DEMYSTIFYING THE REGULATORY LANDSCAPE BASEL III / ACCOUNTING Johann Kruger CA (SA), CFA IFRS and Financial Risk Management Consultant Lloyds Bank Corporate Markets 11 th November 2011
The Changing Regulatory Environment Basel 2. 5 (2011) and Basel III (2013) OTC derivatives, EMIR (2012/13) Volcker Rule & Swaps push-out Securitisation controls: ‘skin in the game’ Mi. FID II, Retail Distribution Review Solvency II Source: Oliver Wyman STRICTLY PRIVATE AND CONFIDENTIAL
BASEL III & BANK CAPITAL STRICTLY PRIVATE AND CONFIDENTIAL
Basel Committee Background Basel Committee for Banking Supervision Functions • Basel Committee provides a forum for regular cooperation on banking supervisory matters. • Over recent years, it has developed increasingly into a standard-setting body on all aspects of banking supervision. Membership • Senior officials responsible for banking supervision or financial stability issues in • Central banks, and Authorities with formal responsibility for the prudential supervision of banking business where this is not the central bank (e. g. FSA in the UK). Chairman • Stefan Ingves, President of the Netherlands Sveriges Riksbank. Secretariat • Secretary General: Stefan Walter, supported by a staff of 14. Source: Bank for International Settlements web site http: //www. bis. org/about/factbcbs. htm STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – Committee Member Countries • Argentina • Korea • Australia • Luxembourg • Belgium • Mexico • Brazil • Netherlands • Canada • Russia • China • Saudi Arabia • France • Singapore • Germany • South Africa • Hong Kong SAR • Spain • India • Sweden • Indonesia • Switzerland • Italy • Turkey • Japan • United Kingdom • United States Source: Bank for International Settlements web site http: //www. bis. org/about/factbcbs. htm STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – Sub-Committees • Standards Implementation Group • Policy Development Group • Accounting Task Force • Basel Consultative Group Source: Bank for International Settlements web site http: //www. bis. org/about/factbcbs. htm STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – Brief Summary Capital requirements • Quality of capital • definition – 14 criteria – mainly focusing on loss-absorbency • proportion of common equity – from 3. 5% to 4. 5% by 2015 • Increase in % of capital – more for SIFIs • RWA measurement STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – Brief Summary Liquidity and leverage • Liquidity coverage ratio (Minimum std by 2015) • Net Stable Funding ratio (Minimum std by 2018) So what? • Net effect: higher cost of doing business – not necessarily offset by lower cost of capital • Impact of Solvency II on insurers: higher capital charge for holding equities and bank paper • Impact of pension fund de-risking: lower demand for bank equities; higher demand for debt securities Basel III are only guidelines, local regulators may enforce higher requirements However, draft EU legislation limits potential for higher requirements than Basel III STRICTLY PRIVATE AND CONFIDENTIAL
Phased Implementation – Market Response • Phased regulatory transition is likely to be overtaken by market considerations • Analysts and the market already differentiate the sector on a pro forma Basel III basis • This will drive early implementation of measures to respond to new requirements STRICTLY PRIVATE AND CONFIDENTIAL
EBA Announcement : 26 October 2011 Term funding guarantee scheme • Banks’ access to term funding (ECB focuses on short term funding) • EU Commission, ECB, EIB to “urgently explore options for achieving this objective” New capital requirements • 9% CET minimum • After deducting MTM on sovereign debt as at 30 September 2011 • Note the French 10 yr yield was 2. 6% on 30 September, but is now above 3% • Banks to submit plans by 2011 • Banks to meet requirement by 30 June 2012 • EBA estimates circa € 106 bn required • Issues • Lack of investor appetite for bank shares • Significant shrinkage of bank balance sheets, possibly contributing to recession STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – What Impact For Derivatives Pricing? Key variables impacting the extent of the increase in RWA requirement in relation to “unexpected losses” • Counterparty credit quality • Maturity • Expected exposure (market movements and funding position) • Type of instrument (Rates / FX / Commodities) * Based on latest Basel Proposals (latest publication in June 2011) and, subject to change as the regulations are finalised for the EU and the Netherlands, and depending on expected exposure assumptions STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – What Impact For Derivatives Pricing? Overall increase in charges at typically 2 x*, but could be several times for long dated credit intensive trades AA to A counterparties • typically single digit basis points* on regular vanilla interest rate instruments and • double digit increases in costs for XCCY swaps and commodity hedges BB to BBB counterparties • low double digit basis points* on vanilla interest rate instruments and • possibly large double digit increases in costs for XCCY swaps and commodity hedges General Increase in Capital Requirements Phased in From 2013 Increase in RWA for OTC Derivatives: Big Bang Effect on 1 Jan 2013 – inc Existing P’folio * Based on latest Basel Proposals (latest publication in June 2011) and, subject to change as the regulations are finalised for the EU and the Netherlands, and depending on expected exposure assumptions STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – What Impact For Derivatives Pricing? Our calculations show the following effect on some standard transactions in terms of multiples applied to credit spreads: A BBB BB Aggressive Conservative Receive fixed GBP, pay floating GBP 5 yr 1. 6 x 2. 3 x 1. 4 x 1. 7 x 1. 4 x 2. 3 x Receive fixed GBP, pay floating GBP 10 yr Receive Fixed GBP, pay Fixed USD 5 yr XCCY 2. 4 x 3. 0 x 1. 8 x 2. 1 x 2. 0 x 2. 5 x 1. 8 x 2. 3 x 1. 4 x 1. 7 x 1. 5 x 1. 8 x Receive Fixed GBP, pay Fixed USD 10 yr XCCY 2. 5 x 2. 8 x 1. 9 x 2. 1 x 2. 3 x Receive Fixed GBP, pay Floating USD 10 yr XCCY 2. 4 x 2. 8 x 1. 8 x 2. 0 x 2. 3 x FX Fwd 1 yr 100 m Buy USD, sell GBP 1. 8 x 1. 3 x For example, we recently looked at a 20 -year cross currency swap for a good credit (single A) and the running cost was calculated as 50 basis points. * Based on latest Basel Proposals (latest publication in June 2011) and, subject to change as the regulations are finalised for the UK, and depending on expected exposure assumptions STRICTLY PRIVATE AND CONFIDENTIAL
What then shall we do? (1) Unintended consequences • • • Costs for corporate hedgers could be prohibitive – especially accessing foreign capital markets Posting collateral and exposure to unacceptable levels of cash flow risk – putting the real economy at risk Discouraging hedging by corporates, who represent less than 15% of the market volume What then shall we do? • Cease to hedge • Greater use of natural hedges • Greater use of purchased options • Credit breaks • Deal with ignorant banks/Do as much as possible hedging while the market is behind the curve • If all else fails, collateralise or clear centrally (if possible) • Lobby the Basel Committee in relation to OCT derivatives used to manage corporate risk STRICTLY PRIVATE AND CONFIDENTIAL
What then shall we do? (2) More Efficient Use of Capital by Banks • RWA reporting • Collateral management • Counterparty risk exposure management Product mix/innovation • Caps/ Swaptions /LLS • Margin funding • Collateral transformation • Synthetic margin swaps • Borrow from the capital markets (insurance companies; pension funds) • Securitisations: ratings for derivatives (especially useful if super-senior) STRICTLY PRIVATE AND CONFIDENTIAL
Basel III – Recent Developments • Basel guidance incorporated into proposed regulation and directive (CRD IV) • Main capital requirements, including CVA RWA on OTC derivatives included as regulation – therefore NO flexibility at national level • Any lobbying by corporates must now be directed towards the European process and timing is critical – CVA RWA is of particular concern • Countercyclical buffer requirement included as directive • Increasing media attention to conflicting requirements of Solvency II and Basel III , i. e. • requirement for more capital and longer dated funding for banks vs • higher capital charges for such instruments on insurance company balance sheets • Australia to adopt 2 years early • China to require higher than Basel III minimum for its banks STRICTLY PRIVATE AND CONFIDENTIAL
ACCOUNTING STRICTLY PRIVATE AND CONFIDENTIAL
IFRS for SMEs • 74 jurisdictions have either adopted the IFRS or stated a plan to adopt within three years • In Europe, reception has been cool • Adopted: Bosnia; Macedonia • Available for use: Switzerland • Planned: UK, Ireland • Others are studying it • Netherlands: no plans to adopt *Excluding charities and small companies as defined in company law, current proposed requirement is for years beginning on/after 1 July 2013. STRICTLY PRIVATE AND CONFIDENTIAL
IFRS 9 – Finally a principles based standard IFRS 9: Overhaul of Financial Instruments Accounting (including derivatives) • IAS 39 replacement – why? • Three phases • Classification • General hedge accounting model + portfolio hedging of interest rate risk • Impairment • Convergence STRICTLY PRIVATE AND CONFIDENTIAL
IFRS 9 – Finally a principles based standard The good news • 80: 125 corridor disappears • Retrospective test disappears – continue to recognise all ineffectiveness • Hedge accounting for option time value • Rebalancing allowed • Component hedging for non-financial items • Derivative on derivative rule (NIH; interest rate hedging) • Alignment with true risk management process STRICTLY PRIVATE AND CONFIDENTIAL
IFRS 9 – Finally a principles based standard The bad news • Voluntary de-designation possibly prohibited • Delays • EU endorsement process STRICTLY PRIVATE AND CONFIDENTIAL
Option time value behaviour – P&L behaviour Example: USD Revenue – buy GBP call vs. cylinder (add sold GBP put) Which causes most volatility? Time value behaviour at inception in relation to spot movement (assume static vega and theta) Gain If vega increases = expansion of peak/trough As time passes (for constant vega) = contraction of peak/trough Put strike (sold) A 0 B Loss Call strike (bought) X-axis: GBPUSD FX rate Potential volatility of the call: A Potential volatility of the cylinder: A+B STRICTLY PRIVATE AND CONFIDENTIAL
Accounting – Current Issues • IFRS 13: Fair Value Measurement • Single standard • Similar to FAS 157 (and text currently in IAS 39 AG) • Credit valuation adjustments for corporates • IFRS 10, 11, 12: Consolidation, joint arrangements, disclosures of interests in other entities • IAS 19: Post employment benefits STRICTLY PRIVATE AND CONFIDENTIAL
Accounting – Current Issues • Exposure draft: Capitalisation of operating leases • Increase in net debt • Earlier recognition of expenses • Impact on service contract • Increased disclosures • Onerous systems requirements Exposure draft: Accounting for insurance activities • IFRS and US GAAP conversion STRICTLY PRIVATE AND CONFIDENTIAL
Strategic Financial Reporting Issues The analysis of financial reporting policies among FTSE 100 companies shows that they use non-IFRS profit numbers extensively to communicate performance to shareholders FTSE 100 Financial Reporting Policies (% of total companies surveyed) 1 Financial reporting policy % that use non-IFRS profit measures to communicate performance to shareholders 79% % that adjust for non-cash volatility from IAS 39 53% % that present the information on the face of the Income Statement 40% Results by accounting firm 2 BDO Stoy Hayward (1) 0% Deloitte (19) Ernst & Young (12) 83% 44% 58% 33% KPMG (17) 77% 46% Pw. C (31) 57% 84% Data gathered from a sampling of 80 FTSE 100 non-financial corporates; Data as of December 2010 based on latest published annual reports STRICTLY PRIVATE AND CONFIDENTIAL
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