Seize the opportunities in regulatory reforms
There is no denying it: regulation is high on the political agenda. Hedge accounting revision, regulation of over-thecounter derivatives markets, Basel III; the mill is running and it would be wise for corporate treasurers to prepare accordingly. By planning ahead, treasurers can transform a mere necessity for compliance into a chance to further sophisticate their treasury organization.
Hedge accounting revision by IASB and FASB
IAS 39 and FAS 133, the standards that currently house hedge accounting rules, have left a distinct mark on the treasury profession. Companies that chose to apply hedge accounting had to adjust systems, internal procedures and sometimes even hedge strategies. Effectiveness requirements prompted treasurers to gather more timely and accurate exposure forecasts and to understand the risks in the business model and the risk components in the company’s products. Also under the revised regulation these are strong drivers for further sophistication of the treasury function.
Both preparers and users of the current standards have commented on the complexity and lack of connection to risk management practices. Hedge accounting is often seen as too costly and restrictive. Another point of criticism is the fundamental diff erence between IFRS and US GAAP, obscuring the comparability and transparency for users of financial statements. While revision is carried out as a joint project of the IASB and FASB, with one of the objectives being to converge the two standards, current proposals indicate that diff erences will only increase instead of disappear.
“By planning ahead, treasurers can transform a mere necessity for compliance into a chance to further sophisticate their treasury organization.”
Although the final versions are yet to be published, it seems the new standards will patch some of the main imperfections. However, also under the new rules, hedge accounting will still not be an easy matter. Effectiveness and disclosure requirements remain with especially the latter becoming more elaborate. There will be room for more complex hedge strategies, previously discarded because of unfavorable accounting treatment, which necessitates systems that can support execution and compliance.
Regulating over-the-counter derivatives
The perceived role of over-the-counter (OTC) derivatives in the financial crisis urged policy makers to regulate OTC markets. Covered by Dodd-Frank in the USA and EMIR in Europe, both directives:
- mandate trading on exchanges,
- mandate clearing through central counterparties (CCP),
- impose capital requirements,
- require that funds for margin and collateral be maintained in segregated client accounts, and
- command certain reporting provisions to improve transparency.
Exemption of mandatory clearing for corporate end-users, on a hedge-by-hedge basis and under very specific circumstances, is under consideration. Yet there is a big caveat if exemption is granted. Under Basel III the capital requirements for non-cleared trades are higher in order to cover higher counterparty risk. Banks are therefore likely to either push for clearing or charge considerably more for non-cleared derivatives.
In any case, costs in a regulated OTC market are a major concern for companies. Mandatory clearing and margin and collateral management will spawn fees for services provided. On the other hand, more transparency in pricing and narrower spreads might reduce the costs of derivatives. Cost of additional capital to meet margin and collateral requirements comes at a price. Assets that are deemed ‘acceptable collateral’ will become scarcer, in turn leading to further increases in their costs. Higher derivatives costs, higher working capital and extra resources to fulfi ll administration and reporting requirements could translate into less hedging by companies, choosing instead to monitor exposures more closely.
Further automation of the risk management function just to sustain an effective workfl ow seems inevitable. Systems should at least off er automated audit trails, documentation and disclosure reports, approved techniques for effectiveness testing and support margin and collateral management.
“Having a game plan ready will add to the robustness of not only the treasury department but to the organization as a whole”
Banks will face stricter capital requirements under the latest Basel rules, which will severely impact banks’ profi tability. This means bank credit will become more diffi cult to access and more expensive, especially for corporates with lower credit ratings. Simultaneously, interests on deposits are likely to decrease further since these will become a less attractive source of funding to banks. Thus, corporate treasurers have a strong incentive to look for alternative sources of funding and investment. For the bigger companies, this is also a chance to decrease bank dependency and spread counterparty risk.
Large corporate borrowers can raise equity or debt capital in public or private markets or find more effi cient ways to free cash available in the company. Small and medium sized companies and start-ups on the other hand, if cut off from bank lending, will rely heavily on the private market and will definitely face higher cost of capital. To increase yield on available funds, companies will turn to fi xed-term deposits instead of earning overnight rates. Of course, the prerequisite is that the treasurer has accurate cash fl ow forecasts available to be able to commit to longer-term deposits. Alternatively, companies might be willing to accept riskier investments in the pursuit of higher yields.
Meeting the challenge
With the current spotlight shining on regulatory reforms, corporate treasurers should use the changing landscape to their
advantage and plan ahead. Compliance requirements form a strong motivation to get budget approval for necessary system upgrades. Developments in derivatives and increasing hedge costs are an excellent opportunity to reassess the financial risks and redefine hedge strategies, policies and internal processes. With banks scrutinizing on profi tability of their clients, corporates can take a head start by actively monitoring and managing the allocation of business to various bank relationships.
Dealing with regulations and reforms is of course challenging. Nevertheless, having a game plan ready will add to the robustness of not only the treasury department but to the organization as a whole, thus once again demonstrating the merit of treasury to a company.