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Understanding the impact of new regulations on bank balance sheets will enable cash investors to most effectively segment and structure their portfolios
CONTRIBUTORS ANDREW LINTON
Basel III regulations redefine global standards for bank capital, liquidity and leverage, and will profoundly impact how banks manage their balance sheets. Liquidity investors need to understand how banks will treat deposits under the new rules. In this way, they can most effectively structure and segment their liquidity portfolios to gain the greatest benefit from the new rules and incentives, and maximize their investment returns.
Deposits deemed to be non-operating cash will be less attractive to banks than those categorized as operating cash. Though the precise definition of operating cash is not yet final, it will be stricter than previous standards. Deposits categorized as non-operating cash, such as wholesale funding from financial services corporations, will move off bank balance sheets into alternatives such as money market funds (MMFs), separately managed accounts (SMAs) and self-directed individual securities.
Though Basel III will not be completely implemented until 2019, in January 2014 European and U.S. banks started to report under the new regulations, and many large banks are choosing to follow the rules sooner than required.
A centerpiece of Basel III—widely described as a “game changer” in the way banks view their deposits—is the liquidity coverage ratio (LCR). It aims to ensure that a bank can meet its liquidity needs in a severe stress scenario. Specifically, the regulation looks to make certain that a bank holds a sufficient stock of unencumbered assets that can be converted into cash within a day, without a decrease in value, to meet all of the bank’s liquidity needs for a 30-day stress scenario. The ratio of high-quality liquid assets (HQLA) to a bank’s expected net cash outflows during this period must be greater than 100%.
Case studies of four liquidity investors—a distressed industrial company, an energy company, a hedge fund-of-funds and a large multi-service financial institution—illustrate how a bank would likely view their cash balances pre- and post-Basel III. The regulations will have a particular impact on financial institutions, an important contingent of liquidity investors.
Properly segmenting cash balances into operating and non-operating pools and making investments that maximize returns on both pools has never been more important. Liquidity investors should work with their banks to maximize their operating cash returns and with their investment managers to maximize their investment returns.
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Central bankers and securities regulators have long sought to strengthen stability and control systemic risk in the global financial system, through both national regulation and a succession of international agreements. This daunting mandate became far more urgent in the wake of the 2008 financial crisis. Dozens of laws and regulations, including the 2010 Dodd-Frank Act in the U.S. and the 2013 Capital Requirements Directive (CRD IV) in Europe, now address a wide range of systemic vulnerabilities. Central to the global effort is Basel III, the most recent—and far-reaching—of the Basel accords.
"Basel III redefines and extends standards for bank capital, liquidity and leverage."
Developed by the Basel Committee on Banking Supervision, an organization that brings together central bankers and other national financial regulators, Basel III redefines and extends standards for bank capital, liquidity and leverage. Like its predecessor accords, it aims to create a more resilient financial sector and ensure that banks can absorb the shocks of severe economic and financial stress.
Basel III’s impact on the banking industry—specifically its impact on the way banks manage their balance sheets—has only just begun to be felt. But it will be profound. Cash investors (including corporate treasurers, insurers, investment firms and hedge funds) need to understand how banks must treat their deposits under the new regulations. While Basel III will not be completely implemented until 2019, key regulations have already begun to take effect, and many large banks are choosing to follow the new rules sooner than required.
"Understanding the impact of Basel III on bank balance sheets will enable cash investors to structure their portfolios to gain the greatest advantage from the new rules and incentives."
Though approaches will vary, many liquidity investors will be compelled to keep at banks only those deposits that can be deemed operating cash. Deposits categorized as non-operating cash, such as wholesale funding from financial services corporations, will move into off-balance sheet alternatives such as money market funds, short-duration bond funds, separately managed accounts and individual securities. More recently, non-operational cash deposits have begun to exit banks and shift into off-balance sheet alternatives—moves that are expected to accelerate.
This PDF describes the history of the new Basel accord, analyzes the substance of the complicated regulations it has generated and explores how cash investors can most effectively manage their liquidity investments in this changed regulatory environment. To illustrate the choices and decisions cash investors will be making, we present case studies of four liquidity investors, describing their cash portfolios and examining how a large U.S. bank would view their funding under the new rules. Throughout, our analysis is based on the U.S. interpretation of Basel III standards. Though specific details will vary from country to country, the principles behind the new regulations will prevail across global jurisdictions.
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