The bulk of the rules in the EU legislative package Capital Requirements Directive IV (CRD IV) took effect at the beginning of January. These prudential rules implement the Basel III agreement on bank capital requirements in the EU and they impose strict capital and liquidity restrictions on banks, building societies and investment firms.
CRD IV is unquestionably the biggest regulatory change to affect the banking industry for decades. Its aim is to prevent another crisis by strengthening the resilience of the EU banking sector so that it can better absorb economic shocks while continuing to finance economic activity and growth. But the scale of the changes, which are being phased in between January 2014 and January 2019, means that their effect will be felt not just within the banking industry itself, but also within the wider economy.
While every bank and corporate will have a different experience of CRD IV, all treasurers need to make sure that they understand the main principles of the legislation and, equally importantly, its implications for financing their business.
When implementing CRD IV, banks have different starting positions and different pressures. It is likely, however, that the directive will bring long-term, industry-wide changes in the cost and availability of funding to European corporates. So far, low interest rates have been masking the costs of increased bank regulation but if interest rates rise over the next few years, those costs will become more apparent. Capital needs to be paid for and the cost will be partly borne by the customers that use it.
The aim of CRD is to prevent another crisis by strengthening the resilience of the EU banking sector so that it can better absorb economic shocks
In theory, European banks have until January 2019 to meet the more stringent capital requirements of CRD IV. But, in practice, individual countries are speeding up the process and making their own stipulations. In November 2013, the UK’s Prudential Regulation Authority announced that it expects the major UK banks and building societies to meet a 7% common equity tier 1 ratio and a 3% tier 1 leverage ratio from 1 January 2014. This is a stricter requirement than that specified by CRD IV and a five-year acceleration in the capital process from the original timetable.
Meanwhile, the European Central Bank’s Asset Quality Review and accompanying stress testing will affect major eurozone banks in 2014. Eurozone banks will need to pass a threshold of an 8% common equity tier 1 ratio.
It is not just capital that will affect costs for corporates. The Basel Committee on Banking Supervision is continuing to deliberate the leverage ratio, which is the ratio intended to set the amount of capital that banks need to allocate against their actual or potential financing without any adjustment for credit risk. If the leverage ratio is too low, a bank will either need to hold more capital, or reduce its assets, or both.
In addition, banks are being asked to hold more assets that can be turned into cash quickly and easily. Since these assets don’t make a good return, the cost of holding them will be reflected in the overall cost of lending to customers.
Banks are also being asked to improve their mix of funding arrangements, putting greater emphasis on deposit funding and longer-term debt. Both of these are expensive and that cost, too, will be passed on to customers in the long term.
From 2019, the UK will have retail banks that are ring-fenced from their wholesale counterparts. With this comes the risk that corporates will concentrate their deposits in the retail bank, which will be perceived as safer, while they will want their main relationship to be with the wholesale bank, which can offer a wider product set. This could create further distortion in the funding market.
The effect of regulatory change will vary between banks, with each making different deals with their corporate customers. But, overall, costs for corporates are likely to increase. Meanwhile, where banks need to achieve higher capital ratios and want to avoid raising new money, there could be a contraction in supply. This is likely to be where a bank engages in marginal activities or has a small market share in certain countries or business sectors.
At some point, it may no longer be efficient for banks to provide expensive funding for their corporate customers. This will make the option of going direct to the capital markets more attractive to companies. Ultimately, it is one of the objectives of CRD IV to rebalance the provision of finance away from banks towards the markets.
The main principles of CRD IV include:
Mark Penneyis head of capital management, global markets, and Dominic Kerr is head of European corporate origination at HSBC
