Financial institutions are beginning to get a better grasp on Basel III as they work their way through compliance efforts. Those that strive to be ahead of the game are busy reinventing products and developing innovative ways to tip-toe around the regulation in order to maintain profitability while meeting liquidity coverage ratio requirements.
Treasury professionals are in the process of preparing for Basel III by redesigning their product and pricing strategies. More in-depth customized pricing models and increasingly segmented product lines are two likely outcomes of new regulations, based on the findings of Informa Research Services' May 2014 survey of treasury professionals at 14 of the 37 U.S. institutions with over $50 billion in assets.
Contrasting interpretations of the economic incentive criteria in Basel III are leading some banks to consider offering fewer products that allow customers to avoid fees by maintaining higher balances. The LCR makes it less profitable for banks to offer deposit accounts that give customers incentives to maintain excess funds, since these kinds of economic incentives disqualify a product from being classified as an operational (i.e., stable) deposit. The theory behind the rule is that any money that clients do not need for day-to-day transactions is not very stable, since they would be more likely to withdraw it in the event of a crisis.
Some industry insiders believe that product features such minimum balance requirements, earnings credit rates and exception pricing count as forms of economic incentives under Basel III. For example, remarks made during the comment period to the Federal Reserve implied that earnings credit features, which apply credits on customer deposits to offset service fees, encourage depositors to keep excess balances in their operating accounts.
This is a concern for 35% of respondents in the survey, who indicated that they anticipate making strategic changes to their ECR product lines to avoid having them classified as incentives. However, others insist that earnings credit rates are not economic incentives, since they are a less direct way of compensating their commercial clientele for account balances than hard interest on interest-bearing checking accounts.
In lieu of minimum balance requirements and ECR features, banks may begin offering more products that use alternative approaches to compensate for lost fee revenue. For example, the practice of requiring customers to perform a certain number of transactions per month may become more widespread among offerings for commercial clients.
One-third of survey respondents do not feel that strategic changes to their current ECR offerings are warranted. They expect the Basel committee to acquiesce to the requests of the financial industry's biggest players and exclude ECR product types in the final rule. Either way, we believe that ECR products will continue to be a key component of commercial product lines across institutions. If banks don't receive an exception to the rule, they are likely to create their own loophole.
The debate over economic incentives isn't the only concern that product managers are currently facing. Now pricing groups need to focus on creating new ways to recover losses related to higher run-off rates the increased percentage of client deposits that banks are now required to hold in reserves on less stable account types. With higher capital requirements cutting into banks' profit margins, one could expect banks to raise fees and lower deposit interest rates in an effort to recoup lost revenue. However, ideal depositors are now in short supply and fee hikes are bad for business.
This competitive pricing dilemma has spawned many theories. Some suggest that institutions will actually raise commercial interest rates in an effort to compete for more lucrative clients. However, a mere 7% of survey respondents claim that their institutions will adopt this strategy.
Instead, they say they will look to alternative methods of maintaining profit margins. The plan is to focus on adjusting their funds transfer pricing (the valuation of the profitability of deposits and loans) and increase lending spreads to compensate for the higher cost of funding.
Considering the limitations now faced by large commercial institutions, we believe that Basel III has opened up a tremendous amount of opportunity for small- to mid-size institutions. Because smaller banks face fewer restraints, they now have a competitive edge.
Banks that are not subject to LCR requirements may now begin devising campaigns to pursue clients that are no longer advantageous for large institutions to maintain, such as correspondent banking clients. Smaller institutions may also have the capability to offer product types that are less profitable for larger institutions under Basel III. Moreover, they may be able to offer higher interest rates and lower fees to certain types of clients because they are not discouraged from doing so by LCR requirements. In the coming months, it may well pay to be small.