One of the key differences between Basel III and the other Basel versions before it is the concept of liquidity management.

Bruce C. Lynn

Bruce C. Lynn

Under Basel III, banks must maintain certain levels of high- quality assets (government securities, for example) to offset the probability that a bank will experience “significant” cash outflows (of deposits, for instance) over a 30-day period, outflows which could jeopardizing its financial existence. While maintaining more high-quality assets can enhance the stability of a bank, the need for more assets means a bank will need to maintain or acquire expensive capital, potentially decreasing a bank’s overall profitability (its return on assets or equity).

To offset potential costs, some banks may choose to pass on costs to their customers. This “valuation decision” can depend on the level of a customer’s deposit balances and purpose. For example, funds on deposit by companies kept for “operational purposes” are more valuable to a bank because these deposits are considered more stable than “nonoperational” or “excess” deposits. A more stable deposit base means banks need to worry less and keep lower levels of high-quality assets. Opinion_Bug7

Those new Basel rules may affect certain current international practices, like the one associated with pooling deposit balances across various corporate entities.

“Cash pooling” is the practice of treating disparate cash balances as one single balance across many currencies, legal entities, and banks to recognize lower net interest expense, lower FX exposures, and, sometimes, lower transaction costs. But the use of cash pooling can obfuscate the purpose of those balances, making it harder for banks to understand what levels are operational and which ones are excess. Blurring a deposit’s purpose could subject a bank to potential costs.

As a result, both banks and corporates will be forced to periodically review questions about what is a best use for that “useless” (nonoperational) cash on deposit if both parties are to get the best value out of their banking relationships.

Corporations will also need to place a premium on answering the question “How much liquidity is enough?”

Companies that forecast the answer to that question correctly will still find pooling to be desirable, since the level of their deposits can be directly related to their operational needs. Also, pooling is a good way to consolidate nonfunctional currency balances and reduce market risk for corporates. Since currency pooling provides foreign exchange trading and other opportunities for banks, its use will continue even if at lower activity levels.

Corporations that keep “excess” deposits at their banks may find pooling becoming too expensive, since excess deposits could be considered “nonoperational” under Basel III. If so, then these excess deposits could subject the banks to extra costs by forcing them to hold high quality assets as collateral. The more assets they hold the more expensive capital they must maintain.

A corporation that uses a netting service may find it advantageous to combine transaction netting with pooling at one bank during the settlement of the netting process, since deposit levels maintained would be more related to operational needs.

Banks and corporates will need to do a better job of communicating the purposes behind holding respective future deposit levels.

Today most companies undertake formal bank reviews infrequently, say, one to two times a year. As a result, forecasting deposit levels or setting targets is usually not on the agenda. Quarterly or more frequent reviews may become the order of the day. Here are some review hints:

  • Corporates should set deposit levels based on business activity and communicate that target to the bank to insure the bank doesn’t “inadvertently” allocate extra costs to a relationship.
    • Banks should specifically ask corporates for their deposit targets, short and long term. While all corporates calculate their cash position, most do not do so against a key target if recent AFP and PWC surveys are to be believed. If corporates do not understand their excess needs then how will a bank know?
  • If there are extra costs leveled by a bank to a company’s relationship considering the bank’s desired return on assets, growth in revenues, or its risk profile, for example, then the company should ask the reasons for those extra costs during a review. It is even possible that companies may decide to disburse this excess cash (deposits) to investors (in the form of dividends or stock buybacks, perhaps) to avoid banking costs. They could even pay down debt with this excess cash. Yet, at the end of the day, companies will need to keep some level of cash at their banks, rather than buried in the corporate backyard.The bottom line is that corporations will need to do a better job of matching sources and uses of funds. That will be especially so if, post-investor-payout, there is less cash left over for operations. Banks can reduce their costs by seeking better deposit-level planning in conjunction with their corporate customers.As result of Basel III, corporations will also need to answer the question “How much risk is too much”? Companies subjected to extra charges could opt to spend down, use the extra cash (see above), or even move their relationships to another, more friendly bank.Spending could take the form of investing in some interest-earning assets that transform excess demand deposits into investments with stated maturities. Companies could even decide to acquire other companies, a great way of spending down excess cash while earning returns far in excess of what a CD could generate.

    But no good deed goes unpunished. Deposits at that one or more friendly bank(s) could be associated with greater counter-party risk putting principal at risk. Could the also lead to higher administrative costs to monitor more cash at more banks?

    Investing in interest earning assets could subject the principal to market risk as interest rates rise. Need to rewrite investment policies?

    Bidding wars for acquisitions can use up a lot of cash quickly while the returns are years away. Investors may not be pleased too over pay for “bad” acquisitions.

    Finally, risk comes in many forms. A company with “too many” bank accounts may find itself spending too much time just trying to answer basic questions like “Its 9 a.m. Where in the world is my cash?” The operational risk is that treasury cannot watch everything all the time and could suffer “random” penalties because it may have excess cash.

    The Bottom Line

    CFOs and treasurers need to reduce the complexity of the company’s banking network and align it more closely with their companies’ operational needs. Corporates will need to model and focus more on the value of their banking relationships, something few treasuries do well. Not many treasurers, for instance, can fully answer questions about how much did their companies pay a specific bank last year on a global basis, considering credit, cash management, FX, credit card, fiduciary, and trade-finance services.

    Finally, an issue both banks and corporates will need to face is how to measure the impact of the regulations on a relationship-by-relationship basis. Today, banks are still struggling to look at the impact of Basel III on an enterprise level, but they have individual customer profitability systems. On the corporate side, few possess or make full use of their treasury management systems to model bank-relationship values.

    Based on my experiences, the banks have the lead in this “know thy need” battle. After all, banks are in the liquidity and risk business, while corporations are in the business of selling widgets. The good news is that there’s still time for both sides to update their relationship tools and targets since the regulations will take years to become fully operational.

    Bruce C. Lynn is a managing partner at Financial Executives Consulting Group.

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One response to “Why Basel III Matters”

  1. Compliance with capital adequacy norm has assumed critical importance for Indian Banks. According to a research conducted for 70 banks of 30 countries by self and two students, circa 88% of their revenue is dependent on earnings from lent assets, as against world average of 72% and the lowest 53% in USA and Canada, with Europe at 69%.
    Till such time Indian Banks earn substantial income from other services, they have no other option with demonic presence of NPAs. Our sample survey also revealed that predominant dependence on interest income is also there in banks of other Asian countries and Australia. One may read our research paper in the November, 2014 issue of The Indian Banker magazine

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