by Lee Taylor
Product Council Chair – Liquidity, iGTB
All Games Evolve
We all have our favorite sports; amateurs like to experiment with butterfly strokes when in the water, professionals enjoy half-pipe skiing in the snow. No matter what your favorite sport is, chances are, had you lived at a different time in history, you wouldn’t have recognized it as the same game that is played today; all games evolve.
Take the example of soccer; people around the world enjoy this 90-minute action-packed clash of twenty-two adrenalin-filled players. But did you know that King Edward III of England banned this game in the 1300s? King James I of Scotland once said in Parliament, “Na man play at the Futeball”. Corner kicks were added to the game only in 1872 and it was not until 1878 that a referee used a whistle.
Much like the sports that have been evolving, and we can be assured that they will continue to evolve in the future too, the game of banking and its rules has also been undergoing a constant change. Consider the Basel Accords. Basel I was introduced in 1988 and set minimum capital requirements for banks. In 2004, Basel II was published with the idea of superseding the Basel I. However, before it could take full effect, the financial crisis hit the world, forcing regulators to introduce stringent standards taking the form of Basel III.
Basel III regulation is intended to strengthen the global financial system. One of the main outcomes of Basel III will be a significant rise in the banking industry’s capital requirements (and therefore, potentially, borrowing costs). For example, some estimates put the additional capital required by the European banking industry to comply with Basel III at around 700 billion euros, reducing return on equity by up to 30 per cent.
Key components include the new capital adequacy measures for certain global banks under the Supplementary Leverage Ratio (SLR). The Liquidity Coverage Ratio (LCR) stipulates coverage of cash outflows that may be withdrawn in a crisis. The combined impact of these will increase banks’ costs of holding High Quality Liquid Assets (HQLA), which are required for certain types of deposits under LCR.
Under the US interpretation of Basel III standards, unsecured wholesale funding from non-financials services corporations would receive 40% run-off factor. Unsecured wholesale funding from financial services corporations- deposits seeing as non-operating cash would receive a 100% run-off factor.
Basel III puts the whole relationship between banks and its corporate clients now under scrutiny: cash flows, cash forecasts, the amount of business ‘owned’ with the company are all being reviewed to determine the overall ‘value’ of each relationship.
The game is evolving and both banks and corporations are recognizing this. Historically corporate treasurers valued banks for the liquidity they can provide. Soon, banks will value corporate treasuries for the kind of liquidity they can provide. Treasuries have historically looked to banks for stability, places they can move money into or out of at a moment’s notice. Soon, banks will look at corporations according to how much they add to or take away from the bank’s stability.
Preparing for the New Game
Though Basel III will not be fully implemented until 2019, key regulations have taken effect and they are already having a profound impact on how banks manage their balance sheets. It is important for corporates to understand how the banks will treat deposits under the new rules. Individual banks will change the demand from short term to long term funding. Also, the impact on the financial system will reduce risk, reduce lending capacity and reduce investors’ appetite for bank debt and equity.
Until now, banks have carefully constructed their products and services around coinciding sweet spots for their customers. Basel III will essentially alter a bank’s sweet spot. Banks will need to continue to look for ways to earn the highest return on capital, but the roads to get there will be different, and will probably vary from bank to bank. The entire game is undergoing a transformation and the changes will be so profound that some companies may have to look outside of banks for services, funding or cash investing.
The Dynamics of the New Players with the Old Ones
In the new regulatory environment created by Basel III, corporations can expect to experience greater rate variations on deposit products based on banks' different liquidity requirements and ratings. Return on overnight investments is likely to fall while longer-dated deposit products should provide an opportunity to increase returns. In order to take full advantage of such opportunities, corporations will need to actively manage their short-to-medium term investments. Additionally, they will need to work to both minimize counterparty risk and increase the accuracy of their cash forecasting
The type of deposit a bank used to covet may now be an unwelcome burden. One can imagine many cases in which a bank would no longer accept volatile deposits. Daily sweeps into investment vehicles might be unattractive. Instead, banks will court particularly stable depositors. Firms paying with compensating balances may become more attractive.
Preserving the Spirit of the Game
Since Basel III limits banks' options to allocate their equity and funds to particular investments, products or businesses, banks have to rethink their strategies and business models. As McKinsey writes: Implementing the new rules will require three distinct initiatives: strategic planning for the Basel III world, capital and risk strategy, and implementation management. Some of the decisions to be taken are:
- To comply with the new requirements by raising new capital or by reducing business activities –
- How to restructure the balance sheet, the funding mix and the product mix
- How to improve profitability in order to maintain RoE – options for business growth are limited; cost reductions and price adjustments might be an answer.
Under Basel III, the old “know your client” (KYC) dialogue between banks and corporate clients will incorporate a “know your bank” perspective.
With Basel III full implementation looming, banks are yet again bracing themselves for the changes to come from new regulation. In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measurement, but what will this really mean for a bank?
The new gaming gear has been ordered, uniforms are being tailored, the stadium is being readied. The kick-off is just around the corner. How will the corporations and banks play this one out?
About Lee Taylor
Lee is a specialist in Transaction Banking. She has held strategic Treasury positions, as Cash/Network manager in regional and global roles covering Western/Eastern Europe, Africa, Gulf, Asia and Latin America, with Coca-Cola Hellenic Bottling Company and Cadbury.
In addition, a 16 year career with Citibank in various senior roles within Cash Management Services and 6 years with JP Morgan as a Managing Director - NBFI Sales TS Head for the EMEA region, places Lee in a unique position of understanding market trends, challenges and opportunities both in the Banking and Corporate Sector.