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The Impact of Basel III

Why It Should Matter to both Banks & Corporates

30Apr

One of the key differences between Basel III and the other Basel versions before it is the concept of liquidity management.

Under Basel III Banks must maintain certain levels of high quality assets (e.g. government securities) to offset the probability that a bank will experience “significant” cash outflows (e.g. deposits)over a 30 day period, outflows which could jeopardizing its financial existence. While maintaining more high quality assets can enhance the stability of a bank, the need for more assets means a bank will need to maintain / acquire expensive capital, potentially decreasing a bank’s over all profitability (e.g. its return on assets or equity).

To offset potential costs some banks may choose to pass on costs to their customers. This “valuation decision” can depend on the level of a customer’s deposit balances and purpose. Example: funds on deposit by companies kept for “operational purposes” are more valuable to a bank because these deposits are considered more stable than “non operational” or “excess” deposits. A more stable deposit base means banks need worry less / keep lower levels of high quality assets.

These new Basel rules may impact certain current international practices like the one associated with pooling deposit balances across various corporate entities. “Cash pooling” is the practice of treating disparate cash balances as one single balance across many currencies, legal entities and banks to recognize lower net interest expense, lower FX exposures and, sometimes, lower transaction costs. However, the use of cash pooling can obfuscate the purpose of these balances making it more difficult for banks to understand what levels are operational vs. excess. Blurring a deposit’s purpose could subject a bank to potential costs.

  • Corporations will need to place a premium on answering the question “How much liquidity is “enough”?
    • Companies that forecast the answer to this question correctly will still find notional / physical pooling to be desirable since the level of their deposits can be directly related to their operational needs. Also, pooling is a good way to consolidate non functional currency balances and reduce market risk for corporates. Since currency pooling provides FX trading and other opportunities for banks, its use will continue even if at a lower activity levels.
    • Corporations that keep “excess” deposits at their banks may find notional pooling becoming more (too?) expensive since excess deposits could be considered “non operational” under Basel III. If so, then these excess deposits could subject the banks to extra costs by forcing them to hold high quality assets as collateral. The more assets they hold the more (expensive) capital they must maintain.
    • A corporation that uses a netting service may find it advantageous to combine transaction netting with pooling at one bank during the settlement of the netting process since deposit levels maintained would be more related to operational needs.
  • Banks and Corporates will need to do a better job of communicating the purposes behind holding respective future deposits levels. Today most companies undertake formal bank reviews infrequently, say 1 to 2X a year; forecasting deposit levels or setting targets is usually not on the agenda. Quarterly or more frequent reviews may become the order of the day. Review hints:
    • Corporates - should set deposit levels based on business activity and communicate that target to the bank to insure the bank doesn’t “inadvertently” allocate extra costs to a relationship.
    • Banks – Specifically ask corporates for their deposit targets, short and long term. While all corporates calculate their cash position, most do not do so against a key target if recent AFP and PWC surveys are to be believed. If corporates do not understand their excess needs then how will a bank know?
    • If there are extra costs leveled by a bank to a company’s relationship considering the bank’s desired return on assets, growth in revenues, risk profile, etc then the company should ask the reasons why during a review. It is even possible that companies may decide to disburse this excess cash (i.e. deposits) to investors (dividends? stock buyback?) to avoid banking costs. They could even pay down debt with this excess cash. Yet, at the end of the day companies will need to keep some level of cash at their banks, not buried in the corporate backyard.
    • Bottom line – corporations will need to do a better job of matching sources and uses of funds especially if, post investor payout, there is less cash left over for operations. Banks can reduce their costs by seeking better deposit level planning in conjunction with their corporate customers.
  • Corporations will need to answer the question “How much risk is too much”?
    • Companies subjected to extra charges could opt to “spend down” / use this extra cash (see above) or even move their relationships to another, more friendly bank. Spending could take the form of investing in some interest earning assets which transform excess demand deposits into investments with stated maturities (i.e. these deposits may no longer be considered “hot money” under Basel III). Companies could even decide to acquire other companies a great way of spending down excess cash while earning returns way in excess of what a CD could generate.
    • No good deed goes unpunished
      • Deposits at that one or more friendly bank(s) could be associated with greater counterparty risk putting principal at risk. Could also lead to higher administrative costs to monitor more cash at more banks?
      • Investing in interest earning assets could subject the principal to market risk as interest rates rise. Need to rewrite investment policies?
      • Bidding wars for acquisitions can use up a lot of cash quickly while the returns are years away. Investors may not be pleased too over pay for “bad” acquisitions?
    • Risk comes in many forms. A company with “too many” bank accounts may find itself spending too much time just trying to answer basic questions like “its 9AM, where in the world is my cash?” The (operational) risk is that treasury cannot watch everything all the time and could suffer “random” penalties because they may have excess cash.
    • Bottom line
      • Reduce the complexity of the company’s banking network and align it more closely with your operational needs.
      • Corporates will need to model / focus more on the value of their banking relationships, something few treasuries do well. Example: Few treasurers can fully answer the question about how much did they pay bank XYZ last year on a global basis considering credit, cash management, FX, credit card, fiduciary, trade finance services, etc

Finally, an issue both sides (banks and corporates) will need to face is how to measure the respective impact of the regulations on a relationship by relationship basis. Today, banks are still struggling to look at the impact of Basel III on an enterprise level but they have customer profitability systems; on the corporate side few possess / fully utilize their treasury management systems to model bank relationship values.

Based on my experiences the banks have the lead in this “know thy need” battle. After all banks are in the liquidity and risk business; corporations only sell “widgets”. The good news, there is still time for both sides to update their relationship tools and targets since the regs will take years to become fully functional.

Corporates especially will need to step up their game with better bank relationship and cash forecasting models; future operational demands will require better tools (still too many stone aged spreadsheets?) and more or better trained treasury staff. Factoid – According to AFP and PWC surveys 50% or fewer treasuries have any metrics or benchmark against KPI targets. Banks on the other hand have been using measures like ROA for relationships or RAROC for years.

In the upcoming rising interest rate environment the cost of a “mistake” will only get larger for both sides.

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