4/18/2014 Portland, Oregon – Pop in your mints…
Up until the financial crisis of 2008 and beyond, most Americans who were not alive during the early 1930’s had grown up in a world where choosing a bank was largely a matter of preference. Once the FDIC insurance program was instituted on January 1, 1934, depositors had little to worry about.
The financial crisis that the world just experienced was a wake up call on many levels. The first alarm rang for many Americans, members of congress included, when the Troubled Asset Relief Program (TARP) was sent on a freight train through the House and Senate under the threat of an imminent global financial meltdown. Meanwhile, in Europe, the European Central Bank and European Union take a series of measures to shore up both their banking system as well as the finances of their member nations.
Giving away trillions of dollars to businesses who made bad decisions, while ultimately the chief function of government, is, paradoxically, politically unpopular. As such, the governments of the world, who found themselves on the hook for losses in the financial system of a nature that many of them could not hope to understand in terms of nature and scope, began to devise a series of rules that would ensure that this sort of thing would never happen again.
So it was that, sometime in 2009, the word Basel, which until that time was a typo on a recipe card, became prevalent in the world of banking.
Basel is a city in Switzerland where the world’s banking regulators chose to meet to put their minds together as to what types of rules were needed so that the financial crisis would never happen again. Today, five years later, the rules that they took so much time to tailor are indeed perfect for a world that existed five years ago. As it stands today, the rules could very well be the cause of the next financial crisis.
The Basel accords and, more specifically, the Basel III Liquidity ratio, which is our focus today, are generally aimed at ensuring that large banks (those with $50 billion USD or more in assets, “too big to fail”, if you will) will always have enough liquid assets to meet the demands made on it each day.
The Basel III liquidity ratio is a simple ratio which places a banks Liquid Assets, meaning cash, Treasuries, and Agencies) over its Stressed Cash Outflows (meaning maximum foreseen withdrawals during a liquidity crisis). The banks must report this ratio at a set time every business day. If the ratio is over 100%, all is well. If not, not, meaning the bank could be forced by regulators to initiate a strategy to unwind its operations.
While the numerator of the liquidity ratio is extremely simple to calculate, it is driven by the denominator, which is infinitely more complex. This is where you and I, fellow taxpayer, come in.
Banks will be required to stratify their deposit customers well beyond the simple consumer and business account denominations that have sufficed to some degree until now. They are now required to carefully monitor customers to better understand their daily inflows and outflows from their accounts in order to arrive at a maximum Stressed Cash Outflow number for each category of account.
As a practical matter, the bank will assign each category of customer and account a “run-off” factor, which is expressed as a % of the account’s balance on any given day that may “run” out of the bank. Again, this number is critical for the bank, as it ultimately determines its reinvestment strategy and, by extension, how profitable a deposit customer is.
The good news is that consumer and small business accounts which are FDIC insured are, as of the most recent comment period, assigned a 3% run-off factor. Meaning that for every $100 on deposit, the bank must buy $3 worth of Treasuries as an offset, and it is free to invest the remaining 97% in loans or other more profitable investments.
This means that competition for deposits from consumers and small businesses just got more intense, which should generally be good news for customers. They should expect to see increased savings rates and incentives to hold both more cash and conduct more business at a specific bank, as it will be in the bank’s best interests to retain them and understand their spending habits.
The bad news begins outside of the realm of FDIC insured accounts. For all balances over the FDIC limits for the same customers, the run-off factor, which, all things being equal, has an inverse relationship with a bank’s profitability, jumps to 10%.
For larger Corporate customers, who tend to have operating (daily transaction) and non-operating (reserve) accounts, the run-off factor jumps to 25% on operating accounts and 40% on non-operating accounts. This makes large corporate customers somewhat less attractive.
The people that no one will want to bank with, from a run-off factor standpoint, are financial companies (think Insurance companies, small banks, etc.) who are presumed to have a run-off factor of 100%, meaning these companies, under Basel III liquidity rules, must be seen as ready to walk into the bank on any given day and withdraw all of their accounts.
In a way, the 100% run-off factor on financials makes sense, as it requires all large banks to hold Treasuries to backstop the accounts of financial companies. It is a “regulatory” guarantee that these companies will always be liquid.
The way around the 100% run-off factor for financials and other large institutions are accounts with covenants to provide the bank with at least 30 days notice before withdrawal. This type of notice requirement, in theory, gives the bank time to arrange its investments to be able to meet the cash outflow without impacting overall stressed cash outflows.
As one can imagine, Basel III will lead to a number of new banking products in terms of accounts and credit lines. Briefly, this is what consumers and companies can expect to see as January 1, 2015 approaches:
1. A dogfight for small, FDIC insured deposits.
2. Decreased access to business lines of credit, as the Treasuries will be the default reinvestment vehicle for banks as they attempt to sort out their daily Liquidity ratio.
3. Point 2 above means that low-interest rates on Treasuries are likely to be embedded for quite some time.
4. Deposit products which cannot be withdrawn with less than 30 days notice without steep penalties. One idea we have heard is a “perpetual 31 day time deposit,” meaning that the 30 day withdrawal notice requirement is embedded in the covenant, it is like an operating account that the customer has to give 30 days notice, like they would a landlord, to the bank before withdrawing.
As the Affordable Care Act has fundamentally changed the healthcare industry, Basel III will fundamentally change the banking industry. While its aim is to forever stabilize financial markets, its implementation may be the biggest threat that financial markets have seen since late 2008. Beyond that, it places the bedrock of finance firmly on the shoulders of sovereign bonds, which, despite being seen as completely liquid, hold a myriad of unknown risks.
Basel III, coming January 1, 2015. The time to prepare is running out, and the time for action is upon us.
Stay tuned and Trust Jesus.
Key Indicators for April 18, 2014
Copper Price per Lb: $3.03
Oil Price per Barrel: $104.30