The new Basel III rules promise to significantly disrupt some of the flagship services offered by banks to their corporate customers under the heading of International Cash Management. Basel III will impact those services the most where the bank currently offsets credit and debit balances in its own books for the purposes of calculating credit and debit interest, regulatory capital, central bank liquidity reserves and deposit protection premia.
These products go under names like "Balance Netting", "Notional Pooling" and "Interest Optimisation", and basically coming down to a contract where the customer has numerous accounts at the "Pool Bank" in the names of different operating subsidiaries and divisions. The contract enables the bank to construe the credit balances as security for the debit balances, and to link the debit and credit balances for the purposes of the different calculations of capital, reserves and so on. Without that linkage the bank would have to make a charge on the customer regarding each account balance individually – and the very point of the product is that the bank charges based on Net balances, not Gross balances.
These arrangements will be upset firstly by Basel III Liquidity Coverage Ratio: banks will in future have to provision the gross credit balances with a certain proposition of High-Quality Liquid Assets (such as government bonds) unless the account is used as an operational account by the customer. The accounts generally fail the test of being operational. Since these services are offered by the bank out of one single banking location – and it is frequently London or Amsterdam – subsidiaries have to move their funds position into the "Pool Bank” in order to participate, which means moving out of their operational bank.
In other words a customer that is long of cash has to transfer its credit balance from its bank in its own country and into the "Pool Bank". A customer that is short of money is permitted to overdraw its account at the "Pool Bank" and send the proceeds to its bank in its own country to eliminate its overdraft there. By this means all the funds positions of all the participant entities are centralised at the "Pool Bank", and then pooled.
It is the customer's bank in its own country that holds the operational account. The only accounts in the "Pool Bank" that might count as operational accounts are the UK subsidiary's account if the pool is in London, or the Netherlands subsidiary's account if the pool is in Amsterdam. Because the credit balances in its books are not being held in "operational accounts", the Pool Bank cannot use 100% of the credit balances in the pool to fund the overdrafts in the pool. Instead it has to buy High-Quality Liquid Assets to the value of a proportion of the credit balances, leaving it needing to charge the customer for:
- the loss of yield on the High-Quality Liquid Assets compared to re-cycling the balances as loans to other subsidiaries of the same customer;
- the interest paid by the bank to borrow the amount it invested in High-Quality Liquid Assets, because the bank will be short of that amount of money when it comes to funding all the overdrafts in the pool.
The other aspect of Basel III that impacts these services is the introduction of a maximum leverage ratio for banks: the target ratio is 3% at least, and is arrived at by dividing the bank's "Capital Measure" by its "Exposure Measure". The "Capital Measure" is basically the bank's Tier 1 capital, so not including any mezzanine debt, subordinated debt or preference shares. The troublesome one is the "Exposure Measure".
The "Exposure Measure" is the total quantum of positions the bank has in its books that could result in a loss: on- and off-balance sheet. In particular it attacks these types of Cash Management product because:
- exposures are recorded at their nominal value, not their risk-weighted value. An overdraft secured on cash in the same currency might well be assigned a risk-weighted value of 2% of its nominal value. For Basel III Leverage it is assigned its full nominal value;
- exposures that have been netted must be recorded gross. The leading exponent "Pool Bank" nets out the customer's funds positions 100% in its own balance sheet because it does not allow any pool to have a net long or net short position: the customer must ensure that, at the end of each business day, the credit balances of one set of subsidiaries exactly match the debit balances of the remainder.
The leading exponent "Pool Bank" can thus permit the customer to insert an unlimited amount in credit balances as long as it takes the same amount out in debit balances. The bank only had capital of EUR332 million at the end of 2014 so, under Basel III Leverage, it could only allow an amount of 332 million divided by 3% = EUR11 billion to be the total aggregate amount in all pools it runs for all customers. It is understood that the equivalent amount today is a major multiple of that figure.
The leading exponent "ool Bank" will be hardest hit because its accounting and capital treatment of the service is the most aggressive going in, but as a class of products these "Balance Netting", "Notional Pooling" and "Interest Optimisation" ones will need considerable re-engineering in order to continue to deliver value to customers.
All change in the pool, then.
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