The Alternative Investment Management Association and S3 Partners jointly sponsored a new survey and report on the consequences of the Basel III reforms on the alternative-investment world.
Basel III, a voluntary set of banking-supervisory standards for capital adequacy, stress testing, and market liquidity, published in its final form by the Basel Committee in April 2014, led in The United States to (among much else) the September 2014 issuance of a final rule by the federal banking agencies implementing the liquidity coverage ratio (LCR). This is a rule mandating the size of the pool of liquid assets that banks must maintain in order to cover net outflows over a one month stress period.
Basel III also involves a longer-term liquidity rule, the net stable funding ratio (NSFR), which requires that banks hold long-term debt or equity against hard-to-finance assets.
The AIMA/S3 report on the consequences is consistent with the broad outlines of a report by Edward Grissell and John Duckitt that appeared in the Q1 2015 issue of the AIMA Journal.
Among the findings of the AIMA/S3 study:
- Half of firms report that their financing costs have already risen: half of those say the rise has been greater than 10%.
- Seventy-five percent of forms expect further cost increases over the coming two years.
What the Prime Brokers are Asking
- Fund managers say that they will have to rethink their prime brokerage relationships as a consequence of Basel III.
- More than 67% say that they have been asked to cut the amount of cash they keep on their brokers’ balance sheets.
- Roughly one third have been asked to move a portion of their book to swap,
- Also, one third has been asked to change the type of collateral they post, which is as much an ROA as an ROE issue.
The NSFR in particular has meant that alternative-investment clients with illiquid strategies, which of course require the funding of assets that cannot qualify as high-quality liquid assets, will face significant impact.
Along with Other Challenges
Basel III has gotten off the drawing boards and is having real-world impact at a time when the banking industry is facing other regulatory changes, such as the Volcker rule in the U.S., the Vickers reform in the U.K., and the Bank Structural reform in the EU, all of which have a common characteristic. They all (in the words of the AIMA/S3 paper) “restrict the activities that can be undertaken by a banking entity, as well as the investments that it is able to make.”
Meanwhile, the Financial Stability Board and the Basel Committee have together developed a Total Loss-Absorbing capacity (TLAC) standard that applies to global systemically important banks (G-SIBs), designed to ensure that a failed G-Sib will have “sufficient loss-absorbing and recapitalization capacity to implement an orderly resolution that minimizes impacts on financial stability, ensures the continuity of critical functions, and avoids exposing public funds to loss.”
These reforms all add up to the same squeeze, ensuring that banks can no longer simply seek to maximize their revenue in their relations with hedge funds and other alternative vehicles. Banks have to assess carefully “the capital implications and other constraints of individual clients and business lines.” For the alternative investment world, then, there aren’t as many full-service banks as there used to be.
The survey respondents come from around the world, but with a strong emphasis on North America and the United Kingdom, which represent 52% and 32% of the population, respectively.
Likewise, the alpha-seeking participants in the survey pursue a wide range of strategies in that search, but the emphasis us on long-short equity. That strategy represents 21% of the whole. Multi-strategy entities constitute another 15%. The third best represented strategy is the event-driven.
The survey’s results are, the report says, “generally consistent across all participants regardless of size, strategy, or geography.” The impact of regulatory winds on the relationship between hedge funds and their prime brokers in particular is seen in a consistent manner across the landscape.
One survey respondent in particular put the general sense of puzzlement that this has generated in succinct terms. He said, “The fact that free cash balances are no longer wanted by our bank financing counterparties is insane. If you can’t deposit cash with a bank, them where…?!”