Basel III, Volcker Rule, Dodd-Frank and the Asia CFO
For those who knew James Stewart as CFO Malaysia at the Royal Bank of Scotland, his 2013 move to Wolters Kluwer Financial Services as General Manager, APAC Compliance Division, may be a bit of a head-scratcher. But there is a method to the seeming madness.
“In the banks, CFOs in finance departments are very much back-office and are not that involved in the front office,” he explains. “I’m taking a slightly different line to get a bit more business-facing experience. We’ll see what happens. I might be back as CFO one day.”
Still, as a former CFO who is now a specialist in regulatory reporting compliance products and services for banks, Stewart is in a unique position to talk about how Basel III and other new regulations will affect the CFO’s work in Asia, including cash and treasury management.
He recently spoke with CFO Innovation’s Cesar Bacani. Excerpts:
Banks are supposed to have 100% LCR (liquidity coverage ratio) by 2019, but it seems some Asian regulators are looking at adopting 100% LCR sooner.
In January 2013, the Basel Committee said it was prepared to allow some transition to a 100% ratio, but then most of the Asian regulators had come out and said, we think [our banks] are going to be OK. We’ve got enough liquidity.
And if [our banks] don’t have enough liquidity, we’re prepared to accept things like committed facilities with the government or with the reserve banks, and therefore we can get to 100% LCR.
It depends on the country. Australia, for example, has said [it will adopt] 100% LCR on consolidated, all currencies, and also 100% at the individual currency level. That’s a tricky implementation. You need to measure your high quality liquid assets and whether 100% of your cash flows are in that currency.
The Singapore regulator has not quite finalized, but it’s saying that it wants 100% for certain currencies. For other currencies, it’s allowing a transition, starting at 40% and then move that up over time.
We’re still also waiting for Hong Kong’s final guidelines. The Hong Kong Monetary Authority is leaning towards adopting a phased-in approach, starting at 60% in 2015 and 100% in 2019.
Will LCR have an impact on bank lending to corporates? At a 100% ratio, every dollar of bank lending will need to be matched by a dollar of a high quality liquid asset.
Absolutely. If banks are not at 100% liquidity coverage ratio, a lot of their funds cannot be used for lending. They have to park that into high quality liquid assets, which have very low returns.
That was the real concern when this came out first in 2010. If you start imposing this ratio on the banks, then you’re going to stall economic recovery because what you need is bank lending. This may not be possible because they will not have [enough] liquid assets.
But lending is not going to dry up [in Asia]. The regulators have said they are pretty comfortable with the LCRs [of banks in the region]. Everyone’s already there; there’s not going to be an economic impact.
What about the other ratios, such as the Net Stable Funding Ratio?
They are not at the same level of confidence. That’s why [the Basel Committee is] still actually tweaking the requirements. LCR is used to cover short term cash flows. The Net Stable Funding Ratio (NSFR) is to make sure that over a one-year horizon, bank funding is much more stable.
NSFR disincentivizes wholesale funding or money market activity, which is one of the reasons for the global financial crisis. Instead, NSFR incentivizes things like retail deposits and long-term debt issuances. These are sources of funding that’s not going to get pulled from the banks at short notice.
The Basel Committee has said NSFR will go live in 2018, but no one knows what it’s going to look like yet. The equation will be stable funding divided by what they call the “stress cash outflow” scenario in one year. That has to come out at greater than 100%, enough to meet possible outflows over a one-year horizon.
Retail deposits are limited in markets with small populations like Hong Kong and Singapore, not to say Australia and Malaysia. Will that affect their banks’ NSFR, and therefore the ability of those banks to lend?
If the banks can’t get access to enough retail deposits because the market is too small, the local regulators might give some concessions, just as the Australian regulator has done with LCR . . . Australia is allowing what is called “committed liquidity facility” to count as high quality liquid assets for [calculating] LCR. On the NSFR, they might do something similar.
The aim of the NSFR is to make banks less reliant on less stable sources of funding, so short-term deposits will not be as attractive for banks.
They might have to pay up on the funding side for long-term debt issuance or to persuade retail depositors to get fixed deposits for a year or two years. You’re already seeing a bit of that in LCR, where the banks are trying to move some of the one-month deposits to 31-day deposits, because 31 days just steps slightly outside of the 30-day horizon [and therefore qualifies as a high quality liquidity asset].
What about the capital adequacy ratio (CAR)?
The banks used to be able to include Tier 2 equity [such as undisclosed reserves, revaluation reserves, general loan-loss reserves and subordinated debt] in determining CAR, but that’s been phased out. Now it’s just Tier 1 equity [common stock, retained earnings, non-redeemable and non-cumulative preferred stock].
What Basel III is going to do is phase in an increase in the minimal CAR requirement by 2015 [to 10.5% from the current 8%]. Some regulators are saying that if you are a systematically important financial institution [i.e, too big to fail], then you need to carry an extra 2.5 percentage points on top of the 10.5% by 2019.
How will this affect the availability of lending for corporates?
It limits it in the sense that every loan the bank issues carries risk, and against that risk, it needs to hold enough equity. If you continue to leverage your equity to lending, you would need to increase equity.
So if a bank cannot increase equity, it is forced to cut lending in order to bring up its CAR to the levels required by Basel III?
Yes, and this was the problem the banks were having after the global financial crisis. They were forced to increase their equity to maintain their profitability, but issuing equity was very costly for them. Their share price was heavily discounted. In actual fact, you saw them heavily bring back their lending portfolios.
But the banks seem to have repaired their balance sheets. They are adequately capitalized now. Obviously it’s a spectrum, but in general most of the regulators seem to be OK with the current level of capitalization. So now they’re adding the liquidity ratios on top of that.
The Asian banks were never in the same position as the European banks. They didn’t suffer massive losses and therefore massive impact on equity. In the US, UK and Europe, equity was reduced through the massive losses, and some banks had to issue equity at a massive discount in 2009.
Is there any impact from regulations like the Volcker Rule in the US, for example? As I understand it, this will limit proprietary trading by the banks.
The Volcker Rule, which is separate from Basel III, is part of the Dodd-Frank [Wall Street Reform and Consumer Protection Act]. It’s so complex that they’re still working on it. Volcker is supposed to go live in this year, but we still haven’t got final guidance.
The Volcker Rule is definitely going to impact the banks, very much so. Anyone with exposure, anyone regulated under Dodd-Frank will be impacted.
But I haven’t seen any Asian regulators pick up on Volcker. They have picked up on [other parts of] Dodd Frank, so the over-the-counter (OTC) derivatives regulatory reform, that’s big in every country. Volcker itself seems to be at this point US-specific. But there’s not many banks that don’t have operations in the US, so by default, they are all impacted.
It’s a nightmare for banks because that’s really curtailing all of their proprietary businesses. A lot of the proprietary businesses are built out through financial instruments and derivatives, where the bank takes a position off the back of clients. All of that will have to be shut down.
Will this have an effect on the availability of funding for corporate as well as the kind of financial instruments that may be offered to corporates?
I don’t think so. The financial instruments will always be there. It’s more that the banks need to ensure that when they accept these positions from client that they do not carry a position on the other side. You as a client will still have access to all the same instruments. The bank that’s doing the transaction with you will have to make sure that they square that position off.
Is it possible that the cost of capital will increase because proprietary trading will no longer be able to subsidize the bank’s lending, transactional and services?
Absolutely, because the banks having huge profits were able to take lower return on equity on some of the lending divisions . . . For example, Goldman Sachs’ proprietary trading accounted for more than 50% of its income.
Banks in Asia don’t normally do proprietary trading?
Not to the same extent as the US banks. But Asian banks will certainly have some proprietary trading. They will still carry risks for certain time periods.
What will be the impact of Basel III and other regulations on bank CFOs?
It would be very hard. The banks had been under pressure and therefore may not have made the investments that they should have in the last couple of years. So you end up getting a CFO in a position where they have probably not quite the same team size that they had gotten used to in the boom times.
The amount of reporting has certainly increased. And because the regulator has become so stringent in effectively tying heavy penalties to non-compliance, that reporting is not just external. It needs to be the foundation of internal risk management as well.
The CFO ends up being lumbered with a lot of these things. He needs to make sure the capital adequacy ratio reporting is calculated correctly and passed on to the regulators. Internally the business should be made aware [of CAR issues] and models should be in place to assess new transactions. And now the CFO has got the Basel III liquidity ratios [to deal with as well].
Regulators are also coming at it from a perspective of wanting consistent information. Maybe in the past, the CFO could just have done some regulatory reporting and the balance sheet, and the risk view or the operational view of the transactions could have been submitted by different departments.
But now we see most of the regulators saying, if you’re submitting a liquidity report and the balance sheet, they should all tie together. And the CFO has to cope with that because the CFO is the steward of all that information.
There’s also the issue of the format. I remember ten years ago XBRL coming in, but it’s only now we’re seeing pretty much every regulator saying: I want this submission by XBRL . . . In Asia, definitely the Australians are using XBRL, the Indians are on XBRL, the Malaysians are going there, Indonesians.
How about non-bank CFOs and treasurers? Are there implications on the way they conduct financial management as banks become subject to more stringent regulations?
The CFOs of securities firms and asset managers are in the same boat. For other companies, there may be some impact in the way they work with the banks.
It’s obviously an incentive for corporates to have good credit histories and a higher credit rating, because it makes the cost of borrowing cheaper and perhaps will subject them to less restrictive covenants. If you are unrated, you can still get funding but probably at a higher rate and more restrictive covenants.
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