Asiamoney’s May 2011 cover story warned about the cost of Basel III regulations for international firms hedging international debt issuance.
In short, we warned that once Basel III was introduced the cost of conducting non-centrally cleared long-dated currency swaps would rise so much that they could potentially knock-out the US dollar funding market in Asia as a viable funding source.
More recent analysis by Citi’s Adam Gilmour, head of corporate sales and structuring for Asia, and his team indicates that even very short tenor liquid products such as FX forwards will also become highly costly under the new bank regulatory regime, which is set to kick in by the end of next year.
A forward is an over-the-counter contract between two parties to buy or sell an asset at a specified future time at a price agreed today.
Under Basel III, banks providing this type of product will require some collateral when offering non-centrally cleared forwards to counterparties. The riskier the counterparty, the most collateral needed.
The calculations for additional collateral are based on taking into account the 10-day value at risk (VaR) level of the currency pairing and adding that with the stressed 10-day VaR, which incorporates the most stressed period in recent history.
VaR is the probability of the risk of a complex mark-to-market loss on a portfolio of financial assets over a certain period of time. For example, if a portfolio of stocks has a 10-day 10% VaR of US$1 million, there is a 10% probability that the portfolio will fall in value by more than US$1 million over 10 days.
The riskier, or lower-rated, the counterparty, the greater the VaR, and the most capital they will have to stump up to engage in a swap.
The worry among some banks is that this new rule will hit Asian corporates particularly hard because many have lower credit ratings. This would raise their FX hedging costs, and would also impact loans and other basic financing products where a bank takes on counterparty risk.
Citi estimates that the reserve charges for forward contracts for the US dollar and the yen, the euro and the US dollar, and the US dollar and the Korean won could reach around two basis points (bp) of the notional value of a three month contract, 6bp for six months, 15bp for nine months, and 24bp for 12 months.
These estimates are far from final. However they are far more expensive than the current counterparty risk charges demanded by banks, and they could prove to be even higher for lower-rated Asian corporates.
There is another option to reduce the cost of FX forwards: centrally clearing the derivatives. Basel III has said that the spread cost of a centrally cleared forward will be zero, an intentional move as it is geared to luring as much derivatives activity to be centrally cleared.
However participating in central clearing requires a company to be a member of the central clearing house, which charge more the lower the credit quality of the applicant. Therefore the likelihood of low credit Asian corporates getting involved in central clearing is slim because it’s likely to cost them a lot, particularly if they don’t venture into derivatives all that often.
Theory vs. practice
The overarching premise of Basel III is good. Few people would reasonably disagree with the notion that banks need to be better capitalised and that the rising cost of doing business in the financial markets is necessary to better reflect the risks associated with international financing.
But if Citi’s calculations are accurate and the costs of FX derivatives rise too much there is a genuine risk that it will stunt economic activity. Basic hedging products such as forwards are a cheap, liquid and a valuable tool for a CFO and must not become so expensive as to force corporates to ignore them entirely.
If Asia is to be the powerhouse that brings the world out of the economic doldrums there needs to be a careful examination of the impact of Basel III. If the regulations are deemed to be too prohibitive to daily business a re-assessment will be required.
Slow wins the race
One interesting impact of this is that it stands to benefit Asian banks, at least in the medium term.
Regional lenders are likely adopt the full Basel III requirements later than their Western counterparts. The US banks, for example, have puffed out their chests and promised far earlier adoption of the 2019 final deadline.
But such early adoption leaves them having to incorporate increased derivatives costs, which will make their services far less competitive, at least to regional Asian corporates.
The desire of such banks to convince stockholders just how extremely well capitalised they are may leave them liable to missing out on golden opportunities in emerging markets.
In contrast Asian banks, which are unwilling to adopt Basel III so early, have an opportunity to request less capital from their counterparts for business than early Western adopters of Basel III. They will inevitably gain market share in the region’s OTC derivatives market as a result.
One executive from a Western bank fears Asian banks will capitalise on the regulatory arbitrage. He also foresees the capital requirements easing over time as regulators come to realise the VaR calculations are too stringent.
“You can envisage Asian banks gaining the market share and then keeping those relationships when the calculations are changed and everybody is once again doing business on the same regulatory terms,” he says.
If this is the case then so be it. Western banks have had primacy in the OTC dealer space for some time—the top 14 largest OTC dealers hail from Europe and the US—so opening up the playing field to more competitors would be no bad thing.