How Can Companies Potentially Increase Profit & Contribute To Economic Growth Under Basel III?: A practical guide with Real-life Borrowing Examples, and Recent Economic Researches on US, China, EU and UK.

HOW CAN COMPANIES POTENTIALLY INCREASE PROFIT & CONTRIBUTE TO ECONOMIC GROWTH UNDER BASEL III?

-A Practical Guide with Real-life Borrowing Examples, and Recent Economic Researches on US, China, EU and UK.

By A. WONG

THE PTI Group

Published by The PTI Group (www.the-pti.com)

The PTI Group (PTI) is a consulting, financial services, financial data and training group set up by professionals with diverse experiences, and international working exposure to several countries.

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© 2014 The PTI Group

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ISBN 978-988-12417-7-1

Disclaimer

While this book strives to be as accurate as possible, it is noteworthy that the regulations (including but not limited to banking regulations), requirements under Basel III as well as banking practices may evolve over time. It is also important to take note that banking practices, standards and requirements may vary for different banking institutions, and also from country to country.

This document should be considered as reference only, and does not constitute any professional, legal or other advice in whatever ways or of whatever kinds. No part of this document represents any advice nor guarantee for obtaining any credit facility in whatever amount &/or of whatever types, whether from banks or from any other financial or non-financial institutions. This document also does not represent any advice nor guarantee for successful negotiation for a lower or more preferential interest charge or other financing expenses from any bank, or any financial institution in any country or in any jurisdiction. This document also does not guarantee in any way a bank can save capital or achieve capital efficiency.

We strive to ensure the information contained/methodologies used/calculations shown in this Book is accurate and free from error. However, we have not verified nor validated any of the source of the data used for the researches quoted in this Book, including sources of data for secondary researches referred to in this Book. In addition, we are not making any representations nor do we guarantee the accuracy or completeness of any of the data, researches, information contained, ideas, suggestions mentioned, calculations shown or methodologies used in this Book, whether such data, researches, and information is/are primary research(es) conducted by us, or research(es) conducted by third party(ies), whether the research is further based on or derived from another prior research or researches undertaken earlier.

This document should not be relied on as indicating comprehensive nor complete information that an individual, company, borrower, potential borrower, bank or any staff of a bank etc. would need to consider in granting or borrowing any form of financing from any financial institution, or in planning or managing capital of any bank.

No one, including government official(s) of any country, jurisdiction or place etc. should rely on this document for implementing any new government policy or any change to existing government policies. We will not, in any way, whether legally or in whatever ways, be held responsible for such action or the consequences of such action.

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© 2014 The PTI Group

Acknowledgement

I would like to thank those who have been supportive of me all along, including my family and my good friends. I would also like to thank God that I can finally finish this book eventually, despite the challenges.

Preface

Basel III may sound familiar to you, as it is sometimes mentioned in the news or newspaper. But what actually is Basel III?

Leveraging on rules of Basel II, Basel III are the new capital standards for banks in various countries around the world. In general, implementation of Basel III in different countries around the world has resulted in a more level-playing field in terms of regulatory environment for banks operating in different countries, compared with the pre-Basel II era. However, certain national discretions allowed under Basel III, i.e. discretions for certain rules permitted by regulator of that jurisdiction, have made rules of Basel III implemented in different countries not precisely the same.

As its name implies, the III in Basel III actually means the rules are the third sets of capital standards for banks published by Basel Committee. The first set of standards was enacted in 1988 (known as Basel I), while the second set of capital standards has been promulgated in 2006 (commonly referred to as Basel II). The third set of standards, i.e. Basel III, contains rules additional to Basel II, and also for some areas, rules of Basel III have superseded in whole or in part the earlier rules of Basel II. Therefore, in case of discrepancies between rules of Basel II and Basel III, it is generally expected the newer rules under Basel III will prevail. Examples of new requirements introduced under Basel III include leverage ratio, liquidity risk, capital conservation buffers etc. It also means that some part of the requirements under Basel II, where no newer superseding rules have been issued under Basel III, still remain valid and applicable.

Basel III is a very complicated set of capital rules for banks, with many detailed, specific and technical requirements. In this Book "HOW CAN COMPANIES POTENTIALLY INCREASE PROFIT & CONTRIBUTE TO ECONOMIC GROWTH UNDER BASEL III? - A Practical Guide with Real-life Borrowing Examples, and Recent Economic Researches on US, China, EU and UK.", we will firstly go through briefly what are Basel III, then an overview of the capital rules and requirements of Basel III will be provided, including:

A general understanding of the different types of risks (credit risk, market risk, operational risk and liquidity risk),

Asset classifications,

Different treatment for on- and off-balance sheet exposures,

Credit risk mitigation (CRM) techniques (i.e. collaterals and guarantees etc.),

Risk-weighted Assets (RWAs), and

Requirements on bank capital etc.

It is important to note that when we refer to Basel III in this Book, we are collectively referring to the new capital rules for banks (which is either additional to or has superseded the rules under Basel II), as well as the rules under Basel II which are still applicable.

Basel III consists of many technical jargons. In this Book, every attempt is made to try to use plain language as far as possible in this Book, so that even for those without much prior experience in Basel III, it will not be too difficult to understand.

The approach adopted in this Book is highly practical and useful. Real life borrowing examples are cited to explain what a company can do in borrowing from a bank, in order to help its lending bank(s) to potentially save capital. It is hoped the examples can serve to illustrate the elusive concepts under Basel III.

Moreover, various economic and statistical data as well as researches on US, China, EU and UK etc. are also included and analyzed with respect to the importance of bank credit on the economy in this Book. In general, the economic and statistical data of US, China, EU and UK mostly covers the period 2003 to 2013, including the data before and after onset of the financial crisis in 2007.

The economic and statistical data cited, researches and analysis mainly on the four of the largest countries/regions in the world (i.e. US, China, UK and Europe) provide valid support for the importance of bank loans to the economy. In fact, the significance of bank credit for the economy may deserve greater attention by government officials of different countries, and even the general public.

This Book seeks to offer insightful guidance to borrowers about how to potentially save capital for its banks. If the borrower can help its banks save capital, it is anticipated the capital saved can be used to provide additional loans to other borrowers assuming the bank will not hold excessive reserves, and capital requirements remain the same. To elaborate, without affecting the bank’s current capital position here also means the banks will be under less stress to raise additional capital (assuming capital requirement remains the same), which is expected to potentially avoid/lessen pressure on market liquidity.

This Book would be a useful and an essential reference to CEOs, CFOs, Heads of Accounting, Heads of Finance, and Chief Accountants etc. of companies, bankers, government officials and policy makers. By mastering knowledge in this Book, it would provide insights as to how a borrower can collaborate with a bank to achieve capital efficiency, such as the type of Financial Collaterals to provide, to meet the specific requirements for Financial Collaterals, and to understand the implications of different financing alternatives/credit facilities etc. on bank capital requirements.

As mentioned above, besides the author’s explanation of Basel III requirements & implications of a company’s borrowing decision on bank capital using a very practical approach, this Book is also based on economic data, researches etc. including those on four of the largest economies in the world, i.e. US, China, Europe and UK.

For researches used in this Book, such researches include both primary researches conducted by the author, as well as leveraging on researches done earlier. Nevertheless, most of the underlying data of the researches, whether for primary or secondary researches, are from official sources, adding to the credibility and the realism of the results of the researches.

Objectives of this Book encompass:

To explain the various concepts under Basel III relevant to companies borrowing from banks, so that even readers with non-banking background can understand the basic requirements of Basel III;

To help the readers grasp the essential concepts under Basel III, and apply such concepts in borrowing from banks;

To enable the borrower to potentially contribute to capital savings of its bank(s);

To lead to structuring of loans and other financings from banks in a wiser way in terms of bank capital efficiency, both by financial professionals and bankers;

To place the borrower in a better position to negotiate with the bank for a more preferential interest charge for its loans;

To potentially help alleviate or reduce the chance of tightening up of funding in general in the market, e.g. triggered by banks raising new capital through issuing new shares;

To achieve win-win situation for both the borrower and the bank, i.e. capital saving for banks and potential saving in financing costs for the company - through helping to avoid general rise in interest rate, and saving the bank’s capital;

To hopefully provide insights to government officials and policy makers, so appropriate government policies can be designed &/adjusted to ease bank credit;

For each country/jurisdiction, to help enhance its competitiveness through making bank credit more easily available &/or relatively cheaper to companies in general; and

To contribute to growth of economy over a relatively longer-term at a macroeconomic level.

Value of this Book

Notwithstanding monetary easing (or more commonly known as QE) under the financial crisis since 2008, it seems credit crunch has deteriorated in general in many countries around the world. The credit crunch since 2008 can be attributable to both the supply and demand of credit. Please refer to relevant sections of this Book.

With capital efficiency for banks achieved through wiser borrowing decisions of companies as advocated in this Book, it is hoped to help alleviate bank credit from further constraining (assuming inter alia, all factors remain the same). In addition, improving bank capital efficiency is expected to help increase availability of bank credit in general, especially from the supply side of credit.

Under Basel III, capital requirements for bank will be gradually increasing, e.g. Common Equity Tier 1 (CET1) ratio, and Minimum Tier 1 ratio etc. With the rising capital requirement coupled with the tapering of QE3 in US, inter alia, market liquidity is expected to tighten. Therefore, by helping its bank to potentially save capital, the company may probably be helping itself as well, since it is expected to help reduce chances of general tightening of funding in the market, due to banks raising additional capital.

Since capital requirements will become increasingly more stringent under Basel III, inter alias, e.g. even without new loans lent out (i.e. without increase in risk-weighted assets), banks would need to raise additional capital. Coupled with tapering of QE3 in US, general funding costs are expected to rise, as liquidity in the market in general is expected to tighten.

By equipping borrowers with the necessary knowledge to achieve capital savings for banks, it is anticipated to lead to the following potential benefits, if the borrower can apply such knowledge in its borrowing decisions:

If a corporate borrower can help banks to reduce the amount of capital needed to be raised, it is expected to help alleviate (or at least reduce the chance of tightening) market liquidity generally.

The bank capital freed up can be used by the bank to lend out other loans, without affecting the capital position of banks, as we will see it this Book.

By contributing to achieving capital efficiency of its banks, the borrower can potentially help improve profitability and return of banks, e.g. in terms of return on regulatory capital. If the bank is listed, improving profitability and return would have important implication on the bank’s share price.

By helping its bank to save capital, the corporate borrower would be in a better position in negotiating with its bank for more favourable finance charges.

It would help reduce chances of potential increase in general funding costs due to rising demand for funds, as a result of banks’ need to raise additional capital.

It is hoped to alleviate credit crunch due to bank credit supply side reasons, as bank capital requirement was cited by banks in UK as one of the major reasons for reduced success rate for loan applications in 2010.

As per evidence from recent economic data and researches of US, China, EU and UK, bank credit plays a vital role in the economy, e.g. export, and innovation of firms etc. Therefore, better management and greater access of bank credit via bank capital efficiency is expected to not only contribute to the economy, but also enhance competitiveness of a country on a broader scale and over the longer-term.

It is important to note that the rules under Basel III are subject to national discretions and modifications for different countries/places. This Book is based on the original Basel III rules (i.e. the Basel III rules originally promulgated by Basel Committee on Banking Supervision before application of any national discretion). Companies in different countries are advised to take note of whether any national discretion has been exercised for the Basel III rules in their country/place. In case of doubt, the company is advised to consult its bankers, consultants, or other professionals, if considered necessary.

In this Book, based on researches and economic data of China, US, Europe and UK, we will also look at the relationship between bank credit and the economy, so that the readers can have a better idea about how credit provided by banks can impact the economy. In addition, the readers may be better able to appreciate the role and importance their company can play in their lending decisions, in casting an impact ultimately on the economy.

In another Book "FINANCING HANDBOOK FOR COMPANIES – A Practical Guide by a Banking Executive for Companies Seeking Loans & Other Financings from Banks (Financing Handbook for Companies") published earlier by PTI Group, an overview, features, purposes, pros and cons etc. of the different financing alternatives for companies have already been given, and therefore will not be repeated in this Book.

If the readers are interested in knowing the details and operations etc. of various financing alternatives, the readers can refer to the Financing Handbook for Companies, which contains useful background knowledge for the readers to understand this Book.

For clarity purpose, readers are kindly reminded terms with special meaning under Basel III (i.e. jargons of Basel III) will be capital-lettered in this Book, in order to differentiate terms generally used.

List of Figures

FIGURE 1 MONEY SUPPLY CREATED THROUGH NEW RESERVE

FIGURE 2 DEFINITION OF MONEY SUPPLY IN US

FIGURE 3 DEFINITION OF MONEY SUPPLY IN EU

FIGURE 4 MONEY SUPPLY DEFINITION IN UK

FIGURE 5 DEFINITION OF MONEY SUPPLY IN HONG KONG

FIGURE 6 MEASURES ADOPTED BY GOVERNMENT IN UK TO IMPROVE ACCESS TO FUNDING OF FIRMS

FIGURE 7 SELECTED RESULTS FROM EUROSTAT’S 2010 ACCESS TO FINANCE SURVEY – 20 MEMBER STATES OF EU & UK

FIGURE 8 FINANCING OF UK NON-FINANCIAL CORPORATIONS BY SOURCE OF FUNDS

FIGURE 9 KERNEL DENSITY DISTRIBUTION OF FIRM-LEVEL TOTAL FACTOR PRODUCTIVITY (IN LOGS)

FIGURE 10 REGRESSING FINANCIAL INDICATORS OF CRISIS DUMMY

FIGURE 11 PRODUCTIVITY LEVELS OF EFIGE FIRMS (TFP - LEVINSOHN-PETRIN) AND FINANCIAL CONDITIONS