Impact of Basel II on Notional Pooling
Basel II has been recognised as promising important changes to the cash management marketplace, even if its overall impact may be relatively containable for banks that already adopted a RAROC (risk-adjusted return on equity) model. The steps from pre-Basel to Basel I, and from Basel I to RAROC involved fundamental change to mind-set and business practice: Basel II offers important refinements to the banks that are already sophisticated.
Basel II will be formally introduced in 2006/7, but banks are already putting in place the processes, collecting the data, and refining their product offerings to be in line with the approach the bank has selected in each line of business, for both minimum capital requirements and operational risk capital.
Of all the cash management products affected by Basel II, notional pooling will see the greatest change, partly because there is such a diversity of approaches among banks to the current game.
Notional pooling offerings from different banks – under the pre-Basel and Basel I regimes – may appear to users as very similar, but each bank justifies the offering internally with reference to the legal and regulatory rules dictated by where the pooling is taking place, where the bank is incorporated, and what capital adequacy regime is in place inside the bank.
Right now all OECD banks are still subject to the formal guidelines of Basel I, namely that the bank must hold capital in the amount of eight per cent of risk. A minimum of four per cent of the eight per cent must be tier one capital. This is equity and dividend bearing: to obtain shareholder money, banks need to show earnings of 20-30 per cent a year on tier one capital (called their return on equity or RoE).
The balance can be tier two capital, usually subordinated debt. This is interest bearing at a premium of perhaps two per cent a year over the bank’s senior debt. For internal purposes the tier two capital is usually assumed to cost the same as senior debt, and the premium is transferred onto the tier one capital, raising the RoE target, or hurdle rate, to 22-32 per cent.
To compute the risk on a particular transaction and how much tier one capital is required against the transaction, banks identify a facility weighting and multiply it by the nominal amount of the transaction. The tier one capital is four per cent of the result.
The facility weighting is derived from multiplying the product weighting by the counterparty weighting:
The result is a percentage between 0 and 100 per cent. The worst case is then that the bank has a facility weighting of 100 per cent and so must hold tier one capital of four per cent of the nominal. This is the case with loans to corporates under Basel I. Both the product weighting and the counterparty weighting are 100 per cent, so the bank has to hold capital of four per cent of the nominal. To achieve an RoE target of 25 per cent, the interest margin must be 25 per cent x four per cent = one per cent or 100 basis points. This hurdle rate increases as the bank’s RoE target increases. The product weighting falls if the transaction is well secured, eg with cash security, with guarantees. The counterparty weighting falls – under Basel I – if the counterparty is an OECD bank or government.
The counterparty weighting can fall further when the bank has adopted the RAROC model which enables banks to do business with higher-quality clients at spreads/fees much lower than those dictated by Bank of International Settlement (BIS) weightings.
RAROC works like a playground seesaw. Individually counterparties are rated on a scale from 1-20. The average credit rating in the part of the portfolio, which is not classed as ‘past due’ or worse, is about eight – the pivot of the seesaw. The average spread on all lending must still be 100 basis points if the RoE target is 25 per cent, but credit ratings 1-7 pay less and credit ratings 9-16 pay more. Clients rated 14-16 in the system find the spreads unaffordable, so new business is only created with clients rated 1-13. Spreads on 17-20 clients equate to penalty rates because 17 is ‘past due’, 18 is ‘Chapter 11’ and so on.
The bank’s risk rating system and its application are reviewed by the bank’s internal and external auditors and possibly by the regulators to ensure that on average the bank is holding enough capital to meet Basel I guidelines. Although RAROC enables banks to lend to higher-quality clients at spreads/fees much lower than those dictated by the BIS weightings, this is only possible if they take on higher-paying risk as well.
One of the prime purposes of Basel II is to formalise how banks in different countries implement their RAROC models – now to be known as internal risk based approach or IRB. Banks can adopt the standard approach (non-IRB), which remains like Basel I, or the standard IRB, or advanced IRB approach. Most pooling banks will adopt the advanced IRB model, since it is the closest parallel to the RAROC models already in place.
The basics of a pooling structure involve customers being able to run overdraft positions on current accounts, while others are in credit. The bank agrees to receive no – or a very low – interest spread because either:
Right now, because the cash is recognized as security for the overdrafts, the bank eliminates the overdrafts from capital adequacy calculations (by applying a facility weighting of 0 per cent), and may also be able to eliminate the matching cash and overdrafts from its reported balance sheet.
The advanced IRB approach introduces specific tests in this area. IRB dictates that the bank’s ability to count any security against a loan becomes contingent upon the quality of its controls in place to address operational risk. Basel II gives categories of operational risk, and the most relevant to taking security against a loan being the category execution/ delivery/ process management, where example risks are:
The new tests will cause banks to review the way in which they have treated pooling up to now:
Basel II imposes specific tests and obligations at three levels that impinge on notional pooling: lending (regardless of whether there is security); secured lending (regardless of whether the bank tries to eliminate it from the reported balance sheet); and on-balance sheet netting, ie the ability to eliminate matching assets and liabilities from the reported balance sheet. The main points are as follows:
Basel II obligations and tests regarding all lending:
Obligations and tests regarding secured lending, ie all loans where credit mitigation is used (in this case the mitigation is cash in other accounts and possibly cross-guarantees):
On-balance sheet netting is directly addressed – the bank must have all of:
If these tests are all met, there is a 0 per cent credit conversion factor (or CCF) to the overdrafts, ie no capital is needed. This does not apply if there is a currency mismatch (or, by implication, where an inadequate haircut exists). CCF is the Basel II replacement term for Facility Weighting.
It should be possible for all banks that fall within the scope of Basel II to offer pooling even if they cannot do it now. But regulations that forbid residents and non-residents in the same pool are not changed as they are not dictated by bank’s capital adequacy. Other residual areas not resolved by Basel II include:
Furthermore, there is no stance taken on the need for cross-guarantees to demonstrate that all participating accounts in a multi-entity structure are held ‘in the same right’, thus allowing pooling for balance sheet and/or capital adequacy purposes.
Equally there is no position taken on structures such as Treasury Reference Accounts, namely accounts jointly held between the subsidiaries (one per subsidiary) and the treasury centre (joint participant in all accounts). Day-to-day payment operations are done in the name of the subsidiary, but the pooling structure chooses to look at the treasury centre as being the owner of all balances for pooling purposes, and so is seen as the bank’s single counterparty.
The major problem with meeting all these tests is that almost all notional pooling documentation is untested. Instead it is a patchwork of individual pieces that may have been tested, or which have not but in turn rely on codified or precedent case law. Is it feasible to achieve legal certainty when the above is the case?
So what happens? If banks offer pooling at nil spread now, they need to achieve a 0 per cent CCF on the lending under Basel II in order to continue in the same way. But it will be hard to argue this when the bank’s financial control function (FinCon) reviews the tests set in the Basel II documents and all the hoops that have to be jumped through in order to have the credit risk regarded as zero, ie to obtain a CCF of 0 per cent.
More likely is that pooling structures are assessed as failing enough of these tests to mean that both credit risk capital and operational risk capital are imposed by FinCon. Click here for case study examples of how pooling structures may be treated under different scenarios.
The other aspect is the allocation of operational risk capital itself to pooling, and the charge for it.
Basel II imposes a need to hold capital against operational risk by using the gross revenue of the bank and its lines of business as the token for the scale of risk being run in them.
The standard measure for the Payments and Clearing line of business is that it should hold 18 per cent of the LoB’s gross revenue.
So if the division’s revenue is $20m, it attracts $3.6m of capital. If the bank’s RoE target is 25 per cent, the LoB has to earn $900,000 extra in order to pay for that capital.
Notional pooling is problematical because gross revenue on the product should basically be zero, implying that operational risk capital should be 18 per cent of zero = zero.
An inverse relationship is at work here. A zero-rating is not credible given the operational risk involved in getting the pooled treatment. The most aggressive treatments involving the highest operational risk would then get the lowest amount of capital allocated against them.
Instead of this FinCon is likely to come up with an allocation that is a percentage of the matched balance, i.e. expressed as basis points per annum on the overdrafts when drawn and matched by cash. The worst-case would be basis points per annum on the overdraft limits. This could be a major area of divergence between pooling banks.
The last but by no means least area of concern is in the workings of Basel II’s third pillar: market discipline. This requires transparency and disclosure in the form of reports – to be freely available – showing how the figures look behind the scenes.
These reports would involve banks showing the gross situation on the accounts pre-pooling even if on-balance sheet netting had been carried out. This might be particularly difficult for the smaller specialist banks. A bank with reported balance sheet footings of E900m and a capital of E70m might look well capitalized on paper, especially if a good proportion of assets were in inter-bank deposits and government securities.
If, however, the bank is running 20 pools for customer groups that each have $250m on both sides of the coin every day, then the assets and liabilities grow by over E4bn when the accounts are shown gross.
This bank with third pillar balance sheet footings of E5bn but the same capital of E70m looks like it is overtrading, spinning a big wheel based not on its own financial resources but on the credit lines extended by other banks, often its payment correspondents.
Of course, if such a bank found that its regulator applied a CCF of three per cent to its pooling business (as in the example above), then the bank would need E120m of capital to operate, plus whatever was needed to support other activities.
Pooling banks will have a lot of work to do to migrate current structures into a Basel II environment. The spreads that banks will want to retain will no doubt rise. Since all plausible pooling banks are OECD banks and fall within the scope of Basel II, the playing field becomes levelled between banks, if not between pooling locations.
Pooling may become the preserve only of the best-rated corporates, where an unsecured overdraft would have a very low CCF under the bank’s IRB system anyway, and banks may be willing to subsidise the pooling as long as the nominal amount was not so high.
This course is only open to banks that have a wide product range and can earn back on other services what they give up in the pooling.
The outlook is not so great for the specialists. Their business depends on their achieving a 0 per cent CCF and on-balance sheet netting, and on the support of other banks. It is very hard to see how all three can be maintained in the new environment.