The new requirements of Basel III are already forcing banks to reassess every aspect of their relationship with corporates. In core funding, trade finance and transaction services products will change and pricing will rise. It is possible that some relationships will not survive the turmoil.
Adapt or perish
Even before the Basel III regulations on stronger capital and liquidity requirements were approved by the G20 in November, banks were already beginning to provide new products that were more in line with the new regulations, for example incentivising longer-term corporate cash deposits. They were also looking to control the amount of risk-weighted assets on their books.
What this means to a corporate treasurer is that there will be fewer opportunities to earn interest on capital that has to be easily accessed. Treasurers will also need to ensure access to capital so that they are less dependent on any one financial institution, and strengthen cash management practices to make the most efficient use of the capital that is available.
At Barclays Corporate, several new products have been launched that give corporate treasurers an incentive to keep cash deposits with the bank for a longer period. “Clearly, it’s in our interest to adapt to the new regulations with this kind of product,” says Richard Martin, Head of Payments and Cash Management at Barclays Corporate in London. “One such product offers a special rate for deposits that are kept with us by companies for more than 100 days. We are working on several similar offers.”
At Deutsche Bank, a full-scale review of the entire product line is underway, and the bank is formulating new strategies with corporate clients for working with risk-weighted assets.
“At Citigroup, we are also in the process of reviewing our strategies and products in response to Basel III,” says Ruth Wandhöfer, EMEA Head Market Policy and Strategy at Citi Global Transaction Services in London. “Given the proposed rules on run-off rates and liquidity buffers, market participants are looking for ways to ensure more stable and long-term deposits, as well as to develop solutions to improve liquidity visibility and adapt cash and collateral management services where necessary.”
What is absolutely clear to bankers throughout the world is that post-Basel III banking will mean a different approach to pricing. While there is always talk in the industry about creating a ‘partnership’ with clients, about relationships rather than product sales, the plain fact is that almost all of the products that bankers offer to their corporate clients will be significantly more expensive with Basel III. What bankers are doing now is trying to find ways to adapt to it as quickly as possible.
A shot in the dark
Although Basel III was officially approved at the G20 conference in Seoul in November 2010, it isn’t clear yet exactly what its full-scale impact is going to be. “It’s a regulatory shot in the dark,” warns Karl-Heinz Boos, Managing Director of the Association of German Public Sector Banks.
Boos is particularly concerned as no studies on the impact are envisaged, so it will not be clear to what extent banks will be hindered in supplying loans to the economy. Many analysts think that small and medium-sized companies will be hit hard, unable to tap the capital markets yet shut out from much bank funding.
“The net effect of the Basel rules is that obtaining credit will become more expensive for all corporates and that this will not be equal over all companies,” comments Peter van Rood, Corporate Director of Treasury, AkzoNobel. “Those with lesser credit profiles will suffer more.”
“Initial observations suggest that Basel III will have implications on the cost of trade and the relative value of deposits to a deposit-taker based upon type of client and whether these relate to their operational business or strategic investments,” adds Yera Hagopian, Liquidity Solutions Product Executive, Treasury Services, J.P. Morgan .
Certainly the reforms are to be implemented on a very slow timetable. The new rules, to be phased in between 2015 and 2018, demand that banks hold 4.5% of common equity and retained earnings. The current minimum for core Tier 1 capital is 2%. The new regulations also call for a ‘buffer’ of 2.5% to be built up in good times, taking the total capital required to 7%. Banks can dip into the buffer in times of hardship, but if so, they must restrict dividend payments.
The reforms are expected to cut deeply into most banks’ capital ratios. First, the definition of what counts as capital has been substantially restricted, so reserves of capital will be reduced. Then, the number of risk-weighted assets will grow because higher charges will be applied to bank trading books and other risk-laden activities.
In practice, analysts say that there are, and will increasingly be, inconsistencies among banks in the ways that they identify risk and reserve capital. Determining banks’ respective positions is not yet possible.
It is however clear that banks have every interest in conserving as much non-risk-weighted capital as possible under the new rules. The Basel Committee is also taking a closer look at the composition of banks’ capital. To reduce the risk that banks might run short of cash in the event of widespread panic and a run on deposits, the Committee has developed ways to measure the stability of capital. This is an attempt to judge how long different types of deposits are likely to remain with the banks. Retail deposits are typically considered fairly stable, since few consumers move their money in and out of banks to gain a few basis points of interest – it’s just not worth it, given the work involved. Corporate treasurers, on the other hand, manage such deposits very actively.
Price increases for borrowers
The Basel Committee itself noted in a report published in August 2010, ‘An assessment of the long-term economic impact of stronger capital and liquidity requirements,’ that the stronger capital reserve requirements and more critical view of capital stability would lead to an increase in lending spreads. The Committee predicted in the report that such costs would be “passed directly on to the borrower.” The reasoning is as follows:
Banks lengthen the maturity of wholesale funding. Banks are assumed initially to fund 25% of their wholesale debt at less than one year, and reduce this quantity towards zero as they work to meet the requirements. The result is an increase in interest expense based on the difference between the costs of short- and long-term debt. Throughout, the volume of interbank funding and that of trading liabilities are assumed to remain unchanged.
Banks increase their holdings of highly-rated, qualifying bonds. This shift away from lower-rated, higher-yielding assets is assumed to reduce the return on these interest-earning assets by 100 basis points.
Finally, and only if needed, banks reduce “Other Assets”. Interest income declines, assuming these other assets earn a higher return compared to the original investment portfolio.
Each of these changes either reduces interest income or raises interest expense, thereby lowering net income. Banks avoid a fall in their ROE by raising lending spreads. This increase in lending spreads is over and above that due to higher capital requirements. (Cited from the report).
It should be painfully clear that banks will try to pass the costs of Basel III to the client. “If banks are going to have to raise more capital, they are going to need a return to pay for that capital, so they will have to look at their pricing. It’s unclear where that will hit and it’s unclear how big it will be,” says Patrick Fell, Director of PricewaterhouseCooper’s regulatory capital practice in London.
“The market dynamics have long been in a state of flux,” comments Yera Hagopian, J.P. Morgan. “Be it SEPA, TARGET2, Basel II and now Basel III, there has long been pressure on banks to be more efficient, more cost-effective, to offer sound advice and to assist their corporate clients to manage their cash and investments globally.”
Nevertheless, the announcement of Basel III has prompted a number of banks to take the bull by the horns, and begin a complete reworking of all product involving risk-weighted assets. At Deutsche Bank, for example, a complete review for all corporate clients in every area is underway, explains Deutsche Bank Head of Trade Finance EMEA Daniel Schmand.
“A senior board was appointed last year with direct responsibility for reviewing our lines in the light of Basel III,” Schmand says. “The board works with product managers throughout the bank to reconsider not just individual products, but our entire strategy. A full-scale reassessment of what we offer our corporate customers is being made, and we will bring that to the clients and discuss the best ways of creating a holistic relationship.”
Clearly, the new products Deutsche Bank will offer will involve a different treatment for cash deposits, and a separate consideration for risk-weighted assets, Schmand adds.
Deutsche Bank has been exceptionally proactive on Basel III issues. In October, it launched a $10 billion rights issue to raise additional capital to fulfill the requirements. The German bank says that it will be Basel III-compliant by 2013, well ahead of the 2018 deadline.
Sébastien Boschiero, Managing Consultant, Financial Services, at Logica, said: “European regulators led the implementation of Basel II and are likely to be particularly stringent when it comes to the new Basel rules. Several domestic regulators in Europe have already anticipated these new rules and imposed stricter requirements on liquidity. A number of European banks are already adapting their work with corporate clients like us to these new conditions.
“But it does mean that European banks are already at a competitive disadvantage and will probably continue to be until every country follows the same rules.”
New product in trade finance
Bankers warn that another consequence of the Basel III regulation in its present form would be to put pressure on trade finance. Several studies, including a study by the International Chamber of Commerce which was published in October, have shown that traditional trade finance would become 15% to 37% more expensive under the new regulations, and that trade finance volume would be cut by 6%. This would also mean a $270 billion-a-year reduction in global trade and a 0.5% fall in global gross domestic product.
Ruth Wandhöfer, EMEA Head Market Policy and Strategy at Citi Global Transaction Services points out that Basel III does not sufficiently distinguish between trade finance and other forms of corporate lending. “Perhaps the biggest concern is the impact of the proposed regime for off-balance-sheet transactions, which would require banks to apply a 100% credit conversion factor for any off-balance-sheet instrument, including, for example, letters of credit. This is five times more than the 20% credit conversion factor currently used by the market for this type of trade finance instrument.”
She adds “I don’t believe the regulators behind Basel III were really intending to create unnecessary challenges for trade finance specifically. However, this unintended consequence could potentially be a very damaging one for global trade. Emerging market countries that are most dependent on trade could potentially be the worst affected.”
Smaller banks are also likely to suffer. “The major banks will still do trade finance, either taking the extra costs or passing it on to corporates. It’s only 2% to 10% of their total revenues.” But the smaller the bank, the larger the share of revenues comes from trade finance. It could be 30% to 40% of revenues. So smaller, local banks will be particularly hurt by Basel III, and that means that smaller local corporates in emerging markets will also take the brunt of the new regulations.
The International Chamber of Commerce has published a study looking at the default risk of trade finance instruments. The study examined the trade finance activity of nine global banks from 2005 to 2009, which together arranged 5.2m transactions accounting for $2.5 trillion. It found that only 1,140 of those transactions defaulted. Of the 2.8m transactions arranged during the crisis in 2008 and 2009, only 445 defaulted.
Trade finance bankers believes that, under the new liquidity ratio, national regulators will determine the percentage of the potential drawings from letters of credit that will be included in the calculation of net cash outflows. National regulators will also rule on export credit. Banks in Europe, for example, are already working with local regulators to define terms that will not strangle the industry.
A decade or more ago, in foreign exchange, the sector’s leading banks reviewed their relationship with their corporate customer bases. They looked at profitability per client and culled those counterparties with whom they felt doing business made no sense. The word ‘corporate’ was dropped from some banks’ FX marketing materials. Is Basel III the catalyst for a similar shake-out in transaction services?