Treasury and Trade Solutions

Basel III: Rethinking the Correspondent Banking Model

2 Treasury and Trade Solutions

LCR include an expansion in the range of assets eligible as HQLA and some refinements to the assumed inflow and outflow rates to better reflect actual experience in times of stress.

Once the LCR has been fully implemented, its 100% threshold will be a minimum requirement in normal times. During a period of stress, banks would be expected to use their pool of liquid assets, thereby temporarily falling below the minimum requirement. The Governors and Heads of Supervision agreed that the LCR should be subject to phase-in arrangements which align with those that apply to the Basel III capital adequacy requirements.

The LCR will be phased in from 1 January 2015, with an initial minimum threshold requirement of 60%, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019. The Basel Committee hopes the graduated approach will ensure introduction of the LCR will not disrupt the banking system or the financing of economic activity.

The LCR is a short-term liquidity measure and is accompanied in the Basel III liquidity rules by the Net Stable Funding Ratio (NSFR), which is a long-term measure designed to determine the minimum amount of stable funding over a one year time horizon. It aims to promote structural funding changes towards more stable, longer-term funding.

Combined, these rules will have an impact on deposit pricing, particularly for financial institutions, says Ahearn. “The requirements of Basel III for capital mean there will be a shortage of liquidity as a result.”

Basel III: Rethinking the Correspondent Banking Model

A fundamental change in the trade business has begun that will have dramatic ramifications for financial institutions. With the revised Liquidity Coverage Ratio (LCR) – part of the wider Basel III reforms – now defined, a clearer picture has emerged of the obligations required by financial regulators.

“The implications of the Basel III reforms are still rolling through the industry,” says John Ahearn, Global Head of Trade, Treasury and Trade Solutions at Citi. “Many banks are trying to work out their positions. From a trade point of view, we think it will have a dramatic impact and will force financial institutions to reassess their trade businesses.”

Liquidity Coverage Ratio DefinedThe LCR is one of the Basel Committee’s key reforms to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. It is designed to promote the short-term resilience of a bank’s liquidity risk profile by ensuring that a bank has an adequate stock of unencumbered high-quality liquid assets (HQLA). These assets must be able to be converted into cash easily and immediately in private markets to meet an individual institution’s liquidity needs for a 30- calendar-day liquidity stress scenario.

Recent revisions to the LCR, which was first published in December 2010, incorporate amendments to the definition of HQLA and net cash outflows. A revised timetable for phase-in of the standard and additional text to give effect to the Committee’s intention for the stock of liquid assets to be used in times of stress were also made. The changes to the definition of the

Full implementation of Basel III will have a significant impact on banks’ trade businesses. Aggregation and securitization could be the key to success.

John Ahearn

Global Head of Trade Citi’s Treasury and Trade Solutions

Sameer Sehgal

Head of Trade, Europe, Middle East and Africa Citi’s Treasury and Trade Solutions

3Rethinking the Correspondent Banking Model

These three elements combined are putting pressure on many FIs in the trade business, says Ahearn. “Put together, the top ten banks have a market share of 27% of the trade business. There are very few banks outside the top ten that have more than a 1% global share. Full implementation of Basel will raise required pricing and will make certain types of transactions impractical. The Basel III capital rules are making it more difficult for banks to compete in this sector, especially those banks without operational scale and global networks.”

“The changes in store, thanks to LCR and Basel, are clearly revolutionary in the banking industry and for the trade business. While a few top, global banks have an active distribution desk, asset optimization is an important discipline; not only to manage credit and sovereign risk, but also LCR and HQLA which is clearly radical and alien to a great deal of banks,” says Sameer Sehgal, Trade Head for Europe, Middle East and Africa at Citi. “The industry will therefore need a concerted focus to address this key regulatory requirement. For starters, it might mean banks with serious trade aspirations will be required to develop distribution capabilities of their own. It might also mean on a parallel basis, seeking advisory support from the more established trade banks on their experience and best practices so as to expedite their respective learning curves,” says Sehgal.

There is potential for some banks, such as Citi, to realign their models and become an asset servicer in the trade business. Such a model would be similar to that of the credit card business, says Ahearn. From an early, fragmented model, aggregators emerged followed by an asset securitization model.

“Today most credit cards are securitized and off balance sheet of FIs. We think the same thing will happen in the trade business. We are entering the point of aggregation, and we are looking at ways to do the securitization. Supply chain finance assets have the potential to be a brand new asset class, similar to commercial paper that is off balance sheet.” At present, institutional investors do not fully understand the concept, but recently in the US, the National

Elements of Change There are three elements of Basel III that are driving change, says Ahearn. First is capital, the requirements for which have increased for a variety of banks. However, to the industry’s surprise, the cost of the capital has not yet been priced through to the trade asset side of the business, he says. But while the requirements for capital have increased for a variety of banks, this has not yet been priced through to the asset side of the business.

Next is liquidity, where dramatic changes are not occurring. “We are now in the most liquid environment we have been in; central banks are pumping liquidity into the market in the US, Europe and Japan. Yet, particularly for the US dollar, banks are pricing extremely high. It is not uncommon to see Libor plus 25bp or 50bp on the liability side of the market.” Again, this has not been translated through to the asset side, but Ahearn believes it will. “There is a large disconnect in many markets where the next interest margin spread is as thin as 20-25bp. That is not a sustainable model and the cost of liquidity will have to start being priced through.”

Many banks may not be able to meet their LCR requirements because many FI deposits may not qualify. “Citi believes there is a high likelihood that correspondent banking models will change as a result. Traditionally, banks have put assets on their balance sheet to protect their cash management and deposit business. But if those liabilities that they are protecting have no value under LCR there will be dramatic ramifications in the near term. Liquidity may be the driver of a spike in pricing on the trade side of the book.”

The final element of Basel III that is driving change is the leverage ratio framework. This is designed to restrict the build-up of leverage in the banking sector to avoid destabilizing deleveraging processes that could damage the wider financial system and economy and to reinforce risk-based requirements with a non-risk-based “backstop” measure. Implementation of the ratio began on 1 January this year with bank-level reporting to financial supervisors of the leverage ratio and its components. Public disclosure will begin from 1 January 2015. “Most banks are now working on their leverage ratio, but many will fall outside the requirement, particularly those whose asset growth has been curtailed.”

With the revised Liquidity Coverage Ratio (LCR) – part of the wider Basel III reforms – now defined, a clearer picture has emerged of the obligations required by financial regulators.

4 Treasury and Trade Solutions

“A number of banks have already approached Citi regarding opportunities to partner in this space,” says Sameer Sehgal. “These banks are smaller in size and scope, but understand that the global Trade industry is moving toward market consolidation. Within a few years’ time, they acknowledge that a select group of major trade banks will not only be the processing engine for all trade banks globally, but also help address the balance sheet and liquidity needs of the trade industry,” says Sehgal.

The current trade business models as they exist today cannot continue for long, warns Ahearn. As Basel III changes the business model for correspondent banking, institutions will need not only very robust back office processing and reporting capabilities but also sufficient capital and liquidity. Only a handful of players globally have those capabilities, says Ahearn.

Association of Insurance Commissioners undertook an exercise to prove supply chain finance assets could be an investible asset class.

Ahearn says banks that want to continue to play in the trade business should gear their operations towards becoming a market consolidator as well as an asset manager, repackaging assets to institutional investors.

“Certain banks will have to make a decision about whether they remain in the trade business. If you have less than a 1% share of the business, it makes sense to consider whether to partner with another institution that has the capital and liquidity necessary to help serve corporate customers,” says Ahearn.

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“The requirements of Basel III for capital mean there will be a shortage of liquidity as a result.”