New terms for a marriage of convenience

Impact of Basel III on corporate banking relationship

New terms for a marriage of convenience

While Basel III may restore the health of the financial markets and the banking industry in the long run, it will also have an impact on the real economy and business in the mean time. The economic impact of Basel III is often mentioned, but seldom analyzed in detail. This article assesses the potential impact of Basel III on companies and outlines some options that corporate treasurers and bankers can explore in order to minimize the effects.

Unfortunately Basel II was not able to prevent the near meltdown of the financial markets in 2008. The Basel Committee on Banking Supervision (BCBS) responded to the weaknesses in the financial system uncovered by the crisis with a new and improved Basel III framework on capital and liquidity for the banking industry. By 2019, possibly after some modifi cations, Basel III will be incorporated in the national legislations and the regulatory frameworks of most (if not all) western economies.

The new Basel III framework not only increases capital requirements for banks, it also introduces stricter rules regarding ratios. First of all, Basel III restricts the instruments that can be classifi ed as capital and makes the capital requirements even more risk weighted than its predecessors. It also makes them countercyclical, urging banks to reserve more capital in prosperous times depending on their risk strategies. Furthermore, Basel III introduces new ratios such as the Net Stable Funding (NSFR) and the Liquidity Coverage (LCR).

Zombie banks?

Deleveraging bank balance sheets may well be in the long-term interest of a healthy and confi dent financial industry and general economy. Cheap and abundant credit in the past decade might be the root cause of the 2008 financial crisis and the current recession. Corporate treasurers and CFOs will have already noticed that the risk sensitivity of banks is curtailing funding for otherwise healthy business plans. To the extent that bankers are still extending their institutions’ balance sheet to clients, funding has become even more expensive. Basel III increases the price of credit for a long time to come. Graph 1 on credit spreads indicates that irrespective of credit standing, all companies are confronted with higher spreads. Lower rated companies however are confronted with substantially wider credit spreads than their better-rated peers. The contraction in the credit industry is discouraging investments and real economic activity. In this sense, Basel III could prolong the recession and present the bill for cleaning up to the real economy.

With credit becoming a less attractive profi t engine, banks will divert their focus to fee-earning businesses such as cash and transaction management. Banks began to realize the importance of transactional services, which necessitate daily interaction with clients, as well as being a stable revenue source. Moreso than before 2008, banks are now pushing clients for additional fee business as a trade-off for credit.

The corporate response

As bank credit becomes more expensive and scarce in the run up to Basel III, lower-rated and non-rated companies, which are predominantly dependent on bank credit, will suff er more compared to higher-rated companies that have access to other non-bank sources of funding as well. Corporates should diversify their funding and explore alternatives to bank funding. Alternatives such as private placements or the capital markets will become more attractive to medium and smaller-sized corporates. It can be expected that private placement (PP) markets such as the US PP market and the German Schuldschein market will become deeper as it will provide access to a diversifi ed investor base. In case of bank funding, corporates will have to be keen on the structure of credit facilities. The impact of the tenor of the facility and the pricing thereof is signifi cant. For corporates with a lower credit standing, providing tangible collateral can signifi cantly reduce the loss given default (LGD) of a facility and hence improve the pricing. Also, unused commitment will become more expensive, especially for facilities that will be marked as liquidity facilities under Basel III.

Supply chain finance, with or without bank intermediation can also off er access to an alternative and cheaper source of funding for parties in the supply chain to fulfi ll their short-term funding needs. Analysis of public financial data indicates that companies on average require 87 days’ worth of sales in working capital funding of which 42 are taken from suppliers. Since 2008, banks promote alternative solutions such as vendor financing and more fl exible trade credit terms instead of their own balance sheet. These alternative solutions are based on leveraging the credit rating diff erences between trading partners and the surplus liquidity of companies. Although the same public data suggests that working capital funding has not signifi cantly changed since 2007, a break down by rating reveals that better rated companies did invest in trade credit, whereas lower rated companies have unlocked cash by depleting their inventory and taking credit (see fi gure 2). [FIGURE] Figure 2: explaining changes in cash conversion cycle 2007 – 2011 Explanation of abbreviations: DPO: Days Payables Outstanding, DIO: Days Inventory Outstanding, DSO: Days Sales Outstanding, CCC: Cash Conversion Cycle = DIO + DPO + DSO The investment in working capital by better rated companies is by no means altruistic. Investing in customers and suppliers can create higher returns at an acceptable risk when compared to depositing in a bank. Off ering reverse factoring schemes to suppliers and more fl exible trade credit terms to customers secures production and sales while increasing profi t by adding interest income or gross margin to the P&L. Furthermore, vendor financing schemes bond the relationship between trading partners.

Active working capital management: more of the same?

During the next few years, with financial markets and banks in depression, active working capital management will become key to business success. Better rated companies are well positioned to leverage their credit standing and put their amassed liquidity balances to use. While their revenue has increased by 15% since 2007, the cash they report increased by 80% in the same period. This liquidity could be used for debt repayment, but could also be used profi tably to strategically support the business. Figure 3: Cash accumulation 2007-2011 Active working capital management can secure (strategic) business relations and increase profi tability, but at the same time requires investment in processes, information and credit management. An active working capital management strategy requires convergence of sales, procurement and finance. It also requires a convergence of information on order, invoice and settlement across the value chain – inside and outside the company. It will also put e-invoicing on the agenda again. E-invoicing not only promises process effi ciency, but it can also be leveraged as a trigger for funding, discounting and could also be used as representation of collateral. Treasury can play a pivotal role in developing best practices in active working capital management, because its key value drivers are time value of money and credit risk management. Banks that are investing in transactional banking might find a niche by developing products and services to exchange transactional information in a secure and reliable way among all actors in the value chain.

Risk management

Basel III also demonstrates that active management of the (implied) credit rating, especially for corporates with a lower credit standing, will pay off . Given the current exponential relationship between credit rating and the price of credit, a slightly better creditworthiness can signifi cantly lower the cost of credit. Through sound financial risk management and solid cash forecasting, corporate treasurers will not only stabilize cash fl ows and reduce the company’s risk profi le. They will also be able to reduce the need for stand-by committed credit facilities that act as a cushion for liquidity risk. For those corporates that do not have a credit rating it will become important to have an understanding of how a bank perceives their credit risk and also to make sure that banks perceive it correctly. Another eff ect of Basel III on corporate risk management will be the higher capital charges for banks on counterparty risk on OTC derivatives, which will likely refl ect in the pricing (for more information see Jaco Boere’s column on OTC derivative reform on page 19).This will particularly aff ect lower rated counterparties and the longer-dated deals. Corporates should reconsider their current hedging programs in relation to these developments. As most corporates currently trade on an uncollateralized basis, collateralization could be an option, although the companies that will probably feel the pain most of all don’t have the available liquidity, or only at a high price. Other measures that can be taken are the inclusion of break clauses in CSA (ISDA credit support annex) or by changing the way corporate risks are hedged.

Corporate cash and liquidity management

Cash concentration structures deployed by corporates such as notional pooling and zero balancing (ZBA) will be aff ected by Basel III as well. Currently notional cash pooling is a popular structure for concentrating cash and optimizing interest across bank accounts. As the conditions that allow the netting of credit and debit cash balances become stricter, the feasibility of notional pooling for banks will become more diffi cult. Also the LCR will have an unevenly negative impact on notional pooling compared to ZBA. This can make ZBA the preferred solution for liquidity management. Corporate short-term investments will also be aff ected by Basel III. In relation to the LCR and the NSFR, a short-term corporate bank deposit, depending on the conditions, is typically considered as a less stable type of funding for a bank and will have a lower weighting compared to other sources of funding. Therefore, short-term corporate deposits are likely to be less attractive to banks under Basel III than they have previously been.

Conclusions

We are now on the road towards Basel III but there is still uncertainty about the regulation’s consequences and how banks will respond to it. It is likely that banks will at least partially pass the additional costs in credit and derivative pricing on to the real economy to preserve the same level of returns, although one can also argue that Basel III will change and reduce the risk profi le of a bank and that banks therefore may suffi ce with lower returns. It will change the corporate borrowing landscape as well as the corporate-to-bank relationship. The impact may be severe in Europe as traditionally banks play a more dominant role in funding corporates in Europe compared to the US. Bank relations will be more driven by credit as it becomes scarcer. Before banks will utilize their balance sheet for sure they will assess the client relationship for risk adjusted return and reciprocity. This brings credit and transaction businesses of banks again closer together. For corporates it is important to understand and quantify their total banking wallet, how these products impact the capital that will have to be allocated by banks in relation to Basel III and how to distribute it among the relationship banks.

The disintermediation of banks in providing credit will force corporates to diversify funding sources. The capital markets, private placements and asset-backed funding can fi ll this gap for some corporates, but the real economy itself can also take over this role especially for small and mid-sized corporates. Active working capital management and supply chain financing can provide interesting financing opportunities as an alternative to standard bank financing. Corporates should be keen on their position from a financial and credit standing point of view, relative to other parties in the supply chain. Given the current diff erentials in cost of credit and the introduction of Basel III, diff erences in creditworthiness provide opportunities for all parties in the supply chain. Corporates should diversify their funding and explore alternatives to bank funding Active working capital management will become key to business success.