The Financial Professionals Forum 2012
Banking Regulations
Ruth Wandhofer, Global Head of Regulatory & Market Strategy, Citi
Implications for Corporate Clients
The Financial Professionals Forum 2012
Table of Contents
1. Global Regulatory Environment 4
2. Basel III 9
3. OTC Derivatives Legislation 16
4. SEPA in Europe 21
5. Considerations for Corporate Treasurers 25
The Financial Professionals Forum 2012
Current Regulatory Environment: Global Reform Re-focus on global commitment and strong trend towards hands-on regulation
Market & Data Transparency
Financial Institution
Capitalization
Investor Protection
Global Approach & Response
NEW POLICIES / LEGISLATION Basel III and expected worldwide
legislative measures US Dodd-Frank Act European regulations
NEW AUTHORITIES / REG BODIES EU 3 new bodies: ESMA, EBA, EIOPA US Bureau of Consumer Financial
Protection, SEC Investor Advocate Office
INCREASING SAFETY OTC Derivatives Central Clearing CCP Interoperability EU ECB T2S securities settlement platform Hedge Fund legislation BCBS intraday liquidity reporting proposals
REVIEW OF WHOLESALE & RETAIL RULES Oversight of hedge funds Strict liability for custodians Investor and Depositor Compensation Schemes Consumer protection and enhanced payment
services conduct of business rules
FOCUS ON SYSTEMIC ASPECTS Minimum Liquidity Requirements Minimum Capital Requirements Limits on Proprietary Trading Enhanced Oversight of Systemically
Significant Firms Orderly Liquidation of Insolvent Firms
(Recovery & Resolution planning)
Greater Global
Cooperation - G20 -
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Elections timeline 2012
Finland
Russia
France
Czech Rep.
Slovenia
Lithuania
USA
Romania Portugal (tbc)
Malta (Mar)
Cyprus (Feb)
Germany (Sep)
Italy (Apr)
Mexico
India
China (Autumn)
South Korea
Greece
Iceland
Ireland (referendum)
Czech Rep. (tbc)
Bulgaria (tbc)
Netherlands (snap)
2013
Greece
Turkey
jan feb mar apr may jun jul aug sep oct nov dec
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Hot Topics on Treasurers’ Agendas Today Increased uncertainty and a wide range of possible economic, financial, and business outcomes are shaping Treasurers’ agendas
Managing the fallout from ongoing market crisis – Driving initiatives on bank counterparty risks, supply chain risks, commercial policy, and cash
management structures
Reassessing balance sheet structures – While high cash levels are a drag on b/s ratios, market events are highlighting need for strategic
approach to defining liquidity risks
Refining Emerging Market strategies – “EM dependence” is rising…Citi now expects fully 30% of 2012 global GDP growth to be generated
solely by China
Extending treasury role in working capital management – Continuing to work with businesses on procurement and customer terms, ROIC targets for initiatives,
sponsoring supply chain financing tools
Talent management for attracting and retaining people – A key imperative – and a challenge – to manage the business shift to EMs
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While Regulation Is Keeping Banks Busy… The financial services industry is busy implementing a host of new regulations
A few examples… – Basel III (Global) – Dodd-Frank (US) – FATCA (US) – Repeal of Regulation Q (US) – Financial Transaction Tax (EU) – MiFiD II (EU) – Solvency II (EU) – Securities Law Directive (EU) – Single Euro Payments Area
(EU)
– Independent Commission on Banking (UK)
– FSA liquidity regulation (UK) – CBRC new
capital adequacy ratios (China) – APRA accelerated Basel III
timeline (Australia) – And more
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Basel III introduces radical changes in capital rules and a one-size fits all set of liquidity ratios.
The Move to Basel III
4
Basel I: 1988 Basel II: 2005 Basel III: 2010
Established minimum Total Capital ratio
Simplistic credit-risk model focused on solvency risk
Prescribed risk-weights applied to counterparty categories
Standardized or VAR model for market risk added in 1996
Retained minimum capital requirement, but…
Enhanced sensitivity of credit risk measurement
Expanded scope of risks, including operational risk
Still primarily focused on solvency risk
Live in EU (2008) and many countries, exc. U.S. (thus far)
Significantly increases quality and quantity of capital
Adds new measures for liquidity and leverage
Differentiates global systemically important banks
Still a work in progress
To be phased-in over six years, starting 2013
Key Precepts
Important to keep in mind that Basel is a global initiative, with recommendations ratified by the G20 and affecting banks worldwide
The Financial Professionals Forum 2012
Basel III: in a nutshell
Liquidity coverage ratio – Banks have to examine likely net cash outflow over a 30-day period, and hold highly-liquid assets to
sell to meet such outflow – Some facilities and deposits are assumed to be more likely to be drawn/withdrawn
Net stable funding ratio – Same idea but this looks at stickiness of deposits – amount of stable funding must exceed amount
needed – Amount needed calculated by reference to assets and off-balance-sheet items
Leverage ratio – Crude comparison of capital and assets (no risk weighting here)
CCP clearing – G20 agenda – Requirement for collateral or capital – Banks’ exposures to CCPs cease to be zero-weighted
And – Inter-bank risk weights increase – Lending is more expensive than holding debt securities – Additional capital buffers e.g. “counter-cyclical”
5 areas of key changes proposed
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Basel III Negatively Impacts Trade Finance
Credit Risk
Single asset class for all corporate exposures does not reflect historical low risk from Trade – Stringent data requirements and historical lack of data for Internal Ratings Based approach has been an industry challenge.
ICC / ADB survey indicates overall default rate for Trade Finance of 0.022% and LGD of 40% from 2005 to 2009, but banks are unable to utilize this data.
– Despite low industry defaults most IRB ratings have increased capital for all but the most highly rated
Leverage Ratio
New non-risk based Leverage Ratio introduced to control excessive leverage, but universal Credit Conversion Factor (CCF) for all off-balance sheet exposures is not commensurate with the actual limited risk of highly documented, short-term and self-liquidating trade instruments – CCF was increased from 0%-50% to 100% for Trade increasing capital from 1.6% to 3% – Trade transactions are held off-balance sheet until processing is verified (more than 50% fail original submission) and because
many expire unutilized (86% of Guarantees and Standbys per ICC) – Triggered by genuine underlying economic activity and customer request not to create leverage
Liquidity New Liquidity measures (1) do not consider short term Trade instruments as liquid assets in Liquidity
Coverage Ratio calculations (i.e. in the numerator); but (2) include draws on off-balance sheet trade commitments in the calculations as an outflow (i.e. in the denominator)
Bank Exposure
1.25 asset value correlation (AVC) multiplier for key FI exposures (banks over $100 billion assets or unregulated FI) is not correlated with risk from LC advising/confirmation – Does not distinguish between types of FI exposures – Trade is short-term and self liquidating – Banks without USD liquidity typically have to borrow to support the USD denominated trade flows of their clients; multiplier will
significantly increase their cost and/or decrease Trade liquidity
One year floor on tenor for Trade LCs was just eliminated but other Trade related issues remain
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Basel III and Potential Impacts on Treasury Products 5 areas of key potential impacts
Liquidity facilities? More expensive for banks under LCR, LR in
particular Clearing and settlement arrangements affected
Liquidity coverage ratio treats facilities as fully drawn, so they must be covered by liquid assets
Syndicated credit facilities or capital market instruments? Debt instruments are “cheaper” than loans for
banks But loans have greater flexibility Expect non-bank participants in syndicates
Net stable funding ratio treats debt securities as more saleable Non-bank finance providers such as hedge funds won't have to comply with Basel III
Cash pooling? No Leverage Ratio relief for netting Commitment will involve cost for the bank
Use of cash cover does not benefit bank for LR Committed lines attract liquidity coverage requirement
Trade finance? Highly dependent on interbank credit Leverage Ratio – no risk weighting Also affected by liquidity metrics in relation to off-
balance-sheet risks
Interbank exposures have higher risk-weighting Under Basel 1/2 trade-related letters of credit get discounted (20% or 50%) risk-weightings – but no discounts for LR Liquidity coverage applies to guarantees and equivalents
Derivatives? Clearing obligation will involve collateral and
hence liquidity
Corporates without spare cash/securities may need margin liquidity facilities LCR and NSFR will apply, as well as un-weighted LR
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Basel III remains Work in Progress A high degree of uncertainty, from the formal implementation timeline to the practical aspects of implementation at the individual institution level
Uncertainties in finalization of Basel III…
• Global Systematically Important Banks (G-SIBs)
• Finalization and categorization into buckets
• Liquidity Ratios • Multi-year observation periods
and lack of clarity • Leverage Ratio
• Multi-year observation period and final ratio TBD
Key elements left to local supervisor discretion…
• Timing of implementation
• E.g., US regulators have not granted permission to any US bank to report under Basel II
• Local interpretations or adjustments
• E.g., tenor floor – local regulators can remove 1 year floor on tenor
• Countercyclical Capital Buffer • Trigger points and amounts –
local regulators can set additional buffers
• G-SIB surcharges
For banks, practical aspects may include…
• Reporting requirements
• Multi-year efforts may be necessary to build the technology infrastructure to meet reporting requirements
• Lack of reliable data • Until systems and processes are
perfected, reliance on sources such as existing financial reporting may not provide necessary granularity
• Assumptions made • Many assumptions have to be
made, e.g., in interpretation of definitions related to runoffs for LCR and NSFR
Industry groups are seeking clarification of definitions and to guide underlying assumptions (e.g. LCR/NSFR runoff factors, off-balance sheet conversion factors, tenor floor) which do not match actual
experience in the market
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Summary of Potential Impacts of Basel III on Corporates
The leverage ratio adds additional capital to high quality lending over the Basel II charge. This will effect good quality mortgage business and lending to high quality corporates, encouraging securitisation of mortgages and corporates to use public markets.
The LCR and NSFR regime treat corporate balances less favourably, which could result in lower remuneration on the deposit side as well as less willingness of certain banks to lend.
Overall the NSFR is considered to have a potentially significant impact on economic growth.
In relation to trade, the Loan Loss Reserves introduced already by Basel II continue to impact the cost of letters of credit (LCs) in particular where the seller has a low rating, leading to higher confirmation costs for LCs.
Tangible change is to be expected in the context of OTC derivatives trading due to the clearing requirement as well as the extra capital requirements for uncleared transactions.
Additionally, there is a second order cost effect stemming from the formal reporting requirement on trade repositories imposed by the new regulations; depending on the outcome this could also apply to intra-group transactions under the European legislation.
The Financial Professionals Forum 2012
OTC Derivatives Clearing: Where Is the Regulatory Pressure Coming From?
Short answer: the Lehman Default Problem with bilateral framework: – As shown in Lehman case, counterparties to swaps were unable to access or even recover collateral posted /
exiting trade positions needed to be replaced in dislocated trading conditions – Buy-side collateral management was done on spread sheets prepared by part-timers with limited derivatives
knowledge…
And…the market is systemically large! BIS estimate: notional amount of OTC derivatives outstanding in June 2010 was $583 trillion
Hence…In September 2009 the G-20 leaders agreed that:
“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non centrally cleared contracts should be subject to higher capital requirements”
• A Regulation proposal on OTC derivatives, central counterparties and trade repositories (‘EMIR’) was published by the EU Commission on 15th September 2010 & US Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Act also covers this area
Both (European and US) regulatory approaches set out new rules in relation to mandatory central counterparty (CCP) clearing and risk mitigation in respect of certain standardised OTC derivative contracts
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Requirements for non-financial entities
• Every OTC Derivatives trade, whether cleared or not, has to be reported to a trade repository.
• Non-financial entities are out of scope of the clearing requirement under the US legislation. In Europe they are also out of scope if their OTC Derivative activities fall under the threshold that ESMA will define (use of OTC Derivatives for the pure purpose of risk hedging exempted).
• A trade off between collateralization and capital charge has to be made.
• In July 2012 the BCBS and IOSCO issued a consultation paper that seeks to establish global minimum standards for margin requirements for non-centrally-cleared derivatives. The proposal is expected to create significant liquidity demands and substantially increase trading cost: 1) each derivative counterparty will have to post to the other the full amount of initial margin on a gross basis and 2) initial margin must be segregated and must not be re-hypothecated or re-used.
• A quantitative impact study is being conducted in parallel to the consultation and will hopefully provide further clarity.
The European OTC Derivative rules will also impact the corporate space.
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Collateral Management Considerations for Corporates
Challenges
Liquidity: Need to have sufficient eligible assets on hand to meet daily margin calls
Operational: Margin movements follow strict processes (e.g. ISDA CSA) and rely on daily valuation of open OTC positions
Documentation: Negotiation of necessary collateral agreements can be complex and time consuming
Benefits
Reduces Counterparty Risk: Exposure to counterparty insolvency is offset by collateral held
Frees up Credit Lines: Enabling other transactions
Broadens Scope of OTC Trade Types and Counterparties: Some trade types typically require collateralisation; lower-rated counterparties become acceptable
Supports Access to OTC Clearing: Collateral is a core requirement for use of OTC clearing
Reduces Cost of Trading: Regulatory capital and CVA charges from brokers can be reduced resulting in improved prices on trades
Liquidity and operational concerns deter most corporates from collateralizing their OTC derivatives. However the arrival of OTC legislation and Basel III will tip the scales in favor of CSAs for many entities.
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Checklist for Implementing Collateral Management
Establishing collateral management capabilities imposes significant additional burdens on corporate treasurers. However daily operational tasks are easily outsourced to a services provider.
Operations can be outsourced to service provider
CSA parameters administration
Daily collateral valuation, eligibility testing
Daily OTC valuation (mark-to-market)
OTC reconciliation
Margin call calculation and issuance to counterparties
Margin call agreement with counterparties and dispute management
Selection of assets and instruction of settlement
Proactive collateral substitution
Generation of daily reports an transaction data feeds
Obligations for Corporate Treasury Confirm exemption from EMIR for
parent and all subsidiaries and affiliates
Negotiate CSA agreements and/or OTC clearing agreements
Manage liquidity for collateral purposes
Maintain general ledger / record keeping
Operational aspects of daily CSA management
o Necessary systems and expertise available?
o How to forecast capacity requirements?
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SEPA in Europe: The original scope and objective
European Union (10 non-Euro) European Economic Area (3)
Switzerland and Monaco
European Union (17 Euro)
The Single Euro Payments Area currently spans 32 countries: – 27 EU Member States – 3 additional EEA Member States – Switzerland and Monaco
SEPA governs Euro payments only – Payments in other currencies are not impacted
SEPA is for payments within this geographical area – Payments to/from Europe are not impacted
SEPA will impact domestic + cross-border Euro credit transfers and direct debits
– No distinction between ‘national’ and ‘cross-border’ Euro payments within the 32 countries
Standardised Schemes for CT and DD – Mandatory use of BIC and IBAN – Single legal framework: Payment Services Directive
SEPA addresses non-urgent / retail / ACH payments – Urgent / same-day Euro Wire Transfers are already
integrated across the Single Market
SEPA is trying to complete the Single Market for Euro Payments in Europe
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Long-sought certainty for market participants – current migration for SEPA Credit Transfers at 22%, SEPA Direct Debits at 0.45%
Single end date for both SEPA CT and SEPA DD in Euro Member States
For non-Euro Member States the corresponding end date is 31 October 2016
Most countries Euro Member States expected to work towards Feb 2014 timeline. – Some might choose to migrate earlier; none have announced such decision currently
By end date indicates SEPA CT and DD will have to be executed in accordance with a set of prescribed “technical requirements” to be SEPA Compliant
1st February 2014
SEPA Regulatory Update : Implications of End Date Legislation
1 Feb 2014
1. Migration end-date for SEPA CT and SEPA DD in Euro Member States
2. End-date for grandfathering existing DD mandates to SEPA DD Core 3. Use of ISO 20022 XML standard when initiating and receiving SEPA
transactions; Member States have the option to defer to 1 Feb 2016. 4. Interoperability requirement for payment schemes in Euro Member
States 5. Elimination of the obligation for users to provide the BIC for national
payments, where necessary – Note: Member States have the option to defer application to 1 Feb 2016
1 Feb 2016
1. Elimination of the obligation for users to provide the BIC for cross-border payments
2. Expire of transitional arrangements for so called “niche products”
3. Expiry of transitional arrangements for one-off direct debits used at merchants (e.g. Germany’s ELV)
4. Expiry of Member State option to allow banks to provide conversion services from BBAN to IBAN.
5. Removal of settlement-based national reporting for balance of payment statistics (such as Central Bank Reporting)
31 Oct 2016
1. Migration end-date for SEPA CT and SEPA DD in non-Euro Member States 2. Reachability for SEPA CT and SEPA DD in non-Euro Member States 3. Interoperability requirement for payment schemes in non-Euro Member
States
1 Feb 2017
1. Prohibition of per-transaction Multilateral Interchange Fees for national DDs
1 Nov 2012
1. Prohibition of per-transaction Multilateral Interchange Fees for cross-border DD
Citi played a leading role in the EU-level negotiations and development of industry guidance as chair of European Bank Federation’s (EBF’s) Payment Regulatory Expert Group (PREG)
Immediately
1. Reachability for SEPA credit transfers and SEPA DD in Euro Member States
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Given the many ambiguous points in the Regulation the European Banking Federation (EBF) Payments Regulatory Expert Group, chaired by Citi, has drafted industry guidance, which can be found under the following link on the website of the European Payments Council: www.europeanpaymentscouncil.eu/knowledge_bank_detail.cfm?documents_id=580
Key clarifications include:
Bank readiness of ISO 2002 XML payment processing capability – conversion is not permitted after 2014
The big BIC issue: in a very late addition to the text the EU institutions politically felt that customers should not be required to provide the BIC for national transactions from 2014 and for cross-border transactions from 2016. BIC is a key necessity in terms of payment routing. At global level, BICs will remain a requirement. Corporates should continue focusing on both IBAN and BIC – liability of bank for payment executed via IBAN only is limited / not covered by this Regulation.
Customers using files for payments should initiate/receive in ISO 20022 XML – slight ambiguity in terms of what this really means. It was clarified with the Commission that banks can provide relevant conversion/mapping solutions to client to facilitate connectivity to SEPA (see SEPA guidance).
The potential prolonged co-existence of ‘niche schemes’ (only needing to be announced by Feb 2013) will mean that local clearing systems will continue operating with legacy standards in this space – complexity/cost.
The lifting of the EUR 50,000 limit with regard to pricing parity under Regulation 924/2009 will apply from date of entry into force of this Regulation (31 March 2012). Positive for users.
In terms of banks and customers located outside of SEPA, we clarified with the Commission that these can still benefit from SEPA payments if appropriate solutions are being used via SEPA compliant banks.
Key Challenges with the SEPA Regulation European industry guidance and collaboration will support clarifications
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Evaluate options to free trapped cash
Tap into local knowledge and expertise in growth markets
Integrate treasury processes
Leverage technology to drive efficiency and de-risk processes
Develop firm-wide view of exposures
Implement policies and governance framework to monitor compliance
De-risk supply chain
Centralize decision-making
Plan ahead
Adjusting to Greater Global Complexity The role of the Treasurer has been re-defined as a strategic partner and “gatekeeper” of the balance sheet
Acting as gatekeeper of the balance sheet
Addressing treasury and funding implications of internal processes, policies and capital actions
Identifying appropriate level of liquidity to support operations vs. strategic cash available for investment and expansion
Extracting value from working capital / supply chain financing options to create in-house liquidity
Rationalize account structures, processes and technology
Centralize treasury operations and services, extend best practices
Release cash from working capital cycle
Improve cash forecasting
High proportion of expansion into EM countries and currencies; increasing importance of managing currency risk
Restrictive regulatory and operational environments
Proliferation of systems and data formats; insufficient global visibility into positions
Aggregating critical information for real-time decision support
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Strategic Focus – Optimizing Capital Allocation & Funding Structure
Key Challenges – Increasing Complexity
Maximize Cash Efficiency Improve Risk Management Manage Growth
efficiency, renewable energy & mitigation
In January 2007, Citi released a Climate Change Position Statement, the first US financial institution to do so. As a sustainability leader in the financial sector, Citi has taken concrete steps to address this important issue of climate change by: (a) targeting $50 billion over 10 years to address global climate change: includes significant increases in investment and financing of alternative energy, clean technology, and other carbon-emission reduction activities; (b) committing to reduce GHG emissions of all Citi owned and leased properties around the world by 10% by 2011; (c) purchasing more than 52,000 MWh of green (carbon neutral) power for our operations in 2006; (d) creating Sustainable Development Investments (SDI) that makes private equity investments in renewable energy and clean technologies; (e) providing lending and investing services to clients for renewable energy development and projects; (f) producing equity research related to climate issues that helps to inform investors on risks and opportunities associated with the issue; and (g) engaging with a broad range of stakeholders on the issue of climate change to help advance understanding and solutions.
Citi works with its clients in greenhouse gas intensive industries to evaluate emerging risks from climate change and, where appropriate, to mitigate those risks.
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