity. So long as investors have some ability to invest across the credit spectrum, there is also the opportunity to increase yield.[[[PAGE]]]
How do you see the corporate investment landscape in one or two years’ time?
Many banks are now in the final stages of Basel III implementation, so investors should assume that their banks, particularly global banks, will be Basel III compliant by the end of 2015 or early 2016, so the various implications that apply to corporate investors will already be apparent by this time. Corporate treasuries are already becoming more open to new investment choices, both pooled investments such as MMFs, short bond funds and SMAs, and tradable money market instruments, and this trend will inevitably need to continue.
Treasurers will also have a far more refined view of cash segmentation, with a more specific approach to investing short-term (working capital), medium-term (core) and long-term (strategic) cash with defined investment approaches for each segment. One of the questions will be the extent to which corporate investors will be able to explore opportunities along the credit spectrum, given that regulatory tightening and improved governance mean that banks and financial institutions are probably more secure than at any time in the past. Furthermore, credit rating agencies have become more conservative in the way that they award ratings, so lower (investment grade) ratings may offer greater opportunities to increase yield without compromising on investment quality.
