Having been debated since the financial crisis hit in 2008, last year saw the first major pieces of post-crisis regulation come online across the financial world. The breadth and depth of the regulation is staggering, but there may be a (small) silver lining to the cloud for corporates and banks.
Regulatory response to the 2008 financial crisis has been vast. Basel III, MiFID II and Dodd-Frank are just three examples of the burden that both banks and corporates are facing. This pressure has increased as new standards come into play, while the regulations themselves continue to evolve. The picture can be confusing, especially if you are a corporate waiting to see what costs may be passed down to you from your banking partners.
Timing is compounding this – standards from the first wave of regulation are being adopted in the financial industry at the same time as many economies experience slow or no growth. In the current environment of severe liquidity restraints and spiralling risks, banks and corporates must both find ways to cut their cloth accordingly.
Basel III is perhaps the regulation most associated with the response to the financial crisis, largely because its predecessor, Basel II, comprehensively failed to halt the very events it was designed to combat. The new framework, sanctioned by the Basel Committee on Banking Supervision (BCBS) in September 2010, seeks to address these previous failures by more stringently targeting the quantity, quality and transparency of a bank’s capital.
Basel III also demands that banks improve the quality of their counterparty risk. Institutions need to create cyclical capital buffers on top of existing equity, which are designed to be used in periods of crisis and reconstructed in periods of growth. For banks that are active in trade finance, Basel III requires the institution to hold five times more capital than before to finance these transactions.
“There are those who argue that there are significant macroeconomic benefits from raising bank equity…”
Chris Raftopoulos, Treasury Director, PwC shares his view on the regulatory regime’s opportunities and challenges: “There are those who argue that there are significant macroeconomic benefits from raising bank equity: higher capital requirements, lower leverage and a reduced risk of bank bankruptcies. A contrary argument is that Basel III will result in higher cost of equity financing relative to debt financing, which would lead banks to raise the price of their lending and could depress loan growth and stunt the already fragile global recovery,” he says.
To meet the new requirements, banks are having to allocate more capital and liquid assets across their business while also finding more stable sources of funding. The increase in capital and funding costs for banks is bad news for corporates that are overly reliant on bank funding, as much of the costs are being passed down to the end user. As a result, there is more pressure than ever for the treasurer to optimise working capital efficiency across the enterprise.
A multifaceted challenge
According to Jesús García-Quílez Gomez, Corporate Finance Director at Abengoa, the uncertainty over the effects of Basel III is a challenge for both banks and corporates.
“Banks are having huge problems simply surviving in this financial environment as there is little to no possibility for the majority of them to raise new money. Corporates don’t know what is going to happen by 2012 – we can’t foresee what’s going to happen, we can’t manage our balance sheet. The level of future impact will depend on this underlying issue of the sustainability of the financial institutions,” he says.
“Banks are having huge problems simply surviving…”
Increased costs and feelings of uncertainty could also lead to a fresh wave of mergers within the banking industry, warns François Masquelier, Chairman of the Luxembourg Association of Corporate Treasurers (ATEL). “This is never good in terms of credit because one plus one seldom makes two under these circumstances,” he says.
Another controversial feature of Basel III has been its restrictions on trade financing. Fearing a negative impact on international trade, trade finance market players lobbied against the proposed one-year maturity floor for issued/confirmed letters of credit (LCs) under the internal ratings-based approach (AIRB) for credit risk. The expensive sovereign floor rule applied to banks using the standardised approach for credit risk was also called into question. However, according to Dan Taylor, Global Market Infrastructure Manager for J.P. Morgan Treasury Services and Vice-Chairman of the ICC Banking Commission, the Basel Committee has since made appropriate amendments in recognition that goods constitute collateral for the bank in this sort of finance deal.
“The recent changes announced by the Basel Committee to waive the one-year maturity floor and the sovereign floor for trade finance will help promote the trade of goods, and import and export business, in emerging markets. I would hope that during the observation period for the liquidity ratio the committee will look at making further changes to reflect the low risk nature of trade finance,” he says.
Although the changes are positive news for the industry, they pale in comparison to the challenges that remain from Basel III.
Similar but different: US challenges of Dodd-Frank and Basel III
While the objectives of Basel III and the US Dodd-Frank Act reform are similar, there are differences in the capital requirements, standards and implementation schedules of the different regulations. Two of the main differences in the Dodd-Frank Act are:
The Collins Amendment.
The US federal banking agencies are required to prescribe minimum leverage capital requirements and minimum risk-based capital requirements on a consolidated basis for insured depository institutions, bank holding companies, savings and loan holding companies, and non-bank financial companies supervised by the Federal Reserve.1
The role of rating agencies.
Basel III’s framework for the risk weighting of certain types of securities relies heavily on credit rating agencies’ published ratings. Section 939A of the Dodd-Frank Act prohibits the use of credit rating agencies to implement fresh capital standards for US banking institutions.
“The corporate and the banking world are at risk of splitting into two completely different hemispheres. There could also be a US/Europe split – in which Europe would not necessarily be the winner,” says ATEL’s Masquelier.
“The corporate and the banking world are at risk of splitting into two completely different hemispheres…”
While this split suggests that Europe could be worse off, the US banks and other financial institutions have their hands full with the many areas of Dodd-Frank that are due to go live throughout 2012. If your organisation is US-based or trades there, you need to understand the implications of what is coming over the next year and have your response prepared.
With Dodd-Frank, and Basel III also, there is a strong focus on enterprise risk management. Those organisations that are capable of managing their enterprise risk efficiently while taking on board the new compliance measures will be at a competitive advantage.
Financial markets regulation
As with Basel III, many other ‘new’ regulatory initiatives are sequels to existing regulation that has been deemed by the regulators to have failed or to have not gone far enough. In Europe, the Markets in Financial Instruments Directive (MiFID) has existed since 2004 and was fundamental to the EU’s plan to create a single market in financial services. In October 2011, the European Commission proposed a new directive to advance this work: MiFID II.
Building on the initial directive, MiFID II is designed to promote further competition and harmonisation in the European securities market, modernise market structures, increase market transparency (extending to pre- and post-trade transactions) and enhance investor protection. These new transparency rules also affect over-the-counter (OTC) trading, as the pre- and post-trade transparency rules cut across asset classes.
The directive is complemented by other regulatory changes such as European Markets Infrastructure Regulation (EMIR) that covers all areas of the OTC derivatives market, including equity, credit, interest rates, and most foreign exchange and commodities contracts.
The combination of MiFID and EMIR created a single piece of legislation for optimum harmonisation, the Markets in Financial Instruments Regulation (MiFIR). While its status as a regulation meant that MiFIR had to be adopted, there were challenges as it initially contained elements that were unwelcome in the marketplace.
In January 2010, when regulations such as EMIR and Dodd-Frank were proposing the movement of OTC derivatives trades onto regulated exchanges, the European Association of Corporate Treasurers (EACT) warned of the negative impact these proposals could have on economic and financial stability, and subsequently, employment and growth. Successful in their objection, EACT Chairman, Richard Raeburn, believes that the proposals, without modification, would have drained liquidity out of the corporate sector and reduced the level of hedging.
“The proposals were designed to reduce systemic risk but in this design the legislators have decided to overlook the fact that the real economy has not been a source of systemic risk to the financial system. Why introduce the new framework if the problem in the real economy in the first place never existed?” he says.
However, Raeburn remains positive that further amendments will be made to the directive to accommodate the ‘real economy’, surmising that legislators don’t want MiFID II to undervalue the EMIR exemption of last year. Addressing the issue of global variances, the EACT Chairman also sounds optimistic. “What is evident is that the EU Commission and Parliament, together with the US bodies, are committed to minimising the differences. Neither side wants there to be regulatory arbitrage,” he says.
Now a piece of regulation and not a directive (a difference that allowed the original MiFID to be relatively ignored by most member states), MiFIR will be implemented centrally from Brussels rather than being individually adopted by national regulators. MiFIR has been described as an example of how European regulations could be made to align with Dodd-Frank in the US to prevent the split that was referred to by ATEL’s Masquelier earlier. This is a position that could be strengthened as MiFID II seeks to build on the harmonisation already achieved.
Generally accepted? Accounting standards converge
Regulatory divergence between the US and Europe has been a common theme in the arena of accounting standards. Depending on where your organisation is operating or headquartered, you may be accounting according to the International Accounting Standards Board (IASB) or in line with the US Generally Accepted Accounting Principles (GAAP). However, recently there have been encouraging signs of convergence on both sides.
An example of the convergence and quest for harmonisation can be seen in the standards for financial instruments. The IASB introduced its new principle-based standard IFRS 9 to replace the rule-based IAS 39 in 2009. While not yet finalised, IFRS 9 has been generally welcomed by corporates. Based on a mixed measurement model of amortised cost and fair value, the new model is being implemented in three phases:
Classification and measurement.
Hedge accounting phase.
The final phase, while much deliberated, is likely to be released in Q1 2012. Meanwhile, in the US, the Financial Accounting Standards Board (FASB) and its initiative, the US GAAP, issued its exposure draft on accounting for financial instruments in May 2010. The FASB took an all-inclusive approach, including proposals on hedge accounting, in contrast to the phased approach of IFRS 9.
The two accounting standard setting boards are being encouraged by many international governing bodies, namely the G20 and the SEC, to simplify and improve the accounting for financial instruments and to promote fair competition. Originally intended as a joint venture, each board has been addressing the issues in its own way.
The main difference between the US model and IFRS 9 is the categories available for classifying financial instruments. The US model has retained the ‘available for sale’ category (currently suppressed by the IASB but under discussion) but has very much restricted the type of assets eligible for the ‘amortised cost’ category.
While IFRS 9 is a step closer to convergence with US GAAP rules than its predecessor IAS39, there is still more to be done on both sides before true convergence occurs. Both boards have decided to work on converging disclosure requirements to assist users in comparing financial statements and reconciling differences prepared in accordance with IFRSs and US GAAP, with a common standard and a draft proposal published for public comment in November 2011 until Q1 2012.
“Although we have the classification and measurement rules of IFRS 9, we await an updated exposure draft on the hedging and impairment methodologies. The IASB is also taking the opportunity to consider the FASB’s classification and measurement model. This may see changes to those classification and measurement rules already received and allow for the differences between the IFRS and US GAAP frameworks to be reconciled,” says PwC’s Raftopoulos.
The global financial and capital markets are interdependent, which makes the concept of global accounting standards very attractive. IFRS is best positioned to become the global accounting standard, but faces the challenge that the US is hesitant to adopt it wholeheartedly at present. A complete convergence of standards does not appear imminent, according to Raftopoulos.
“The global financial and capital markets are interdependent, which makes the concept of global accounting standards very attractive.”
“The complete IFRS standard is expected to have an effective date of 1stJanuary 2015. Unfortunately, it is unlikely that some of the more attractive aspects of this standard, such as simplified hedge accounting rules, will be available to EU corporates until the standard is complete and endorsed by the European Union,” he says.
While ATEL’s Masquelier agrees with the postponement of the application date, he has reservations about what may happen in the time between now and then, from a competition perspective. “We do fear a competitive disadvantage compared to other companies in Europe which could opt for early adoption. We in the EU need to first get EU endorsement,” he says.
Until there is full global convergence, traditional problems will continue to effect corporates globally, as well as investors, who will find it difficult to compare companies between Europe and the US.
Regulations see short-term investments focus on security
When they broke the buck in 2007, money market funds (MMFs) were an early warning indicator of the oncoming financial crisis. Always thought of by corporates as a safe and liquid way to invest and make a return on surplus cash, the drying up of the market prompted a rethink by many. Since then, only AAA rated MMFs have proved attractive.
To attempt to fortify the money markets and to protect investors, regulators have brought in rule changes that focus on the security of the investment. One example comes from the Securities and Exchange Commission (SEC) in the US, who have brought in initiatives such as the following:
The maximum weighted average maturity (WAM) of the securities within MMFs has been reduced from 90 to 60 days.
Ten percent of the securities within a fund must mature every day. This rises to 30% within a seven-day period.
Whereas funds used to be able to have up to 5% of their value in tier-2 securities, this limit has now been reduced to 3%. In specific terms, funds can only own 0.5% in a specific tier-2 issuer, half of the previous level.
These are just a few examples of the tightening of the rules that regulate money market funds. The overall effect in the MMF landscape is that, while many rule changes are designed to improve liquidity or offer higher credit quality, the return that investors can expect will be much lower in comparison to the ‘good old days’ of pre-2007. However, the security that AAA rated MMFs offer today does make them an attractive prospect to many corporates with surplus cash, and you are still more likely to generate a slightly greater yield from an MMF than from a bank deposit.
The regulatory environment is a hive of activity at present, with every financial avenue analysed and codified, and modifications and challenges of each initiative becoming the norm. No area is untouched, with topics such as liquidity, accounting, investment, insurance, and the financial markets receiving particular attention.
Some regulatory initiatives can be a double-edged sword. In the investment field, while the Alternative Investment Fund Managers (AIFM) and Undertakings for Collective Investment in Transferable Securities (UCITS) IV Directives present an opportunity to sell funds and centralise across member states, they also force extra costs and liquidity requirements on some players in the EU market.
New challenges are also born. Financial institutions are debating whether the prestige of being recognised as a globally systemically important financial institution (G-Sifi) is enough to shoulder the inevitable regulatory considerations that accompany the ‘honour’; while the regulators have become the regulated as the European Securities and Markets Authority (ESMA) has published the first set of draft Regulatory Technical Standards (RTS) for Credit Rating Agencies (CRAs).
Banks and corporates face a great deal of challenges in keeping up with the sheer volume of regulatory requirements and updates in today’s environment. It is important to consult as many sources of information as possible with regard to the regulatory burden.
Corporates should be consulting their banks on what changes may be coming in the pipeline and what potential costs may be coming their way. And if at all possible, every stakeholder in the financial services world should have a dialogue with the regulators that affect their business, in order to ensure that business practicalities are never far from the regulators’ thoughts. This can be achieved in many ways, whether through speaking to your banking partners, or participating in an industry association, for example. Regulation can only be truly successful if it takes into account the wellbeing of all industry participants.