By Hilary Kabak
Despite the easing of requirements, Basel III is still going to increase the cost of doing business.
Showing the global banking industry some belated Christmas cheer, the Basel Committee on Banking Supervision in early January 2013 eased Basel III’s liquidity rules and extended the timeline for compliance.
Following the announcement banks were elated and corporates too saw a positive, likely thinking that given the relaxation of the proposals, any costs associated with compliance wouldn’t be passed on to them, or if so, to a lesser degree. They would be wrong. After a year in which many corporates saw pricing decrease, they should expect to see it rise in 2013.
According to John Ahearn, Global Head of Trade Citi Transaction Services, the costs of some services will go up 30-40 percent in the next year. “The regulations will impact the cost and availability of banking services from cash management to trade finance to credit,” and banks will be more selective in picking partners, he said. So the decrease some corporates saw in 2012 will not last long.
Luke Zubrod at Chatham Financial has a more aggressive view of pricing. He predicted that stricter capital requirements, instead of increasing or adding fees, will simply push up transaction prices, so the capital set aside won’t prevent the bank from getting a return. That’s because in the OTC market compensation to the dealer counterparty comes by way of fees embedded in the transaction price of a swap (vs. the futures and cleared swap markets where market participants are accustomed to paying transaction fees or commissions).
Capital requirements will be experienced not as a direct fee paid by the end user, but rather as a higher rate paid over time to compensate the dealer for what would otherwise be an unproductive use of their capital.
Mr. Zubrod said price increases could range from 100 to 600 percent increases, but it will be hard for end users to pin this down, largely because they don’t know the costs to the banks of meeting higher capital ratios.
However, some things are pretty certain, according to observers. The capital charge on longer trades will be higher than on shorter trades, and cross-
currency trades will be more expensive than interest-rate swaps.
Therefore, avoiding the higher charges largely comes down to picking the instruments that are right for you: is the instrument of choice now, all other things being equal, the same as the instrument of choice when capital charges are in place?
“The regulations will impact the cost and availability of banking services from cash management to trade finance to credit.”
— John Ahearn, Citi
Other strategies for avoiding higher rates include: introducing changes in contractual terms, for example giving the bank the option to terminate before the end of a contract; posting collateral if a certain threshold is exceeded; or lowering the threshold if such an agreement is already in place.
This is easier for companies with large cash balances and easier access to liquidity, which is also true if you want to lower your rates by clearing a trade—and thus avoiding the punitive capital requirements. You will have to tie up capital, but the amount (at least of initial margin) can be reduced to some extent by using futures transactions, for example. Mr. Zubrod noted that while corporates will be navigating yet another set of conflicting incentives if they have to decide between free cash and lower rates, banks recognize the new dynamic and are already thinking about how to help them with potential new strategies, saying that however many variables there are, “options are likely to emerge.”
Asked about potential strengthening of local funding, he also noted cross-currency swaps were going to get more expensive, with long-dated cross-currency swaps hit hardest. Whereas in the past companies could look for cheapest overall funding and swap it into the end market currency, moving forward it might make more sense in some cases to use local currency and avoid the cost of a swap. However, as with all of the emerging regulations, much remains to be settled in the rules.
One glimmer of hope is that European regulators are actively considering exempting corporates from a key aspect of the CVA capital charges in derivatives trades. If this is in the final rules, the impact of Basel III on corporates in Europe will be reduced.
Some more good news is that while data collection has emerged as a formidable obstacle with Dodd-Frank regulations, there is not going to be a big IT obstacle to complying with Basel III. The main data questions here are: how much will it cost, and will it change hedging strategies?
Banks and corporates should start acting as if Basel III rules were already in effect.
Moving into 2013, Mr. Zubrod noted that most corporates are just focusing on compliance, while any potential resulting restructuring questions are being kept at bay. However, Tom Joyce from Deutsche Bank noted back in May 2012 that banks and corporates should start acting as if Basel III rules were already in effect as soon as possible—this, even though full implementation has been pushed to 2019. Banks will only need to meet 60 percent of the liquidity requirements by 2015.
Once companies figure out what they need to do to be on the right side of the law, somewhere in the second half of 2013 they can start thinking about what they should do—and even what they want to do—to adjust their strategies and keep managing their risk.