Understanding a bank’s corporate debt management

How to cope with the effects of the Capital Requirements Directive IV

Understanding a bank’s corporate debt management

A lot has been written with regard to the introduction of Basel III, both in this magazine and in other media. The world is a different place, that’s a fact. We’ve learned that a more comprehensive insight into the implications of the Capital Requirements Directive is needed.

The impact of Basel III is threefold. Firstly, internal capital charges for banks increase and will be passed through to borrowers. Secondly, lending activities will be curtailed. And thirdly, bank resources will focus on top tier clients. Hedging activities will also be affected, as increases in internal costs are being passed through as a result of Credit Valuation Adjustments and re-margining obligations for the transaction counterparties. This will in particular affect lower rated companies and complex (hedging) transactions. A better understanding of the underlying current in our financial system will facilitate the dialogue between bank and client on the management of corporate debt.

Counterparty risk profiles

A company’s risk profile determines the pricing and capital allocation of its loans. The Risk Weighted Assets (RWA) is a combined banking measure of the risk profile of the counterparty, collateralization and loan maturity. Banks need to allocate more capital to assets with a higher RWA, which in turn increases pricing. Managing one’s risk profile is nothing new, but might increase in significance in the light of new regulation: it may prove beneficial to better manage receivables and reduce bad debt losses, increase collateral values and stabilize supply. Management of counterparty risk, both from a bank and corporate perspective, therefore becomes increasingly important.

Curtailment of lending activities

In recent years the availability of long-term credit has decreased, specifically in loans with a maturity over five years. This is confirmed by comparing the portion of long-term credit as a percentage of total credit outstanding (DNB). Exposure to default risk increases with the tenor of the underlying loans and, as a consequence of the Capital Requirements Directive (CRD) IV, retaining loans with long tenors has become economically unattractive for banks. Matched funding principles further strain the origination of long-term loans. The definition of leverage and funding ratios reduce the bank’s available balance sheet for extending credit in general. The good news is that the pace of disintermediation in the European market is slowly picking up as a substitution for bank loans (SocGen, ECB). It accelerated in particular after the fallout of Lehman Brothers in September 2008 and the subsequent financial and Eurozone crises, but it is not nearly at levels where it provides a substitute for the bank loan market.

Managing corporate debt and liquidity

The curtailment of lending activities will result in a different role for banks in finding suitable financing solutions given its abilities and restrictions. We will probably see credit facilities being split up and ‘specialty lending’ facilities being restructured. It will all boil down to reducing risk weighted exposures without affecting the availability of credit as much as possible. The corporate client increasingly needs an understanding of available debt instruments and their respective treatments under Basel III in order to find the optimal solution to finance the execution of the corporate strategy. Managing corporate debt can become increasingly complicated.

Management of relationships

Banking relationships are commonly managed using the ‘wallet’ approach. Credit commitment is weighted against the fees on services provided in corporate finance, cash management and transaction banking. This evaluation allows the ranking of the relationships and optimization of the wallet. This approach, however, doesn’t consider the capital allocation of each bank, against which the banks weigh fees when considering credit commitment. Again, an understanding of this process facilitates a dialogue with the bank. In a more comprehensive approach, Zanders developed the Wallet Adjusted Return On Capital (WAROC), a derivative of the bank’s Risk Adjusted Return On Capital (RAROC). With this metric one can measure the earnings of a bank on its services weighted against the capital allocation on its credit commitment. As such we measure economic profit of the net wallet earned against economic capital. This distinction makes it possible to differentiate more subtly and negotiate effectively banking relationships and wallets. In the new financial market environment, the dialogue between banks and corporate clients will take on new dimensions.