The Untold Story: Financial Regulation and Corporate Treasury Collide
Across the globe, financial regulators have grossly
overreached over the past five years and are plowing ahead to see who can get
the latest, and toughest, financial regulation announced and implemented first.
It’s a worldwide phenomenon, led by the US and the European Union (EU). Banks
are the primary target, but the impact is already flowing through directly to
bank clients and corporate treasurers are particularly vulnerable.
Contrast this free-for-all with a laboratory experiment. In a scientific
experiment, you deliberately change one variable at a time and hold all the
others constant so you can measure the effects of changing that one variable.
The regulators are experimenting by changing all the variables at once. It’s a
mob rush into uncharted territory, meaning that the results will be anything
but scientific and definitely not controlled.
During 2010, as
Dodd-Frank was making its way through the US Congress, treasurers felt like
spectators in the Coliseum watching the lions devour the bankers. Now they are
about to discover that the lions are making their way into the stands.
A proposed Securities and Exchange Commission (SEC) regulation on money
market funds (MMFs) would require them to float their net asset values (NAVs)
up to four decimal places instead of pegging them to US$1 a share, creating
daily gains and losses and an accounting and recordkeeping Y2K-type nightmare
for treasury investors. The treasury side of compliance will be costly. A study
commissioned by the US Chamber of Commerce and conducted by Treasury Strategies
found that the cost of re-engineering treasury operations to comply with this
one money fund regulation would be an aggregate US$2bn for implementation and
an operating cost increase of US$2.5bn.
Regulators enforcing
Dodd-Frank in the US are moving to require banks to ring-fence their
proprietary trading, to isolate it from their trading on behalf of clients such
as corporate treasurers. A similar measure already has been adopted in the UK.
However, that bright line is imaginary. In reality, all trading is a stew, and
a bank’s proprietary trade may be the counterparty side of making an
operational risk management trade for a treasury. The likely effect of such a
regulation is that banks will cut back or even exit targeted trading, depriving
treasurers of vital risk management tools. JPMorgan Chase was recently fined
just under US$700m for alleged violations in trading electricity futures, a
market that some treasurers use. Such punishments will surely make vulnerable
trading less attractive.
The Impact of Basel III
The Basel III capital adequacy regime, phasing in through 2019, poses a
double threat. More bank capital will be required. Banks will have to raise
substantial amounts of new capital or, more likely, shrink their balance sheets
to achieve the required ratios. Smaller balance sheets mean less lending, a
direct threat to treasurers who rely on bank funding. At the same time Basel
III also introduces liquidity regulation that hits the deposit side of the
bank. Banks will be required to maintain a percentage of ‘stable deposits’.
Under one proposed formula, retail deposits would count as 75% stable,
commercial deposits as 50% stable and interbank deposits as completely
unstable. Banks would naturally favour consumer deposits over corporate
deposits under this scenario. If corporate lending is curtailed and corporate
deposits devalued, treasurers will certainly feel the tsunami.
Massive intervention by central banks in Japan, the US and the EU may have
prevented the worst of the Great Recession, but they have saddled cash-rich
treasurers with an asset that can’t earn any kind of return without taking on
excessive risk. More seriously, they have left financial executives flying
blind when they make long-term capital investment decisions. The value of an
investment is its long-term return over the true cost of capital, but in a
highly manipulated market, the true cost of capital is unknowable. In free
markets, the signals are crisp, clear and immediate. In manipulated markets,
the signals are fogged in. Is a capital expansion with a return of 10% a good
investment? It is if the cost of capital is 1%, but not if the cost of capital
is 12%. When you can’t determine the true cost of capital, you simply can’t
make informed decisions. Therefore, you do not invest. Period.
Loose
monetary policy is distorting the market. Banks’ current robust earnings and
high share prices are due in no small part to the plentiful, almost free money
they get from the extensive quantitative easing (QE) by the central banks. If
you start with low-cost money, you’re bound to make a profit.
That
support has already lasted for nearly five years and the Federal Reserve,
European Central Bank (ECB) and Bank of Japan (BoJ) are under great pressure to
continue it, but the policy will have to end sometime. The end of that
intervention, together with the impact in increased regulation, will force
banks to make tough decisions that will, in turn, require treasurers to make
their own hard choices.
A Changed Environment
All this regulation will play havoc with established relationships. In
the new, super-regulated world, traditional ties may count for less and
products may be highly segmented. It will be important for treasurers to know
not only that the bank puts a high value on their relationship, but that the
particular products and services on which treasury most depends are products
and services that the bank has chosen to emphasise. In a very real sense,
extensive prescriptive regulation outlaws the foundation of relationship
banking. We’re moving into a frightening new world of ‘compliance banking’.
Unlike an earthquake, the approach of a tsunami can be tracked, and
treasurers have time to find higher ground. Many already have invested in
treasury technology to dramatically improve their real-time visibility of a
host of critical factors that a decade ago they had to wait days or weeks to
ascertain. Faster and more reliable intelligence about internal cash flows,
market developments and counterparty status will be invaluable in the days
ahead. Technology won’t solve the core problem, but it will give treasurers
better information to deal with it.
Treasurers can also recognise a
new need to build and manage a portfolio of vendor partners, beyond their
traditional banks. They willl need alternatives, not just to shift business
quickly if a provider seems to be on the brink of failure but to compensate for
business decisions by providers to enter or exit certain activities and product
lines in view of changing regulatory costs. The growing regulation burden seems
likely to impose a high tax on comprehensive providers that have moved, in the
period of deregulation, to become ‘one-stop shops’ to accommodate a host of
treasury needs. The new reality may be more like a return to the markets of 25
years ago, as financial institutions apply a very sharp pencil to calculating
where they can meet their profitability targets and then specialise with
precision. It could take half a dozen providers to give treasurers what they
can get from one or two today.
Markets are dynamic and demand will
be supplied, just not necessarily from the same providers in the same packages
for the same prices. Alert treasurers will be more inclined to visit unfamiliar
trade show booths, take cold calls and talk with peers to spot emerging
providers who may be less constrained by regulation or better able to tolerate
it.
Finally, treasurers also can recognise that they are directly
impacted by decisions made by politicians and regulators and work to influence
those decisions. Through trade associations, treasurers have effectively
lobbied to prevent collateral requirements for over-the-counter (OTC)
derivatives, at least for the time being. However, the influence would be even
greater if treasurers themselves would call on their regulators and legislators
worldwide. The problem is that most politically-savvy corporations focus on
regulations that threaten their core businesses, not their treasury efficiency.
Treasurers may have to show some initiative to protect their profession.
Broad, sustained government intervention in the economy has introduced
market manipulation that distorts financial activity. Now potentially toxic
regulations are on drawing boards. One unintended casualty would be rational,
effective treasury management. Only involved treasurers may be able to point
this out and salvage the value they add to the financial health of their
companies – and ultimately the health of the global economy. The tsunami is
coming, and time is getting short.