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With impending Basel III regulations set to impose much higher capital requirements on banks, theknock-on effects on corporates and their hedging activities could be significant. By starting to look atthe changes now, companies will be able to better understand the impacts on their businesses. Also,given the regulations are not yet finalised, now is the time to make any concerns known to legislatorsand regulators, or the window of opportunity could be missed.

The Basel Committee on Banking Supervision has pretty much firmed up its recommendations for the newBasel III regulations. Local country regulators however are still finalising how to enforce the rules in their ownbackyards. For example, the European Institutions (Council and Parliament) are debating how Basel III will beimplemented in Europe via the Capital Requirements Directive, commonly known as CRD 4. Nor is timing 100per cent clear. Although parts of Basel III are intended to go live on 1 January, 2013, this date may yet change.

These uncertainties make it harder to pinpoint what the exact implications of the new rules will be. One pointthe market generally agrees on is that hedging costs for most corporates are likely to increase.

High level changes to capital requirements

Among the most significant changes, Basel III will increase the minimum level of capital a bank must holdagainst the risk of loss from derivative exposures to counterparties.

A new Credit Valuation Adjustment (CVA) Risk Capital Charge is being introduced, which covers potentialmarket value losses from deterioration in the creditworthiness of a derivative counterparty, short of actualdefault. For example, as the perception of a companys creditworthiness declines, the market value of theirobligations also decreases, even if there has not been a default. This CVA charge is in addition to the existingDefault Risk Capital Charge for counterparty risk.

Potential impacts on corporates

Across Basel II and the impending Basel III, derivative capital requirements are broadly based on three criteria:

1. The credit quality of each counterparty, including both probability of default and loss given default.2. The transactions themselves, where the potential mark-to-market exposure is key. This is especially relevant

to long-dated derivatives, cross-currency swaps, and linker-style inflation swaps.3. The collateral, if any, offsetting the banks exposure, such as through a credit support annex (CSA).

Given that the vast majority of corporates deal on an uncollateralised basis, the first two criteria are key inunderstanding the impact of the increased capital requirements on the pricing of current hedging programmes.It is therefore not surprising that those corporates with a lower credit ranking, or that deal in high-value or long-dated derivatives, stand to feel the greatest impact from the new regulations.

There are certain niches of the hedging markets that could also be adversely impacted by the newregulations, such as in utilities where companies fund and hedge on a secured basis to reduce costor increase leverage.

Total Counterparty

Credit Risk Capital

(CCR) Charge

Default Risk Capital

Charge

CVA Risk Capital

Charge =+

This is the current

CCR capital charge,

modified and re-

named

This is the new capital

charge introduced in

Basel III

Total Counterparty

Credit Risk Capital

(CCR) Charge

Default Risk Capital

Charge

CVA Risk Capital

Charge =+

This is the current

CCR capital charge,

modified and re-

named

This is the new capital

charge introduced in

Basel III

Richard Bartlett

Head of Corporate Debt

Capital Markets & Risk

Solutions EMEA

Global Banking & Markets

Peter Ryan-Bell

Head of UK & Western

Europe Risk Solutions

Global Banking & Markets

September 2011

Basel III: The corporate hedging debate

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As the rules are written today, the significantly lower loss given default (LGD) ratio for secured deals is not

considered at all when measuring capital requirements. Instead, the LGD rate of senior unsecured debt is

imposed. For example, if the true LGD of a deal is 5 per cent and the regulations require 60 per cent, 12 times

the required capital would need to be placed against a deal.

On a larger scale, the new requirements have the potential to create more favourable business conditions for

companies in certain countries if the regulations are not implemented consistently across the globe.

Key questions for corporates

Corporates should consider how they will hedge in the future. Research now will help them understand what the

potential impact of Basel III will be on the pricing of typical deals, as well as what alternatives are available.

Broadly, options for corporates are:

Continuing to deal on a uncollateralised basis and accepting any increase in pricing, or looking for ways totweak the structures of current hedge types so they are less capital intensive

Collateralising their deals with their banking counterparties, or, where possible, clearing their over-the-counter transactions in the same way exchange-traded futures are now

Stop hedging altogether under the view that the additional cost makes hedging uneconomic. In our view thiswould not be a desirable outcome of the new regulation, which was designed, in part, to stabilise the real

economy

For higher-rated counterparties that dont deal in long-dated or high-value deals, the increase in pricing may not

be material and can therefore be absorbed, meaning hedging can continue in its present form. Thats not to say

that the likely increase in pricing wont go unnoticed.

Ways that corporates could tweak deal structures to reduce capital and therefore pricing, potentially include use

of breaks and mark-to-market resets.

When deciding to collateralise or clear derivatives, corporates need to compare the higher price of

uncollateralised trades to the lower price of collateralised trades plus the cost of the liquidity to fund the

collateral. There may also be additional considerations in the accounting of collateral to investigate, such as the

impact on covenants and credit ratings, as well as whether collateral can be accounted for as a cash and

equivalent.

When it comes to those corporates that find the increase in pricing unpalatable and also dont want to

collateralise their deals, they could cease or reduce hedging, or switch to capital-friendly hedging such as

purchased options, albeit with a premium requirement. In this case, it is important to understand how changing

hedging programmes could impact risk profiles, results and of course how the market could react.

Each company has to weigh up the best choice based on their business model and ultimately choose a path that

provides the best trade-off between reduction in risk and cost.

Derivatives and clearing

Outside of Basel III, another important aspect of the wave of new financial regulations is the requirement to clear

many over-the-counter (OTC) derivatives. In Europe, this is being introduced by a piece of legislation called the

European Market Infrastructure Regulation (EMIR), which aims to reduce systemic risk in the financial system

by forcing more OTC derivatives onto clearing houses. The type of transactions captured by these clearing

regulations is not 100 per cent clear, though as a general rule they will need to be standardised contracts.

Most corporates are expected to be exempt from clearing requirements as non-financial end users. However,

they may still have the ability to opt-in. This may cut credit risk, as well as slightly reduce capital and therefore

improve pricing versus the CSA collateralisation of deals with banks. On the flip side, clearing also introduces

the concept of initial margin, which means additional collateral and liquidity requirements above and beyondCSA collateralisation.

Also, there may be complications if a standard hedge transaction doesnt perfectly match the risk being hedged.

This could even preclude the application of hedge accounting.

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Get involved

There is a limited time for corporates to be able to voice any concerns they have on the new regulations, and

that time is now. We have heard Members of the European Parliament speak on this topic, and issue a plea to

get involved. Actions a corporate can undertake include:

Assessing the impact of the current version of the proposed regulations on hedging programmes andidentifying where the regulations can be improved

Creating case studies for legislators, highlighting the impact of the regulations

Working together, including with trade bodies and professional associations

RBS and Basel III

RBS has devoted significant resources to understanding Basel III and other new regulations. Teams in our

Global Banking & Markets (GBM) division have close links with legislators and regulators. We are passing on

our knowledge of the issues to our clients to help them understand and prepare for the impending changes.

Where in the world?

As mentioned, Basel III will be implemented in the European Union through CRD 4. In Asia, regulators in each

country will implement regulations individually, taking their steer from Hong Kong, Singapore and Australia. Inthe US, the Dodd Frank Act, which is reforming banking practises in America, has addressed Basel III, but also

outlined other capital requirements that regulators must figure out how to integrate with Basel. The Federal

Reserve will work on Basel III adoption within the Dodd Frank framework and coordinate with other regulators on

the additional capital issues.

For companies with operations across jurisdictions, it is worth analysing how regulators in different countries

may choose to interpret Basel III recommendations and what that will mean for their businesses.

All together, the many considerations to be planned for under Basel III mean now is the time to investigate how

the changes will impact specific businesses and make use of the consultation periods still open with legislators

and regulators.

Map of proposed regulation

Category Key elements Europe US

Capital & liquidity Improve quality of T1 capital, liquidity, stability and reduce leverage

Systemic risk

measures

Oversight of systemically important financial institutions

Resolution/recovery plans, survive/unwind

Bank structure

reform

Limits on prop trading, private equity/hedge fund investment (Volcker)

Swaps spinoff to separate entity

Over-the-counter

derivatives

reform

Execution shift towards electronic trading

Mandatory clearing of over-the-counter derivatives

Real-time post trade reporting

Position limits; agricultural commodity restrictions

Market reformCredit rating agency reform

Securitisation market reform

Hedge funds and

insurance

regulation

Hedge fund registration, transparency and capital

Insurer capital requirements, Federal Insurance office in US

Investor

protection

Retail structured product standardisation and disclosure

Protection bureau, deposit insurance, retail distribution, disclosure,

mortgage regulation

Basel III

CRD IV

ESRB

Cross-border CrisisManagement

ICB (UK)

MiFID

Dodd FrankAct

EMIR

CRD IICRARegs

AIF MD

Solvency II

MiFID PRIPs

See glossary for definitions

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Glossary

Basel III: Basel III is a series of amendments to the existing Basel Accord, a set of rules designed to stop banks

taking on excess risk and damaging the economy. It requires banks to hold more capital against their assets,

thereby decreasing the size of their balance sheets and their ability to invest with borrowed capital.

CRD 4: Capital Requirements Directive 4, the directive through which Basel III will be implemented in the

European Union.

ESRB: European Systemic Risk Board

ICB: Independent Commission on Banking

MiFID: Markets in Financial Instruments Directive

EMIR: European Market Infrastructure Regulation

CRD 2: Capital Requirements Directive 2

CRAs: Credit Rating Agencies

Solvency II: A new, universal solvency regime for all European insurers that aims to make sure they can

withstand financial market shocks.

PRIPs: Packaged Retail Investment Products

Dodd Frank Act: Banking reforms in America

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