Question Of the 27 countries in the EU, how many have still to implement the Basel II (yes, Basel 2!) banking reforms agreed in 2004?

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1 Quarterly Quiz 2011 Quarter 4 October Bank Regulation In the 1980s new regulations were brought in covering all banks that were active internationally. The reason for the new regulations was to do with perceived unfair competition between banks; some were able to compete unfairly because they were regulated in jurisdictions with a more relaxed attitude to regulation. Of course, such international regulation is only effective if all jurisdictions accept and enforce the new rules. Basel I, as the initial rules came to be known, was superseded by Basel II because the initial rules were seen as too blunt for the more sophisticated banks. The discussions to agree Basle II took up half of the 1990s in an attempt to ensure that all international banks would be included. Even so, it was 2004 that most countries agreed to adopt the revised rules, with notable exceptions such as the United States. One of the key parts of the initial and revised Basel rules was the minimum level of capital required. But the financial market turmoil of 2008 soon demonstrated that the real minimum level of capital for safety was much higher than had been thought! Much has been written about the need for more and better regulation of banks activities, and it might have been thought that governments, particularly in the EU, would have endorsed the new rules embodied in Basel III as a matter of urgency. Of the 27 countries in the EU, how many have still to implement the Basel II (yes, Basel 2!) banking reforms agreed in 2004? (a) 1 (b) 4 (c) 6 (d) 9 The right answer is (c) 6 The lack of urgency is not confined to the less developed countries or others that might be expected to drag their feet. China and the US were noticeable absentees from the list that has implemented Basel II. Of interest also is the number of countries that have drafted rules to implement Basel III 11 of the 27 EU countries. FT.com 18 th October 2011, Countries fail to enforce Basel reforms, by Brooke Masters. 2 The International Competitive Impact of Bank Regulation The introduction of stricter rules on bank capital requirements means that banks will be required to hold more capital to cover their risk assets. Risk assets include loans to corporates as well as other

2 assets. Given that banks need to generate a return on their capital invested, the requirement for more capital means that the cost of borrowing from banks may rise. In a world where different forms of debt capital are available, any increase in cost may make bank borrowing less attractive. In the House of Commons Treasury Select Committee hearing John Grout, Policy & Technical Director at the ACT explained that this cost increase is not inevitable; a reduction in risk associated with bank equity may mean that investors accept lower returns for lower risks so that required returns might fall. He argued that the cost of bank borrowing may not rise as a result of the need for more capital. If new regulations increase the cost of corporate borrowings from banks, is the extra burden likely to fall equally on all corporates globally, even if all countries implement the new regulations? (a) Yes, all corporates will feel the same impact (b) No, large corporations who can access US debt securities markets will suffer a reduced impact (c) No, even large corporations in developed markets can t negotiate a below cost deal. (d) No, SMEs are likely to get special exemptions The right answer is (b) No, large corporations who can access US debt securities markets will suffer a reduced impact In Europe much of corporate borrowing is direct from banks whilst in the US the majority of corporate debt is from the debt markets. This is evidenced in part by the disparity in the relative sizes of the corporate bond markets: the eurozone has a bond market worth EUR 2.2 trillion while the US equivalent has a value of EUR 4.5 trillion. On Standard and Poor s calculations the share of corporate borrowing that is from banks is around 20% - 30%, while the equivalent share in the eurozone is around 70% or higher. This means that European corporates are more likely to have to bear an increased cost than their US counterparts. (c) could be regarded as partially true since some large corporations may have a stronger negotiating power to win a good deal, but much may depend on the volume of remunerative ancillary business they have to offer their banks. In addition, deposits from large corporates are likely to be less desirable for banks than the equivalent deposits from SMEs. At first this sounds illogical, but the planned liquidity coverage ratio may produce this effect. The ratio is intended to measure a bank s liquidity under a stressed situation. It is assumed that SMEs will withdraw 5% of their deposits in a stress situation while corporates will withdraw 75% of their deposits. SME deposits are therefore more valuable to banks than their corporate equivalent. Why Basel III and Solvency II Will Hurt Corporate Borrowing in Europe More than the US by Blaise Ganguin, Standard and Poor s Chief Credit Officer EMEA 88&sind=A&object_id= &rev_id=2&from=SR 3 The Vickers Report

3 The main feature of the Vickers Report (or more correctly, the Independent Commission on Banking Final Report) is the retail ring-fence. This is of major importance to all treasurers that deal with UK financial institutions. As such, all treasurers reading this quiz will be fully aware that domestic retail banking will fall inside the ring-fence, while global wholesale and investment banking will fall outside the fence. Straightforward banking services, including lending for large domestic non-financial companies can fall inside or outside the ring-fence. Which of the following services are NOT prohibited from being inside the ring-fence? (a) Services to non-european Economic Area customers (b) Derivatives trading for the purpose of managing the retail bank s own risk (c) Secondary markets activity (d) Services resulting in exposure to financial customers The right answer is (b) Derivatives trading for the purpose of managing the retail bank s own risk Because retail banking activities inevitably involve elements of risk, the inside activities would be riskier than they need to be if they were unconditionally banned from taking any risk management action. The Treasurer October 2011, The Vickers Report, Distance but no Divorce, by Peter Williams, Editor The Treasurer. 4 Systemic Importance of Some Banks Regarding the ability of banks to absorb losses the committee made separate recommendations for large banks and smaller banks. The definition of a large bank was one whose risk weighted assets (RWA) were greater than 3% of the UK s GDP. A smaller bank was one whose RWA were less than 3% of UK GDP. What equity-to-risk weighted assets ratio was recommended? (a) 8% equity to RWA for large banks, 10% for smaller banks (b) 8%-10% equity to RWA for large banks, 9%-11% for smaller banks (c) Over 10% equity to RWA for large banks, 10-12% for smaller banks (d) Over 10% equity to RWA for large banks. 7%-10% for smaller banks The right answer is (d) Over 10% equity to RWA for large banks. 7%-10% for smaller banks This is an attempt to make sure that the systemically important banks are managed to reduce the risk to the taxpayer in the event of a catastrophe. The logic appears to be that larger banks must be more cautious. But larger banks are likely to be more diversified and therefore present less of a risk

4 to the taxpayer. The argument that may be overriding here is that small banks can be allowed to fail and there is a cost associated with being too big to fail. The Treasurer October 2011, The Vickers Report, Distance but no Divorce, by Peter Williams, Editor The Treasurer. 5 Government Debt The coalition government have centred their economic strategy on debt reduction. At every opportunity they have referred to the credit card being maxed out! One particular minister is particularly fond of describing the UK government debt as comparable to that of Greece. Eurostat is the statistical office of the European Union. Using Eurostat data, what are the relative levels of gross government debt as a percentage of GDP for Greece, Germany, France and the United Kingdom all at the end of 2010 (the latest available year)? Greece Germany France (a) 144.9% 83.2% 82.3% 79.9% (b) 144.9% 71.2% 81.7% 113.7% (c) 144.9% 61.2% 73.4% 98.9% UK (d) 144.9% 52.1% 64.6% 90.3% (e) Don t know The right answer is (a) Greece 144.9%, Germany 83.2%, France 82.3%, UK 79.9% This may seem surprising but is based on the Maastricht Treaty definitions. Using the same data set, Italy has 118.4% debt %GDP, Portugal comes in at 93.3% and Spain at a surprisingly low 61.0%. It all depends on what adjustments and exclusions you make in defining government liabilities. In other words, if making statistical comparisons make sure you use consistent data and definitions. Eurostat website: lugin=1 6 Regulation and Regulators The Financial Reporting Council (FRC) have reported on their investigations into the way companies communicate their key strategic risks to their shareholders. They found that companies had increased their focus on risk in the last few years but that the existing guidance for directors, The Turnbull Guidance, may need some revision. They added that companies should make sure that they understand gross risk as well as net risk to be sure that the full extent of the firm s potential risk was well understood. This is reported in the Technical Update for October in the Treasurer.

5 Over recent months we have become used to hearing that more regulation is necessary to prevent a recurrence of the disasters of 2008 and Every regulator has been keen to demonstrate an enthusiasm for ensuring that they are not the ones to be found wanting next time around, with the result that new restrictions seem to be appearing from all sides. In some cases, company boards are left wondering to whom they are primarily responsible; regulators or shareholders. Apart from suggesting further review of the corporate code, the FRC has come to the defence of companies against over zealous regulators if it believes that their activities are damaging the UK s boardroom culture. 6 What is the alleged requirements of a regulator that precipitated the FRC s comments? (a) The Bank of England has required all company directors to be registered and approved (b) The EU has issued a Directive governing how corporate boards must operate (c) The Stock Exchange has required all board minutes to be published via the Regulatory News Service (d) The FSA has requested to be present at some bank Board meetings (a) The right answer is (d) The FSA has requested to be present at some bank Board meetings The FT reported Baroness Hogg, FRC Chairman, from a speech in which she said that it was crucial that regulators do not usurp the role either of shareholders or of boards. It was widely interpreted as referring to the FSA whose regulatory style has been described as intrusive. The specific allegation that is thought to have inspired the comment was the anecdote that the FSA had requested to be present at some high-impact bank board meetings. FT.com FRC Pledges Action Against Hyperactive Rivals, by Alison Smith, Chief Corporate Correspondent October 23 rd 2011,