Regulation & Standards

Key trends in bank regulation

Published: May 2014

In the aftermath of the recent financial crisis, G20 leaders met in Washington DC to agree a blueprint for reform of global financial markets. The regulatory burden on banks has grown exponentially in the time that has passed since then and it is affecting not just the banks themselves but, increasingly, their corporate clients too.

The list of what a corporate treasurer needs to know about bank regulation is a long one, but there are a handful of distinct themes that dominate. This article, although far from exhaustive, will shed some light on these themes by sketching a broad outline of the emerging regulatory landscape and the key implications for corporate treasury functions.

Bank finance

A change in both the cost and availability of bank finance is undoubtedly the most significant development where treasurers are concerned. Ever since the Basel Committee on Banking Supervision announced tougher capital and liquidity rules, banks have been warning that customers will face more costly credit – or perhaps find it difficult to access altogether – as a result. “Basel III makes us more thoughtful of who the end holders of assets should be, in whatever form,” explains Nick Burge, Managing Director and Head of OTC Clearing at Lloyds Bank. In the post-Basel III world, holdings of longer-dated capital-heavy assets will continue to shift away from the banks to institutions such as insurance companies and pension funds who want longer-term exposures. Banks, meanwhile, “continue to act as arrangers between borrowers and end investors and to provide more of the shorter-term, revolving facilities that banks are best placed to manage,” Burge adds.

There are signs that the banking community was not exaggerating when it claimed that the Basel capital requirements – a risk-weighted capital ratio of 4.5% plus an additional buffer of 2.5% – would have a sizeable impact on longer-term business lending activities. In Europe, despite a prolonged period of ultra-low interest rates, bank lending has remained weak while corporate bond issuance – thanks also in part to unconventional monetary policies – has soared to record levels. As companies continue to flock to the capital markets we are already witnessing a shift in the composition of the corporate debt stack. In Europe, bonds accounted for 18% of the funding mix in the three years before the crisis. In the three years since 2011, they have averaged 31%.

The retreat of bank finance means that those in the SME sector, lacking the capital markets recourse of their corporate peers, are finding credit increasingly difficult to access. “Europe has certainly gone through a period of very weak economic activity and weaker, higher costing bank lending,” says Clive Briault, Senior Advisor, EMA Financial Services at KPMG. “At a time when macro prudential analysis is telling us that we probably need to release some capital, banks are being encouraged to hold more.” Causation is difficult to disentangle, Briault adds, but one could argue that “all that it is doing is having a very pro-cyclical effect, by reinforcing the downward part of the cycle.”

Chart 1: Emergence of Basel IV
Chart 1: Emergence of Basel IV

Source: KPMG Evolving Banking Regulation 2014

Perhaps one small blessing for corporates is the relief Europe granted last year to trade finance from the required one-year maturity rule for risk-weighted assets and a move back to the 20% credit conversion factor for secured letters of credit (LC). Had the regulation remained as originally drafted, all exposures – including low-risk, short-term and self-liquidating trade instruments such as LCs – would have been treated as equally risky. That would have almost certainly pushed up the cost of trade finance, with some estimates suggesting an increase of as much as 75 basis points.

Growing importance of SCF

While traditional forms of credit are likely to retrench in the wake of Basel III, certain forms of credit such as the provision of receivables-based and supply chain finance (SCF) are likely to receive a significant boost. The reasons are twofold. Firstly, the constraints that bank regulation continues to exert upon bank lending to SMEs, will almost certainly encourage more of these businesses to consider alternative methods of funding the business. Meanwhile, corporate buyers are increasingly cognisant of the pressure the credit shortage is putting on their supply chains, and are looking for ways to bolster the balance sheets of their suppliers, while improving their own working capital. SCF, which has been growing at a rate of 25-30% since the crisis, would seem like the ideal solution for both parties.

The second point is that SCF will become a more attractive activity for banks following the full implementation of the Basel Committee’s recommendations. This is because relative to other types of facility, SCF is deemed to be fairly low risk and will therefore remain low cost, Anil Walia, Head of Supply Chain Finance at RBS, explains. “While LCs are likely to become more expensive, receivables purchasing through SCF programmes will become cheaper for the banks,” says Walia. “Since they will be able to provide that at a reduced cost that is where the funds will start flowing in the years.”

Changing relationships

Other banking regulations implemented in the past year are impacting companies in a more direct way. Trade reporting regulations – such as the European Market Infrastructure Regulation (EMIR) – are one example. Under EMIR, corporates that use OTC derivatives products will be required to report trades to one of the newly appointed trade repositories.

For corporates who have never been directly subject to financial regulation before, achieving compliance ahead of the deadline has required them to climb a very steep learning curve. In order to do that, a large number have had to draw upon the expertise of their banking partners. “Treasurers are now finding themselves subject to a whole set of regulations that are often quite complex and lengthy,” says Lloyds’ Burge. “They are very conscious of how big the range of different requirements they need to understand is, and that has required a lot of education.”

On that point, there is a large degree of consensus. “Everyone is suffering from the range and complexity of these requirements,” says Ruth Wandhöfer, Global Head of Regulatory and Market Strategy at Citi Transaction Services. On the positive side, the regulatory burden is at least fostering closer relationships between corporates and their banking partners – something which is increasingly vital for businesses attempting to navigate the changing regulatory landscape. “Sometimes it becomes a community of shared suffering, which is of course good for client relationships in the sense that you always have something to talk about,” she jokes. Citi, she adds, is therefore working hard to make sense of the ever-expanding plethora of regulatory changes and communicating what needs to be done to corporate clients.

The threat of Balkanisation

One of the chief concerns of local financial regulators since the crisis has been to prevent the need to rescue large cross-border banks from collapse in future financial crises. This is driving structural change within the banking sector. An increasing number of national regulators – notably Germany and the UK – are bringing in requirements stipulating that banks operate within their jurisdictions not as branches, but as subsidiaries, each with enough capital to stand alone. For a large international bank, that, in essence, means an end to many of the advantages that can be derived from the pooling of capital and liquidity, such as being able to use surpluses in one country to fund deficits in another.

A shift from a largely global system of entities into a patchwork of smaller, locally funded and regulated subsidiaries will likely be a source of alarm to treasurers of multinational companies. It is certainly one of the trends that worries Wandhöfer the most. “That has the potential to – greatly influence global banking in the long run. I think it could have a huge impact on the network. While suggesting that this type of regulatory response would make delivering these services all but impossible for banks would be an overstatement, it is not difficult to see how it might affect the cost.”

A bank’s ability to move liquidity inter-company on behalf of a client is enormously dependent upon being able to move the funds between branches seamlessly. If the system becomes too fragmented, the result might be that transactions will require the use of external clearing systems. That will mean costs will rise and transactions will need to be submitted earlier, Wandhöfer explains. “Ultimately it could mean that everything becomes more expensive and less efficient for the corporate.” KPMG’s Briault agrees. “Increasing localisation or ‘Balkanisation’ is likely to make it more expensive for international banking groups across the world to operate and that will inevitably push up the price of their services to end users, such as global corporates, too.”

It’s not over yet

Given all the disruption and uncertainty that has resulted, treasurers will surely be eager for the process of regulatory upheaval within the banking sector to culminate soon. However, there are still a lot of issues under discussion – not least where Basel III is concerned.

“I think we are about halfway through,” Briault says. A KPMG report published last September, which Briault co-authored, describes it in more striking terms. Even though the original 2019 deadline for the final phase of Basel III implementation is still some way off, some regimes may yet shift towards a ‘Basel IV’ standard characterised by tougher requirements on the leverage ratio, risk-weighted assets and stress testing. Differences are already emerging. The US and European authorities, for instance, are requiring banks to meet minimum capital ratios after a severe stress test, while others are moving minimum leverage ratios above the prescribed 3%. There is not going to be much respite then. In fact, it could be the case that by the time banks are finally able to fully meet the new regulatory requirements, they will already be out of date.

Corporates, when not managing compliance projects of their own, will need to continue monitoring developments and trying to understand the implications. That might involve, amongst other things, budgeting for increased bank fees and performing regular assessments of the impact upon interest income and expenses.

Developing an awareness of the potential macroeconomic consequences might also give treasurers an edge in the practise of risk management. A growing fear amongst banks is that the relentless regulatory onslaught may already be taking economies – Europe in particular – past the “tipping point” to where the costs far exceed the benefits. If the range of services banks provide to their corporate clients continue to rise in cost, KPMG believes a potentially permanent downward drag on economic growth could manifest, exceeding any benefits gained from improved stability. It would be sensible for treasurers, therefore, to anticipate – or at least not rule out – future periods of financial instability and adjust their strategies accordingly.

As regulatory pressures on banks continue to grow, corporates will continue to look at funding alternatives such as the capital markets, says Briault. Banks will always be needed for payments and basic cash management services, he explains, but greater fragmentation might necessitate treasury to take more of “a pick and mix approach” rather than relying on one banking group for all their funding and liquidity needs.

Finally, if global banking continues to gradually fragment, corporates that traditionally partner with one or several banks internationally might need to change their approach. “Treasurers may find that some banks are pulling out of certain locations as the costs of services go up due to localisation pressures,” says Briault. “That is a change they should be preparing themselves for now.”

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