A whole new regulatory environment is taking shape for banks and near-bank financial institutions. From an investor’s perspective, the new requirements—regardless of the form that they ultimately assume—will undoubtedly influence the stock and bond markets, the over-the-counter derivatives markets and financial transactions in general.
The new liquidity and risk management rules, which came into force January 2013 under Basel III, will have a collateral effect on clients and their counterparties. Pension fund managers are among those who are attempting to identify both the consequences and business opportunities that the rule changes may offer. At first analysis, it is already clear that enhanced requirements for regulatory capital and increased demand for higher-quality and more liquid assets are the main parameters to watch, not to mention new constraints around transactions that involve derivatives.
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Three major themes
Patrick De Roy, partner and national practice leader, risk management, with Morneau Shepell, has identified three major themes to watch as the new rules take effect. The first involves in-house pension plans (primarily DB) for employees of banking institutions. He expects that the transformation of these plans into hybrid or mixed plans, which has only just begun, may accelerate under Basel III, since such moves provide for asymmetrical treatment of actuarial surpluses and deficits. “Even if institutions could be persuaded to turn to other types of plans, they cannot avoid the weight of the past,” explains de Roy.
Under the current rules, pension fund deficits must be deducted from available capital. On the other hand, if there is a surplus, it remains a cushion that cannot be included in the calculation and added to capital. According to De Roy, there is no question that this asymmetry will influence pension fund investment policy and penalize risk taking. “The investment policy for such plans already tends to avoid the risks of the public market. Basel III is likely to accelerate this process.”
The strategies applied to less-liquid assets and the use of derivatives will also be affected. Transparency dictates different treatment, depending on whether transactions occur over the counter (OTC) or are compensated. “With banks often serving as counterparties, greater capital requirements will generate additional costs that will be passed on to the pension funds involved in transactions of this type,” says De Roy, referring to direct and indirect cost increases, by way of hedge funds, for the largest pension funds.
Finally, Basel III adds two liquidity ratios to the principle of liquidity risk management. One is used to define the short-term flexibility level that is required in order to deal with a liquidity shortfall, based on a pessimistic scenario. In this case, the horizon used is 30 days. “This will result in a reduction of risk taking on bank balance sheets and bond arbitrage. We can expect greater sensitivity that favours very liquid bonds or very short-term securities. Indirectly, the downward pressures on bond rates could have an influence on the actuarial liability of pension funds,” says De Roy. He says the consequences on pension funds would be reduced if the effect is felt in the short-term segment of the yield curve.
In a broader sense, De Roy says he can envision a growth in collaboration between banks and pension funds: perhaps only in the area of facilitating arbitrage between the liquidity needs of the banks and the longer-term horizon of the pension fund managers; or perhaps only to take advantage of the higher solvency rating of these funds. “I haven’t taken a closer look at that yet, and I don’t know how these opportunities will develop, but yes, there is real potential there.”
Gérard Bérubé is a financial journalist and assistant news editor with the Montreal-based newspaper Le Devoir. gberube@ledevoir.com