Uncollateralised business loses shine

(The following story appeared in the Dec 3 edition of the International Financing Review, a Thomson Reuters publication)

By Chris Whittall

LONDON, Dec 5 (IFR) - Amid its recent business shake-up, the chief executive of UBS's investment bank, Carsten Kengeter, noted that its long-end rates business had a negative revenue impact of CHF300m per annum.

He subsequently announced officially what many other major dealers now admit privately: the uncollateralised long-dated rates business is not attractive under Basel 3, causing a number of institutions in effect to pull out of it.

"Much of the risk reduction related to long-end rates," Kengeter told the UBS investor day on November 17. "Swaps are an important part of our corporate client value proposition, but they are capital-intensive and currently do not offer attractive returns. We will therefore materially reduce the uncollateralised long-dated transactions  asking corporate clients who want more tailored solutions to pay for the extra Basel 3 capital charge."

Swiss Banks have to comply with Basel 3 earlier than their peers, but dealers on both sides of the Atlantic are already looking at the implications of the regulation. However, it is their corporate clients that will ultimately have to stomach these extra regulatory costs.

The vast majority of corporates are uncollateralised counterparties, and therefore are hit hardest by Basel 3 through a combination of funding, counterparty credit and regulatory capital charges. For those unwilling or unable to collateralise their predominantly long-dated exposures, they are faced with either higher charges or reducing their reliance on the derivatives market.

"We are worried that Basel seems to disproportionately load the capital requirements for uncollateralised derivatives. That creates a push for institutions to collateralise or clear, which treasurers find alarming as managing liquidity risk can be exceedingly difficult for corporates," said Martin O'Donovan, deputy policy and technical director at the Association of Corporate Treasurers.

BALLOONING COSTS

The added costs under Basel 3 could be substantial. According to a recent Standard & Poor's note, a mid BB to mid BBB rated corporate could see its borrowing costs balloon by as much 80bp if trading with a dealer with a 15% return on equity target. That number grows to 107bp if Basel's net stable funding ratio is included in the calculation.

"Corporates represent a huge source of revenues, but that doesn't mean we will forgo the proper charges. We are more and more forced to charge on a stricter basis for these costs that are now hitting the trading books directly and become part of the P&L equation," said one senior counterparty risk manager at a major dealer.

Banks are faced with a dilemma: fully price in regulatory charges and potentially lose corporate business to rivals, or devise ways to reach a palatable price for all involved. In a world where additional expenses are less easily absorbed by a thriving investment bank, many choose the former, explaining that they are no longer willing to swallow these costs for their corporate clients.

"We're definitely seeing some pullback from the uncollateralised business. Current pricing trends for long-dated uncollateralised derivatives are making this business look less attractive," said Jakob Horder, head of European rates at Morgan Stanley. "As more players reduce their commitment, we would expect the market to shrink."

He is not alone in his view. One dealer estimated fully pricing in Basel 3 had cost him 10% of his rates business this year. "The business just doesn't have an adequate return on capital in a Basel 3 world," added one head of fixed income at another major bank.

ADAPTING

But while some banks with smaller corporate franchises scale back, those with traditionally larger corporate client bases have also been busy reviewing their business models in the new world.

John Langley, head of the risk solutions group at Barclays Capital, said there was no doubt uncollateralised swaps would become more expensive under Basel 3, but said that the corporate business would adapt to the new environment.

"It's important to look at the overall client relationship. We look at these issues on a portfolio basis across the entirety of a client's business, which gives us the ability to provide bespoke solutions for a company, even in the long-dated space, and ensure we're still able to generate sufficient returns with a Basel III lens," said Langley.

At the same time, Langley points to a steady flow of corporates signing credit support annexes, which automatically reduce auxiliary charges. For those that don't have the flexibility to sign a CSA, other credit mitigation mechanisms are developing.

In particular, clients are keen to move on from break clauses in swap contracts, which have become less popular in recent times given the risk of having to replace the hedge before expiry.

"Clients are now looking at structures other than the break clauses, whether it is resetting the foreign exchange rate on a cross-currency swap or the coupon on an interest rates swap. This can allow them to get long-dated hedging, but reduces the pricing to an efficient level," said Edward de Waal, head of structuring in the risk solutions group at BarCap.

For those staying in the corporate derivatives space, finding these types of solutions will become increasingly vital. While corporates may be unlikely to forgo hedging altogether, O'Donovan at the ACT indicated that companies would also look to be innovative going forward.

"It can start to change behaviour and business planning, so that natural hedges are established where possible, even to the extent of influencing investment decisions. We are also seeing companies investigate corporate-to-corporate transactions, which would take the bank completely out of the equation if banks priced themselves out of the markets. Those things aren't easy to put together, but people are talking about it more and more," he said. (Reporting by Chris Whittall, Editing by Kathleen Hoffelder)