The global financial crisis of 2007 drew attention to failures by financial services institutions to adequately manage their risks. Governments and regulatory bodies around the world have responded by issuing a spate of new laws and regulations, including the Dodd-Frank Act, the Basel III framework, and updates to the European Union's (EU’s) Markets in Financial Instruments Directive (MiFID) and European Market Infrastructure Regulation (EMIR).
In combination, these new guidelines will have a significant impact on how banks do business—which will necessarily impact their relationships with corporate clients. Treasury & Risk spoke with Takis Sironis, risk management senior principal with Accenture, to discuss what corporate clients can expect from their banks in the near future, and what they can do now to prepare.
T&R: What are the biggest legislative and regulatory changes on the horizon for banks today?
Takis Sironis: We see four primary areas in which impending regulations will have a direct impact on the relationships between banks and their corporate clients. The first is capital; all kinds of transactions will now require more capital from banks. Basel III, in particular, might have a really punitive effect on banks in terms of the capital they must hold. Prices of financial products will be affected, with the creditworthiness of the corporate counterparty determining the size of the impact. All the analysis we’ve seen from the banks suggests that rates and credit products will be hardest-hit.
T&R: Will it become more difficult for companies with lower credit ratings to access longer-term credit products?
TS: Yes, banks are likely to prefer corporate customers with better ratings and products with shorter maturities.
T&R: Will the new capital requirements affect corporate banking clients in other ways, or will it mostly be through higher prices?
TS: From the corporate point of view, it is worth considering whether to acquire clear capabilities—in other words, whether to begin clearing their own financial transactions. Companies that do so will be subject to the same reporting obligations as the banks. But by clearing transactions themselves, companies can reduce the overall price of the transactions.
T&R: How will the derivatives market be affected?
TS: In derivatives trades, banks will be heavily impacted by the increase in counterparty credit charges imposed by the CVA [credit valuation adjustment] capital charge. It’s new in Basel III, and it hits transactions that are collateralized or long-dated. Banks are currently running the numbers to understand how the CVA capital charge will impact their funds transfer pricing. These analyses will also determine how banks change their product pricing to reflect the CVA capital charge, which will obviously be felt by their corporate clients.
That leads us to the second major area in which banking regulations will affect companies’ relationships with their financial institutions: the OTC [over-the-counter] derivatives market structure and execution requirements. Derivatives are one of the most customized services that banks offer because they meet the client company’s needs for a very specific, complex transaction. The new regulations are designed to increase market transparency in OTC derivatives trades. To the degree that they’re successful, banking customers will benefit because there will be increased competition and less emphasis on personal relationships between the company and its banks.
T&R: Will other factors work to either increase or lower prices for corporate banking clients?
TS: Yes. The third area in which we see the new regulations affecting banking relationships is around documentation. Banks are going to have to start doing a lot more post-trade reporting. For instance, they will have to report details of derivatives contracts to regulators. They will also have to provide clients with more information about a range of products, including retail structured products. If used properly, this information can give corporate clients a better understanding of the services they get from their banks.
So even as the documentation requirements increase banks’ costs, they exercise more pressure on the banks through increased transparency. It’s hard to say at this point how these conflicting pressures will affect the pricing of banking products.
T&R: What is the final area in which the regulations will affect banking relationships?
TS: It’s liquidity, which will definitely have a major impact on the banks, but it will also be important to their corporate clients. Under Basel III, there are two new liquidity measures that banks need to conform with: the liquidity coverage ratio, which requires banks to maintain a buffer of high-quality assets to cover 30 days of outflows around liabilities, and the net stable funding ratio, which requires them to keep long-term assets for funding and a minimum level of stable liabilities in relation to their liquidity risk profiles.
Because they specify the quality of assets the bank must hold, these metrics require banks to really understand how they cover liquidity. For instance, if we look at the Eurozone trouble, a lot of European banks may find it difficult to raise U.S. dollar-denominated funding through traditional instruments such as foreign exchange swaps or cross-currency swaps. That puts pressure on internal funds transfer pricing, which at some point may be reflected in pricing of products for corporate clients.
T&R: So, you anticipate that the primary effect of the liquidity regulations on corporate banking customers will be to raise the prices of banks’ products?
TS: They will definitely have an impact on pricing, but they will also have an impact in terms of the deals that banks will offer because they will change the level of actual capital the banks need to hold.
T&R: Are there any steps that corporate banking customers could be taking now to prepare for changes that may be coming from their banks as a result of all these new regulations?
TS: Well, first they need to understand that every bank will choose to respond in a different way to the incoming regulations. One example is the ways that banks are changing the operating model for their internal treasury functions. Some of them are centralizing treasury, while others are decentralizing, splitting their treasury function into several divisions.
The drive to optimize capital and optimize liquidity buffers makes centralization seem appealing. But for some banks, that appeal is overridden by the need to understand exactly how capital is being used in the bank’s different lines of business and how to optimize funds transfer pricing. In the past, that was more in the background, but it’s now a more critical part of capital planning and pricing decisions. For banks that put a high priority on understanding local regulations, decentralizing treasury may be the best choice, despite pressures on capital, collateral, and the like.
T&R: How does this affect corporate banking clients?
TS: From the corporate point of view, it is important to understand how the bank is going to change to comply with these regulations. Are they going to be members of a CCP [central counterparty]? If so, what facilities are they going to offer? For instance, a bank could offer clearing facilities to provide a better pricing structure to their corporate clients. It could also offer more optimized terms for using CSAs [credit support annexes] and other structured deals to ensure that everybody benefits through lower prices for the corporate clients and minimum capital for the banks.
Banks that aren’t CCP members will be affected, as well. They might find it more difficult to make money in certain products, so they may now be considering whether to pull out of certain products that they were previously planning to offer. Companies need to understand their banking counterparties, where they are moving, and whether they will continue to be major players in the products in their current portfolio.
T&R: Should corporate treasurers just sit down and talk to their banks about where they’re going?
TS: That is the obvious way to respond. But a best practice, particularly for large companies, is to take a proactive approach to monitoring and assessing their banking counterparties. Some treasury departments in large corporations are offering an educational program to help treasury and finance employees understand the impacts of the regulations. They have reviewed their major products and major exposures, at least, and they keep abreast of all the changes. How sophisticated and how comprehensive this type of program needs to be varies from company to company.
T&R: To what degree should a company formalize the process of monitoring its banks’ plans to change their product offerings and business lines?
TS: Companies should monitor this on a regular basis. If we look at the horizon of upcoming regulations, not even the banks know right now how they’re going to respond. There is a lot of ambiguity and uncertainty, and as banks absorb the full impacts of the new regulations on their business model, their plans might continue to change. Corporate banking clients should really monitor their banks like they monitor their clients, asking: What’s the current state? What is the strategy? Where are they going? They need to track how the banks respond to all the different aspects of emerging risks.
For example, it makes sense for companies to monitor their banks’ liquidity spreads. We have seen banks’ funding spreads widen due to ratings downgrades and country spreads. That might increase the funding price, which ultimately might lead a corporate treasury function to conclude that it makes sense to go directly to the capital markets, rather than working through the traditional channels of relationships with banks.
T&R: In the leading-edge companies that are effectively monitoring their banks and providing training to employees, where does this type of initiative originate?
TS: In some cases, banks will help their best customers with the training, but usually it originates in the company’s C-suite. When we talk about the C-suite, obviously, the three main stakeholders are the risk management and treasury functions, and the business lines. Treasury needs to manage liquidity exposures, as well as the pricing and impact of deals.
Ultimately, the treasury department needs to work with risk managers and others in the organization to make sure that the company monitors counterparty risk in financial transactions, and that the process for doing that incorporates insights into how the bank is responding to new regulations, and how it plans to respond in the future.