While it’s no secret that new regulations are likely to bump up banking costs, corporate treasuries may feel the pain sooner than they expect.
In coming months, regulators are expected to advance Basel III and components of the Dodd-Frank Act, respectively impacting capital and margin requirements.
The European Commission issued its proposal in July for turning Basel III standards into enforceable rules, and Federal Reserve Board Governor Daniel Tarullo said recently he expects a Fed proposal in the first quarter.
Both regulators have agreed to implement the standards gradually, from 2013 through 2019. Banks’ common equity ratio must increase to 4.5% from the current 3.5%, and their minimum capital level increase to 10.5% from the current 8%, with a capital surcharge imposed on banks deemed globally important.
Basel III doesn’t directly affect banks’ corporate customers, but it almost certainly will increase their costs. Dan Taylor, executive director at J.P. Morgan Treasury Services, notes that banks can either raise capital to meet the new requirements, incurring costs that will most likely be passed on to clients, or deleverage, and thereby inhibit their lending.
While the Basel III changes won’t begin for more than a year, banks are likely to begin efforts to bolster their capital earlier, and so corporate clients may soon feel the impact. “I suspect many banks will start looking at capital increases even before the phase-ins,” Taylor says, adding that such increases, and therefore potential costs to clients, will vary from product to product.
For example, the capital requirement for letters of credit, instrumental in global trade, is 20% under Basel II, but will rise to 100% under Basel III. “The impact of providing letters of credit to a customer will go up significantly,” Taylor says, noting that recent surveys suggest those costs could rise from 15% to 40%.
Basel III is also likely to increase hedging costs for corporate end users that choose not to clear their trades because banks will face higher capital requirements for bilateral, uncleared transactions, and they’re likely to pass those costs on to clients. It remains uncertain whether those end users will be exempted from the clearing and the margin requirements that the Dodd-Frank Act applies to more active swap dealers and major swap participants. Basel III, however, may make the benefit from any such exemption moot or diminish its value.
“The concern is that even if an end user has an exemption from clearing and margin, if uncleared trades become prohibitively expensive, it would effectively undo the margin exemption,” says Luke Zubrod, director of Chatham Financial’s derivatives regulatory advisory service.
Banking regulators have suggested they have the authority to impose margin requirements on corporate end users, while companies argue that Dodd-Frank explicitly exempts them.
Zubrod says a bill clarifying that regulators do not have that authority currently awaits subcommittee approval. If the measure garners significant support in the House, it may prompt the Senate to consider it and could also affect regulators’ deliberations on the final rules, which are expected in the first quarter.
Regulators are also expected to finalize definitions by year-end for the terms end user, market swap participant and swap dealer. Those definitions could push some companies that are active in the swap market out of the end-user category, thereby requiring them to clear trades and post margin.
The final form of those definitions should also resolve whether smaller banks will be exempted from clearing requirements. Dodd-Frank refers to institutions “including” those with $10 billion or less in assets, but that language could pull in larger institutions. Zubrod says he’s heard numbers as high as $30 billion to $50 billion in assets.
“If they do exempt those banks, will they simply use an asset test, or will they require some sort of risk measurement to determine which types of banks can avail themselves of the exemption?” Zubrod says, adding that regulators are expected to finalize margin requirements in the first quarter.
One administrative issue stemming from Dodd-Frank that regulators should resolve soon is whether end users employing centralized clearing functions to execute hedges more efficiently will have to report their activity to swap trade repositories when they are allocated to the proper affiliate.