Press article: Asset management within Basel III framework: back to former gloryDOWNLOAD
A new wave of regulation of the banking sector, traditionally depicted under the acronym ‘Basel III’, is under progress. The underpinning foundations of this large-scale cure program recognise the profoundly volatile and erratic nature of the financial system. Access to funding, resiliency of counterparties, protection against credit risk through collateral management and the eligibility of assets are no longer taken for granted, but rather assimilated as core, structural risk factors.
A set of qualitative and quantitative requirements are being established to mitigate these risks and to ensure supervision facilities. The asset side of balance sheets will correspondingly be cleared-up and managed in a brand new way, taking a liability, constraints-driven perspective. To accompany this structural mutation, and as described in the following, the asset management function is likely to enter a new golden age.
First, the universe of securities eligible for own funds composition is significantly restricted in the Basel III convergence scheme. Pioneering asset management techniques, such as securities picking, portfolio optimisation and tactical allocation program, will all the more recover past laurels as the degrees of freedom tighten.
Second, banking provisions will evolve from merely static to dynamic quantities: the process of reserves accumulation and realisation will be self-regulating. Pragmatically, capital shall be stored ‘when cows are fat’, with a view to be liberated to help sustain times ‘when cows are lean’ - hence a countercyclical flows dynamic. This is very much alike to managing assets with a pre-defined risk envelope, hence giving rise to a range of techniques apprehending the optimisation of the portfolio in order to sustain ‘all-weather’ conditions (hedging, management of derivatives, etc.).
Third, collateral management should emerge drastically reinforced within the Basel III framework. Acknowledging the structural inability to actively diminish the probability of default counterparts, managing collateral is an effective way to optimise recoveries. From a large exposure or capital reduction standpoint, credit risk mitigation techniques are implicitly elected by Basel III as the sole efficient scheme to alleviate credit exposures and spare capital. Considering the ever-growing granularity of liability risks within balance sheets (e.g. short-term inter-banking funding is no longer exempted from global exposure calculation), the need for collateralisation will increase. Within the collateral portfolio, credit risk has been ultimately transformed into other kinds (market/operational/liquidity), which need to be monitored with the same care and principles used to manage the firm’s asset portfolio.
Finally, banks will have to maintain a sufficient level of highly liquid assets to sustain liquidity risk events. Some metrics have been chosen to allow equalisation and benchmarking amongst banks, including the Liquidity Coverage Ratio (LCR), i.e. the ratio of the stock of high quality liquid assets to the net cash outflows over a 30-day time period, estimated under a specified acute stress scenario. As it turns out, the stress scenario is, so far, very aggressively calibrated. Indeed, contractual cash-inflows from intra-group exposures are not taken into account for the calculation of the net liquidity inflows, resulting in a large denominator for the LCR. Combined with the requirement of maintaining high quality assets in excess of this cash outflows provision, this might question the viability of structural liquidity suppliers’ business models. For survival sake, these entities would have no other option but to actively manage a pool of liquid assets. This might, in itself, be a very new activity for institutions which did not need to develop an accurate expertise in the field so far.
In a nutshell, the Basel III framework uniformly increases the role and importance of asset - management within banks; to the detractors of this large-scale reform, this is at least one aspect for which the cure is not worse than the disease.