Pressure on compliance due to regulatory changes
Since the Enron scandal and the resulting introduction of Sarbanes Oxley (SOX), the pace of regulatory change has never lost momentum. On the back of the financial crises of 2008, more new regulations were introduced. The main objectives are to reduce (counterparty) risk and to increase (system) transparency. How can treasury use the necessary compliance process as an opportunity to increase corporate efficiency and reduce cost?
While the details of some new regulations are still being hammered out, a new wave of regulatory reforms is coming and the consequences will be substantial for corporate treasurers. New regulations have an effect on financial policies, processes and systems and finally might impact the financial results. For corporate treasuries, it can be quite a burden to comply with all imposed regulations; as well as the burden in terms of resources and systems, corporates are also facing non-compliance risk.
However, besides the onerous implementation process associated with new regulation, it can also be seen as an opportunity for treasury to evaluate current practices and improve efficiency, risk management and reduce costs.
To gain a clearer understanding, the new wave of regulations can be classified into four different categories: system transparency, accounting, tax and stability
The European Market Infrastructure Regulation (EMIR) is one of the regulations that aim to regulate the financial system, with the main objectives of reducing counterparty risk, reducing operational risk and increasing transparency. For corporate treasury, EMIR can have a substantial impact when using OTC derivatives to hedge financial exposures. European corporate treasuries should comply with new risk mitigation techniques existing of (1) timely confirmation, (2) portfolio reconciliation, (3) portfolio compression and (4) dispute resolution. Moreover when the threshold of EUR 3 billion derivatives contracts is exceeded, the derivatives contracts are obliged to be centrally cleared and daily mark-to-market (MtM) calculations are required. On the other side of the ocean, there is the Dodd-Frank regulation; the US equivalent of EMIR. The main difference between the two regulations are the reporting requirements.
While under Dodd-Frank, only banks have to report the derivative transaction, under EMIR both the bank and the corporate have to report the financial derivative transaction to the regulator. Next to EMIR and Dodd-Frank, the Markets in Financial Instruments Directive (MiFID II) aims to create a stable regulatory framework while mitigating the risk in the financial system. Besides derivative transactions, MiFID II also takes trade in other financial instruments (shares, bonds, etc.) into account. As a consequence, MiFID II will partly overlap with EMIR. The mentioned (upcoming) regulations all affect corporate treasury substantially because of the increased reporting burden on transactions in financial instruments, especially for those corporates using embedded derivatives and/or commodity derivatives.
The Single European Payment Area (SEPA) regulation creates uniformity in Credit Transfers and Direct Debits in the Eurozone and thereby also enhances transparency in the financial system. The implementation of the SEPA regulations is, or was, for most corporates, quite a struggle. However, on the other hand, SEPA has some huge opportunities regarding the corporates’ treasury operations. Corporates can migrate to one or two banks and potentially simplify their cash pool structures significantly.
Both in Europe (CRD IV, Basel III) and in the US (Bank Liquidity Rules) regulations are imposed on the banking sector, to reduce the systematic risk in the banking system by increasing the bank’s balances and reducing both liquidity as solvency risk. Consequences for corporate treasury can be significant. As banks are required to set aside more capital to lend money, lending volumes have dropped and prices have increased. One needs to have a sound understanding of the treatment of various financing options under Basel III in order to find theoptimal financing solution and to minimize the impact of Basel III. Basel III also imposes banks’ higher capital requirements for non-cleared OTC derivatives. The capital charge will depend on (1) the credit quality of the counterparty, (2) the characteristics of the transaction itself and (3) whether or not any collateral (through the ISDA CSA) or security has been provided. Also, other product offerings such as intraday credit facilities and notional pooling structures are notably affected by Basel III.
Beside the increased difficulty to (re-) finance the company, corporates are also exposed to stricter financial covenants. As a consequence, corporate treasury should have a clear overview of their different financial (debt) covenants and manage them carefully, as breaching covenants can be quite expensive. Regulators have also proposed additional regulations to money market funds (MMFs), which focus on reducing the risk of runs on MMFs as a way to reduce overall systemic risk in the financial sector. MMFs are often used by corporates with excess cash for investment, or indirectly to find short term funding by issuing commercial paper (which is purchased by MMFs).
The proposed regulations to MMFs are broadly based on three areas. Firstly, potentially moving from a constant net asset value (CNAV) model – in which NAV can be artificially maintained by an MMF sponsor – to a more variable net asset value (VNAV) model – in which the price will fluctuate according to the market value of the underlying assets – could possibly have adverse effects on the MMF sponsor. Secondly, to decrease this systematic risk created by MMFs, regulators propose a 3% capital buffer for CNAV MMFs. Another proposed change by the European regulators is to diminish the role of external credit ratings on MMFs, since a lot of emphasis has been placed on external credit ratings which consequently increase the risk of a run in the event of a downgrade or negative outlook.
Since 1 January 2013, IFRS 13 has increased the level of complexity in the valuation of the financial instruments that require fair value measurement. This standard requires incorporating in the market value two adjustments: CVA (credit value adjustment) and DVA (debit value adjustment). CVA is an adjustment that captures the credit risk of the counterparties. It represents the potential loss in case of default of your counterparty. The DVA is a little bit less intuitive; it is an adjustment that captures the credit risk of your own company. It represents the potential gain in case of default of the company. The CVA will reduce the asset position (loss) of a financial instrument and the DVA will reduce the liability position (gain) of a financial instrument. The main implication of this change is that treasury systems are not able to compute CVA and DVA values, which require companies to look at a complementary system or to take external advice. A second implication is on the hedge accounting. The effectiveness test compares the change in market value of the hedging instruments and the hedged items, the CVA and DVA adjustments will give some ineffectiveness (even for a perfect economical hedge) and potentially some P&L impact. To reduce this ineffectiveness, many companies are changing the test used from the dollar-offset method (comparison between two points in time) to a regression test (comparison on daily basis for the test period).
Expected in 2015, IFRS9 will significantly change the hedge accounting requirements. Below are some examples of the changes on the current proposal:
- the retrospective test with its 80%-125% boundaries will be abandoned for only prospective test
- changes in the hedge relation would not result in a de-designation but in rebalancing of the hedge ratio
- increase flexibility on how hedge effectiveness is demonstrated
To conclude; both the implemented and contemplated changes in the accounting treatment of derivatives will have an impact on the systems and processes within corporate treasuries.
The Foreign Account Tax Compliance Act (FATCA) may affect multinationals with an in-house bank. FATCA requires foreign financial institutions (nonUS) to report investments and bank accounts held by US individuals and entities. The aim of FATCA is to minimize tax evasion by US individuals or companies. The Foreign Bank Account Report (FBAR) requires US individuals and companies with authorization over any foreign investments and bank accounts, exceeding the threshold of $10,000 a year, to report this to the authorities. As a result it is crucial for corporate treasury to have a clear overview of the bank accounts (including their location) and authorization overviews.
Most of the new regulations have a significant and direct impact on corporate treasuries. Corporates will have an incentive to review existing practices, processes and systems and to review existing policies. Besides the reporting burden and the risk of non-compliance, the aforementioned regulations give rise to clear hedging strategies and appropriate documentation which enhances transparency. Corporates who act accordingly can generate real competitive advantages by having clear cut policies and processes in place where risks associated with financial instrument transactions can be monitored effectively. The same applies to short-term investment policies. The proposed MMF regulations and the impact of Basel III will probably change the relative attractiveness of the various short-term investment instruments for corporates and as a consequence not all investment instruments will be eligible under the existing investment policies.
The challenge for corporate treasuries is to have a good perspective when it comes to understanding the implications of any regulation. Not all regulations might have a direct impact on treasuries. It will be important to have an understanding of how regulations impact banks and financial institutions, in particular, and how these regulations have an effect on the services and products offered to corporates. By altering existing services and products or seeking alternatives, impact can potentially be minimized.