The Impact of Basel II on the Pricing of Cash Pooling
The regulatory changes brought about by Basel II could influence the price – and hence the attractiveness – of cash pooling solutions (both zero balancing and notional pooling). In effect, it is sometimes claimed that Basel II will make cash pooling more expensive and thus unattractive for corporate treasuries. In this article we explore this assertion and aim to provide an objective assessment of the influence of Basel II on cash pooling.
The basic premise for the potentially negative impact of Basel II on the attractiveness of cash pooling products is that the Basel requirements will impact on their pricing. Given that Basel II is changing the way regulatory capital is calculated, the primary impact would come via the required return on capital required as part of overall product pricing. In addition, there might be a secondary effect through the imposition of more onerous operational requirements on banks offering cash pooling products, potentially increasing the administrative cost allocation and hence pricing.
Addressing the first point, we have to answer a fundamental question: do banks actually price their products and services taking into account regulatory capital or do they use some alternative (risk-based) capital definition in their calculations? Obviously, the potential changes in capital requirements introduced by Basel II will only have an effect on pricing if regulatory capital plays a significant role in setting prices in the first place. Therefore, if we came to the conclusion that banks do not price off regulatory capital at all, changes in regulatory capital requirements due to the introduction of Basel II should not have any influence on the product pricing of cash pooling solutions.
Product pricing is influenced by a large number of factors, of which regulatory capital will only be one. More important for pricing decisions will be factors such as the bank’s internal cost structure, the competitive environment and customer demand. Regulatory capital might be considered a constraint by most banks, but it would potentially only be an important determinant of pricing in less sophisticated institutions, while sophisticated institutions will use their own internal economic capital models in defining the pricing strategy for their products and services.
This implies that the changes in regulatory capital requirements introduced by Basel II could potentially affect the pricing decision of those banks that in the past based their pricing on the absorption of regulatory capital.
Let us examine this point further. Basel II introduces changes to the way credit risk capital is calculated as well as introducing for the first time an explicit charge for operational risk.
With respect to the credit risk capital calculations, there are three aspects to consider:
Under Basel I, on-balance-sheet corporate exposures were risk weighted at 100 per cent, regardless of the credit quality of the counterpart. This implied a capital charge of 8 per cent of outstandings in all cases. Under Basel II, the credit quality of the counterparty is explicitly considered in the calculation. In the simplest approach, i.e. the Standardised Approach, risk weights are determined on the basis of external ratings, with all ratings better than BB- attracting a risk weight of less than or equal to 100 per cent. In the more sophisticated internal ratings based (IRB) approaches, the risk weight is determined on the basis of a formula taking into account the credit quality of the counterparty expressed as a probability of default. High-quality borrowers will attract substantially lower risk weights than under the current framework.
Many of the largest customers using advanced cash pooling tools for the management of their treasury activities have external ratings. Thus, the introduction of Basel II could actually have a beneficial impact on regulatory capital requirements for these types of transactions, as the risk weightings will decrease compared to Basel I. For smaller companies without external ratings the risk weight will remain unchanged at 100 per cent. If companies are good quality borrowers and their bank uses an internal rating system, the risk weight should again be below 100 per cent.
In order to be able to use cash pooling solutions, companies will have overdraft facilities in place. As a rule, the overdraft facilities required will be larger the more volatile the cash balances in the entities. Given the volatility of balances, overdraft facilities will often have large unused limits; however, these limits have to be provided on a committed basis by the banks.
Under current regulation, unutilised commitments with a maturity of less than one year do not attract any capital requirements. Under Basel II this changes, as the proliferation of “364-day facilities” in the banking industry was seen as an undesirable form of regulatory arbitrage, with the resulting capital requirements not reflecting the true economic risk of these transactions.
Basel II “remedies” this situation by introducing capital charges for short term commitments. Under the Standardised Approach, they will be risk-weighted at 20 per cent, i.e. attract 1.6 per cent capital as opposed to the 8 per cent required for on-balance-sheet exposures. Under the IRB approaches, the treatment of unutilised commitments will vary between banks using the Foundation Approach (where a supervisory risk weight of 75 per cent and thus capital of 6 per cent is required) and those using the Advanced Approach. In the latter case, banks are required to provide their own estimates for the potential exposure at default for unutilised commitments. In cases of highly volatile utilisation, where balances often have very short maturities, these estimates can be relatively low and capital requirements hence also relatively low.
An additional issue to consider is whether banks include language in their contracts that make the overdraft limits “unconditionally cancellable without prior notification of the borrower”. If this language is considered legally enforceable, banks are allowed to continue allocating a 0 per cent risk weight to unutilised commitments, thus maintaining the status quo.
A third aspect to consider is that of risk mitigation, i.e. the effect of reducing the effective exposure to a borrower through the use of collateral or other risk mitigating techniques.
Some commentators equate the practice of cash pooling to a practice of “on-balance-sheet netting”, which is one form of credit risk mitigation available under Basel II. They then argue that on-balance-sheet netting will become more difficult in future, as a large number of operational requirements are introduced, making the solution too expensive and hence making cash pooling products themselves potentially unattractive. In our opinion, these commentators are missing the point: on-balance sheet netting is actually introduced for the first time under Basel II as a potential means of risk mitigation, in addition to the more “traditional” pledge of cash collateral that was acceptable under Basel I. “Netting” under Basel I was limited to offsetting off-balance-sheet derivative exposures in cases where legally enforceable netting agreements existed.
Most – if not all – cash pooling solutions today use the pledge of deposits or cash collateral in order to be able to recognise the risk mitigation for the purposes of regulatory capital calculation. Basel II is unlikely to change this practice and the only impact on product pricing could therefore stem from an increase in operational requirements for using this type of collateral, which could increase operational costs in banks.
The operational requirements for cash collateral under Basel II do not appear any different from those required under Basel I, i.e. banks are required to ensure that their documentation is binding on all parties and legally enforceable in all relevant jurisdictions. Pledges used in current cash pooling arrangements will generally meet these requirements and Basel II should therefore not lead to additional administrative expenses.
Explicit capital requirements for operational risk are introduced for the first time under Basel II. Again, it is worth noting that the economic capital models of sophisticated banks will already incorporate operational risk and product pricing will therefore also already contain an element of remuneration for operational risk capital. The following observations thus apply only to those banks currently using regulatory capital as a basis for their pricing decisions.
Banks have a choice between three different methods for the calculation of operational risk capital. In the Basic Indicator Approach, operational risk capital is calculated as 15 per cent of gross income of the bank. The effect on cash pooling transactions will then depend on the cost allocation method used by the institution. The Standardised Approach fundamentally follows the same rules, i.e. it applies a multiplication factor to gross income; however, in this case the income of the business line is considered. Cash pooling services would most probably fall under the “payment and settlement” business line defined by Basel and thus receive a multiplier of 18 per cent of gross income for the calculation of operational risk capital.
Under the most advanced approaches, banks can use internal models to quantify operational risk. These models will be based on empirical loss data and an assessment of the controls framework of the bank’s processes. Operational risk capital will then depend on the frequency and magnitude of losses that could occur in a particular business activity. With respect to cash pooling, this should entail that notional pooling arrangements will attract lower operational risk capital charges than zero balancing, as the possibility for mistakes, system failures, and the like that could lead to operational losses are much higher in cases where a physical transfer of funds has to take place.
Considering the points above, we do not believe that Basel II will have a significant impact on the pricing – and hence the attractiveness – of cash pooling services offered by major commercial banks to their corporate customers. Sophisticated institutions will already be determining their product pricing on the basis of their own internal economic capital models and the change in regulatory capital requirements as a result of Basel II should therefore have minimal or no influence on their pricing decisions.
Where banks use regulatory capital as a key determinant of their product pricing, a potential impact exists; however, it is by no means certain which direction this impact will take. While the introduction of operational risk capital requirements could increase pricing, the increased risk sensitivity of the credit risk proposals will lead to lower credit risk capital requirements for higher quality borrowers to counterbalance this. In addition, the magnitude of the effect will depend on the relative importance of regulatory capital in the pricing decision vis-à-vis other determinants such as the competitive environment, market structures and customer demand.