Risk 25: How Basel III is turning borders into barriers

Increasing prices on cross-currency swaps as a result of Basel III’s credit value adjustment charge are making it harder for companies to issue bonds overseas – this is just one example of the fragmentation of global capital markets

Globalisation has produced some powerful icons – the golden arches of McDonalds glowing in more than 100 countries, the Asian and European car plants clustered in Mexico and the southern states of the US, and the US-invented iPhone assembled in China from components made in a host of other countries. But underpinning these developments is a less visible force – the global capital markets that give companies the ability to issue foreign currency bonds and swap the proceeds back into domestic funding, or raise money at home and convert it into foreign currency liabilities. Cross-currency swaps provide that flexibility, but they are now facing severe strain, and companies are having to adapt as a result.

Prior to 2008, banks would typically charge about 10 basis points to execute a 10-year US dollar/sterling cross-currency swap, says the treasurer at one UK company. By June last year, the average cost had tripled to 30bp. Now, he says the same swap incurs charges that range from 45bp to 65bp. If the cost increases further, the treasurer says his firm may stop using the product.

Others already have. Two large companies with a global presence say they are now relying more on natural hedges, borrowing in countries where they have local assets rather than tapping international markets and then converting the liability. Others are likely to lean more heavily on their domestic debt market. But in each case, the outcome is the same: a deglobalisation of corporate funding, which market participants say will hit smaller companies and emerging markets the hardest.

“At the funding level, this forces a re-nationalisation of markets,” says Gaël de Boissard, London-based co-head of global securities at Credit Suisse. “It’s a significant U-turn from where the world has been going for the past 20 to 30 years.”

Prices are rising as a result of the increased capital burden – in part, because of the incoming Basel III rules tightening the definition of capital and insisting on higher adequacy ratios, meaning the industry needs more equity than in the past – but that pressure applies to every business. For cross-currency swaps, particularly those with corporate customers, the big issue is the credit value adjustment (CVA) charge that is due to come into force from the start of 2013 (Risk October 2011, pages 36–38).

If Basel III comes in and the impact on us is even worse than it is now, I envisage using cross-currency swaps would become very, very expensive for us or maybe even impossible – Pedro Madeira, BAA Airports

CVA capital is held to cover the risk that a derivatives counterparty will default while the bank is in-the-money, and can be calculated in two ways – the standardised approach or the advanced approach, with the latter used by most dealers. Under the advanced approach, the charge is determined by a regulator-approved formula, driven by the counterparty’s credit default swap (CDS) spread and the size of the exposure.

Cross-currency swaps are particularly susceptible to CVA because the exposure is determined by interest rate and foreign exchange movements, making it potentially more volatile, especially if at least one of the currencies involved is unstable.

The product involves the exchange of principal in two different currencies, with each counterparty paying interest in the currency of the principal received. Each interest rate leg can be fixed or floating but, as the foreign exchange rate evolves over the life of the deal, either counterparty could find itself losing money. For example, in the case of a company that has transacted a US dollar/euro cross-currency swap to convert a US dollar bond issue into a euro liability, and is paying a fixed rate in euros while receiving a fixed rate in dollars, a weakening dollar would leave the company out-of-the-money and its dealer with counterparty exposure.

As they are often used to hedge bond or loan issuance, the swaps contracts can be long-dated, giving the exposure more room to grow. None of that would be a particular problem if the trade was collateralised – Basel III allows banks to offset received collateral against CVA exposure – but corporate hedgers rarely post collateral, which leads to another problem. Banks will typically hedge client swaps in the interbank market, so the dealer ends up with back-to-back trades that have different collateral treatments. When the dealer is in-the-money on the client transaction, it will be out-of-the-money on the interbank trade, so it will not be receiving collateral from the corporate but will have to post it to its bank counterparty. This results in funding costs that are also passed along to the client (Risk February 2011, pages 18–22).

“We are reacting to the changing landscape, and our pricing reflects both CVA and future capital charges that Basel III would require from us,” says James Bindler, global head of foreign exchange options at Citi in London.

Antoine Miribel, London-based head of CVA trading for global finance and foreign exchange at Deutsche Bank, says something similar. “If a deal is more than a year or two long, we definitely take a look at what the CVA capital charge – or rather profit hurdle – is going to be. That increases the price of the trade.”

That’s an understatement. One European bank agreed to provide prices under different scenarios for two real-life trades with similarly rated clients – one a corporate with a single-A rating that was swapping a notional $100 million for euros, and one a corporate rated A- that was swapping a notional $100 million for Korean won. Both trades had a tenor of seven years. Under the outgoing Basel II rules, the euro/US dollar swap would cost 5.2bp running. That leaps more than three-fold to 18bp under Basel III. The Korean won/US dollar swap would cost 5.8bp running under Basel II and 20.7bp under Basel III (see table A).

Collateralisation brings the cost down sharply – to 1.6bp and 2.3bp, respectively – under Basel III.

But the actual cost passed on to the customer depends on a number of factors: the bank’s return targets, its funding costs, how an individual trade affects the net CVA exposure across a client’s existing book of business, and whether a bank is willing to take ancillary business into consideration (Risk May 2010, pages 26–28). The latter has become decisive for many of the top-tier dealers, says Pedro Madeira, assistant treasurer at BAA Airports.

“We have two or three dealers that still do cross-currency swaps and see it as remunerative on its own. They are usually Australian, Canadian and Japanese banks. They are highly rated with low capital charges. Most of the UK, US and European banks now need other business attached to the swap as a kind of package deal to make it worth their while,” he says.

Bank of Montreal and National Australia Bank say they are pricing cross-currency swaps in line with Basel III. Regardless, companies say it pays to shop around. “There are some banks that are clearly pricing themselves out of the market. We’ll tease them, saying: ‘We notice you are already pricing according to Basel VI, so we’ll deal with someone who is more attractive’,” says the treasurer of a large automotive company.

BAA’s Madeira strikes a more serious note. “If Basel III comes in and the impact on us is even worse than it is now, I envisage using cross-currency swaps would become very, very expensive for us or maybe even impossible.”

There are ways corporates can mitigate these costs using shorter-dated swaps, adding break clauses or agreeing to collateralise, but each requires the company to take on additional risk in some way. The great hope for companies in the European Union is an exemption from the CVA capital charge, which is up for debate as Europe tries to finalise the fourth Capital Requirements Directive, the legislative vehicle for Basel III. But banks are already hiking their prices, and some are avoiding riskier swaps altogether (Risk July 2012, page 10 and Risk July 2012, pages 24–27).

In some cases, this means cross-currency swaps transacted by companies in emerging markets – the additional currency volatility on those trades, along with potentially increased counterparty risk and the absence of CDS markets, means local companies will have to rely on domestic markets instead. “In emerging markets, a corporate would typically issue in dollars and swap it back to its local currency. But going forward, there will have to be more local currency issuance because the swaps will be so much more expensive,” says the global head of emerging markets trading at one European bank.

Credit Suisse’s de Boissard believes the same will happen elsewhere as well. “If a foreign company – for example, an Australian company – wants to issue in Swiss francs, it’s incredibly difficult to do that cross-currency swap. It’s a product that becomes prohibitively costly in terms of capital usage under Basel III. Effectively, it means if you are an Australian company, then you should issue in Australian dollars. If you want to issue in Swiss francs instead, the cross-currency swap is going to cost a fortune,” he says.

Relying on domestic markets raises some obvious problems. First, issuers in smaller currencies may not find enough demand to meet their financing needs. Second, concentrating risk in one currency makes the company vulnerable to local turmoil. For example, the US capital markets were generally open to everyone throughout 2011 – even if at a steep premium – while the sterling and euro markets were completely closed for large parts of the year, says BAA’s Madeira. This is something that worries him. “We are UK-heavy, but we have to diversify. We can’t depend on the UK investor base because we would saturate it, and it is too risky to depend on a single market. But we are left with how to cope with ever-increasing swap pricing,” he says.

Worries about concentration risk are less significant in deeper markets such as the euro or US dollar. Many US companies, even some multinationals, issue purely in US dollars and use cross-currency swaps to synthetically create local funding. But this practice is also being affected.

The treasurer at the large automotive company says it relied heavily on the euro market to fund its global operations for a long time. “If you do that in billions, the increased cost can be quite burdensome,” he says. As a result, the company has begun issuing more in local markets including South Africa, Mexico and Thailand. This reduces the company’s need to use cross-currency swaps to convert euro liabilities into debts denominated in other currencies, and the company’s local assets in the country provide a natural hedge. If the currency appreciates, resulting in a larger debt relative to the euro, it also means the company’s assets in that country will gain in value. “We have the ability to do that because we have financial services entities in more than 40 countries,” the treasurer says.

Other companies are also turning to natural hedges. “A lot of the time, we would want to keep funding raised in the currency of issuance. For example, we have a bond in South African rand, but since we have a lot of earnings in rand, it makes sense to maintain some rand debt,” says Tom Gilliam, senior analyst at the brewer SABMiller.

Although this may develop local markets in new corners of the globe, it is still deglobalisation – it means local operations are issuing local debt, rather than a global hub taking care of financing needs, and available liquidity ends up trapped within each country rather than being moved to where it is needed, says the European bank’s emerging markets head.

This is not the only way issuers are trying to work around the problem of ballooning cross-currency hedging costs. Break clauses – options within contracts that allow one or both counterparties to terminate the contract at specific points – are being promoted as a solution by some dealers, which argue the ability to terminate a swap early means they should not have to hold capital to cover the full duration of the trade. The Basel Committee on Banking Supervision has been silent on the matter, causing some dealers to worry about the appropriate treatment, but other dealers say the clauses are being used more frequently (Risk March 2012, pages 14–18).

“We are seeing more and more of them. They help us handicap the way we calculate the capital requirements on the deal, so we can treat an eight-year deal like a five-year deal,” says Sandra Bailey, head of northern Europe corporate forex at Deutsche Bank.

The problem is a break clause would probably only be exercised if the company’s creditworthiness had deteriorated, meaning treasurers would find themselves needing to replace a hedge at exactly the point when it would be most expensive, and when the company could least afford to pay up.

As an alternative, some companies say they have reduced the tenor of their swaps over the past 12 months or so – few go beyond five years and banks say even that would be expensive for most companies. “As a general observation, the market has less credit capacity to go out to five years on any trade of that sort, and the companies we have dealt with – in particular, the weaker credits – are depending on shorter-dated strategies. They’re having to reduce the tenor instead of going out five years or even three years,” says Bailey.

Another option is to sign a credit support annex (CSA) – the contract that governs bilateral collateral posting. It has helped keep hedging costs down at National Grid, one of the few non-financial derivatives users to have a CSA in place. “We haven’t had to change the way we use cross-currency swaps and that’s because we have CSAs in place. We have noticed a higher charge under the same agreement, but the incremental cost with a CSA between a five- and 10-year cross-currency swap is very small,” says George Karalis, manager of capital markets treasury at the company.

But others are reluctant to make the move, often for fear of the resulting liquidity risk – the possibility that, if the company’s derivatives portfolio moved a long way out-of-the-money, it could exhaust its stock of spare collateral, forcing it to fund excess collateral calls separately. “If we do it, then it could have a very meaningful impact on our liquidity, because the collateral call could happen at a time when you really do not need it, so that has been the argument for us. As long as we can, we want to stay away from it,” says the large automotive company’s treasurer.

Banks can also reduce the CVA charge by buying protection in the CDS market. In fact, single-name CDSs, single-name contingent CDSs and index CDSs are the only hedges recognised by Basel III for CVA exposure – even the portion of the risk driven by interest rate or currency moves. This means a bank determined to hedge its CVA exposure could be driven to buy protection when the counterparty’s credit quality is stable, giving rise to a dangerous feedback loop, critics say. But it at least gives dealers a way to reduce the CVA charge. “We won’t put any Basel III charge on a trade with a corporate that has a liquid CDS. We can hedge it and, therefore, we can mitigate the Basel III impact almost completely,” says Deutsche’s Miribel.

The vast majority of companies are not covered by the CDS market, however. Banks can still hedge using proxy instruments such as an index CDS – but the bank must reflect the basis between the index CDS spread and the individual counterparty spread in the capital charge. If the supervisor is not satisfied with the basis level used, the bank can only recognise 50% of the notional amount of the index hedges. “We are still looking at the numbers, but I think it will be roughly a 50% Basel III discount. Roughly speaking, for a name without a CDS, we calculate the CVA charge and divide it by two because that is how much benefit we can get from index CDS,” Miribel says.

Again, this means emerging market issuers and small- to medium-sized companies are most likely to lose out – the sectors least likely to be covered by single-name CDSs. Dealers say this cannot be an intended result of the regulation, and there is concern the impact of the CVA charge on the cross-currency swap market will have a host of nasty, real-world effects.

“If companies can’t finance themselves or hedge their activities, then that’s a credit crunch,” says Martin O’Donovan, deputy policy and technical director at the Association of Corporate Treasurers. “If a company wants to expand, it will have to do it in a way that doesn’t create that cross-currency exposure. If I am a UK-based company and used to funding myself in dollars and swapping it back, I may decide to invest in the US to generate that funding instead. I will create economic activity where the funding is so I am hedged, which takes jobs and growth out of the country and is negative for Europe, or the UK, or whichever country is implementing these things.”

The European Commission offers its response. “Our goal is to make sure banks are capitalised against pertinent risk. A risk-sensitive treatment to bank exposures susceptible to CVA risk is part of this,” says a spokesperson.

Others see it differently. “Regulators seem to be conspiring to increase our refinancing and liquidity risk while saying they want the opposite,” says BAA’s Madeira. “It is kind of perverse they try to avoid risk so much but are actually increasing our risk.”

 

BOX: Banks get specific

National borders are increasingly becoming barriers, and the impact of rising cross-currency swap prices on corporate financing strategies is just one example – but stories and anecdotes abound.

The treasury head at one AAA-rated UK company says it can no longer borrow money from a Dutch bank it has dealt with for years because the bank won’t lend to customers in the UK anymore.

Banks admit they are becoming more picky. A senior executive at one UK bank says his institution no longer has an ‘Asia strategy’ – it picks and chooses specific countries in which it wants to compete, rather than trying to cover the whole region. And something similar is happening closer to home, where European banks have developed country-specific balance sheets as fears about a possible eurozone break-up prompt them to restrict asset growth in markets where they have limited access to local funding (Risk June 2012, pages 34-35).

One deputy secretary at a European bank says few dealers outside of Spain and Italy are prepared to lend to banks inside those countries any more. “We’re witnessing a re-nationalisation of liquidity,” he says.

At a macro level, the impact of these small changes could be profound. During the last three months of 2011, cross-border lending by banks suffered its biggest quarterly fall since 2008, according to statistics from the Bank for International Settlements. And the International Monetary Fund estimates that, by the end of 2013, a sample of large European banks will have reduced the size of their balance sheets by $2.6 trillion.

There is no single cause. The European bank’s deputy secretary says one reason is that countries become more nationalistic in times of crisis, and policy becomes more protectionist. They cite the UK’s Project Merlin as an example – the agreement between the UK government and Barclays, HSBC, Lloyds Banking Group, Royal Bank of Scotland and Santander UK to lend more to small UK companies.

“They are national regulators and they are present in their home countries. What you don’t have is an organised co-operation of all those regulators. They speak to each other, of course, and co-operate normally, but the reality is they have their own constraints and are only interested in their home market and the consequences of our action in the home market. So the scrutiny is only reinforced as far as it can affect their home economy. What you don’t have is an international regulator interested in the whole picture,” the deputy secretary says.

The same kind of effect could also be a by-product of global regulatory proposals like Basel III, bankers argue, pointing to the liquidity coverage ratio (LCR) that requires banks to hold enough liquid assets to survive a 30-day period of extreme stress. Banks believe compliance is required at the level of national subsidiaries, meaning banks have to tie up liquidity on a country-by-country basis rather than moving it from place to place, as necessary. The same is true of the framework’s capital adequacy requirements.

“Any time you are trapping capital, by definition, it is moving around less than it could. It increases the amount of capital available for local regulators for resolution but it decreases that available for customers,” says the head of securities at one European bank.

Wilson Ervin, adviser to the chief executive at Credit Suisse, says these loosely related policies are the result of a philosophical and strategic shift. “If you look back to the pre-crisis years, you see a totally different trend – towards greater globalisation – and it was the business and financial logic that was driving those decisions. The crisis has moved the impetus away from business and financial considerations towards political and regulatory logic. It has been a seismic shift,” he says. “Unfortunately, I think the effects will include some subtle and negative impacts on things that are important to the world, such as international trade, growth, diversification and competition. You lose a lot of useful benefits.”

Another adviser to the chief executive of a large global bank says many institutions have tended to expand globally on the back of a core, national or regional deposit base. But when the LCR is introduced, those deposits will no longer support widespread international operations. She says the resulting retrenchment will leave a hole that smaller domestic banks will step into. That is a concern for Credit Suisse’s Ervin: “If you are a major international corporation operating in XYZ country, then you are going to be applying international standards that may not be so rigorously imposed by smaller, domestic banks. It’s one of those intangibles that I worry we could lose as we get more nationalistic.”

Others see it as a natural development. “In the short term, there might be a little bit of a decline in risk management,” says Lei Lei Song, macro economist at the Asia Development Bank. “But in the medium and long term, greater involvement by local banks should strengthen the stability of the whole system because the system will become more diversified.”