How Will Basel II Affect Corporate Treasuries?
This article explores the implications of Basel II for corporate treasuries of payments and cash management (P&CM) services. IBOS foresees six main areas that will change in P&CM business as a result of Basel II:
P&CM is sometimes referred to as a non-credit business although this is not strictly true even now. Credit lines are required for:
Basel II’s impact in this area is likely to be:
Basel I and risk-adjusted return on capital (RAROC, see below) have given rise to much drafting of line letters so that they count as existing for the purposes of the customer and rating agencies, but not registered as a firm lending commitment for the bank. Basel II intends to establish a tighter chain so that if a line exists, it must be documented and if it is documented, it is by definition advised, so it represents a commitment.
The challenge for corporate treasuries is likely to come in trying to re-draft line letters, or negotiate some other document from the bank so the bank does not incur extra capital charges on undrawn lines of credit, but where the document fulfils the corporates’ demands and those of rating agencies to be sure the corporate has access to liquidity. If there is no documentation at the bank end, does the line exist? What if the line is needed to convince rating agencies that a CP programme should get an A1+/P1 rating? The consequent questions from this discussion are how much capital will these lines attract and what is the cost?
The main OECD commercial banks currently run a methodology for allocating and pricing credit known as RAROC. This methodology is more advanced than Basel I and broadly overlaps with Basel II. The move to Basel II is not a revolution – but it does not circumvent the recategorisations of lines into more expensive “buckets” as mentioned before.
Basel II minimum capital requirements under Pillar I offer three methodologies for computing the amount of capital needed to support a certain deal with a given customer:
An advanced IRB approach should attribute less capital to the business because it is demonstrably a better managed business and is based on detailed statistics on defaults and losses, however banks that adopt advanced IRB are often those with the highest return-on-equity targets. For example, a foundation IRB bank lending €1m might find itself required to allocate capital of 3 per cent of the loan value. If its RoE target is 15 per cent, the loan margin will be 45 basis point (b.p). An advanced IRB bank might only need to hold 1.8 per cent capital, but if its RoE target is 30 per cent, the margin comes out to 54 b.p. The lesson is – know your banks and the methodologies and RoE targets in place.
Basel II requires that banks hold aside a block of capital to cushion losses derived from operational risk. In Annex 7 of the Basel II consultative papers of April 2003, the Bank for International Settlements (BIS) gives examples of event types, their definition, categories and example activities. The following box is an example:
| Event type category | Definition | Categories (Level 2) | Activity examples (Level 3) |
|---|---|---|---|
| External fraud | Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law by a third party. | Theft and fraud | Theft/robbery Forgery Check kiting |
| Systems security | Hacking damage Theft of information (with monetary loss) |
Similar to minimum capital, banks are offered three methodologies for allocating capital in respect of operational risk. The main OECD banks are likely to adopt either the standardised approach holding a proportion of the P&CM unit’s annual income as capital and an advanced management approach, demonstrating a control environment around each area of risk in P&CM that justifies holding a lower amount. Clearly, the cost of maintaining the control environment should not be so high as to eat up the value of the capital so saved.
Operational risk capital is a new imposition. Since P&CM is an operational business, it should be no surprise that many event-type categories occur within it. Whatever methodology the bank adopts, it will hold more capital than it does now and there will be an apportionment of the cost of capital down to the product and customer level. That means higher fees and new fee categories, and possibly an approval process for usage of products that have no credit needs, such as cheque deposit.
Right now P&CM business is often seen as “ancillary business”, i.e. business that is awarded to banks to enable extra earnings on top of earnings from a credit facility that may be thin (in US banking this is known as “the revolver”). If the ancillary business becomes less profitable, banks will either seek to increase its price, ask for a wider spread and fees on the revolver, or discuss lending and P&CM independently of one another. To counterbalance this, the banks that successfully adopt the so-called “advanced measurement approaches” will have to attribute less capital and should be able to offer lower prices (especially when the ancillary business is transacted in an automated manner). All the same, the idea that P&CM business contains some element of subsidy for the bank will be challenged.
Notional pooling involves customer accounts going overdrawn at a bank at the same time as there are credit balances in the same bank owned by related companies. Basel II addresses such arrangements at three levels:
The results include:
RAROC as a system enables a bank to lend to top corporates at thin spreads, as long as there is lending to lesser credits at higher spreads. The capital held under RAROC is the same as required under Basel I: the two regimes coalesce successfully if the bank correctly manages the distribution of its portfolio among varying credit qualities. Basel II IRB approaches merely state that a bank must hold the right amount of capital for its exposure to a specific client – there is no requirement to have a broad distribution of its portfolio among varying credit qualities. As a result, the bank could concentrate on investment grade credits only and spare itself a lot of capital.
Corporates who are investment grade will want to seek out those banks who are specialising in their market segment because the spreads should be lower. Likewise, corporates who are not investment grade may be exited by those banks.
Basel II is being introduced at the same time as the new legal framework (NLF) for payments in the EU, SEPA in Euroland and Sarbanes-Oxley internationally are having their effect. There are many areas of potential overlap. The new legal framework for payments (version 5) states in Title III, Chapter 2, Article 17.3.a regarding transparency of a payment service: “a description of the main characteristics of the payment services (is) to be provided…including financial limits applied”. If intra-day payments limits need to be advised to the client under the NLF, then capital adequacy may well result under Basel II, including when they are undrawn.
There is a clear correlation between the kind of operating environment in a bank that runs an advanced measurement approach to mitigate operational risk capital and one that can demonstrate processes and controls of a quality to achieve a SAS70 certification, and therefore be accepted as Sarbanes-Oxley compliant. The automation of processes will be even more highly valued in this environment.
One impact of SEPA is the widening in scope of cheaper payments – if the corporate submits compliant data. One might add that corporates who achieve high STP rates represent a much lower operational risk for their banks and will be rewarded with even cheaper pricing. Automation by the corporate should pay dividends.
For a bank to achieve the most advantageous outcome under Basel II on both credit risk and operational risk, it must adopt a demanding environment in terms of services, IT and processes to deliver them, and controls upon them. Factory approaches to credit scoring, operations processing and relationship management will move further upmarket:
In this environment there is scarcely any content to a relationship manager role is that is not a strategic adviser. Decisions on credit scoring and pricing, and on ancillary business will be immune to any discretion that the relationship manager might like to have. Dealing with banks will become more regimented: two banks adopting the same Basel II approaches will be likely to price any deal in the same way, unless they have different RoE hurdles. Banks from different countries will tend to approach the same deal in the same way. Corporates will need to respond to this level of automation and regimentation on the banks’ side, with automation on their own side.
Basel II’s impact may be subtle in some cases, but treasurers will be directly affected by which methodologies their banks use now and which ones they are moving to: this dictates the degree and timing of the bank’s change of behaviour. Treasurers will want to understand how this subject is playing out inside each of the banks used, and how bank regards their companies. Basel II holds out the hope of a reduction in pricing for investment-grade corporates who are committed to STP and whose business represents a low operational risk. For lesser, or volatile, corporates, pricing can only go upwards, for ancillary business as well. There may also be a shortage of banks, as banks continue to refine and narrow their target market definitions.
The interplay of Basel II with other legal and regulatory changes will emerge in due course but there is logic to corporates preparing for automation of P&CM business, because the business environment will become more regimented, and compliant business will qualify for attractive pricing.