Karl von Buren
Head of Financing Solutions
Managing Director and
Global Head of Repo
Head of Prime Finance EMEA
At the core of the new regulations is the recognition that it was principally a liquidity crisis and an over-dependence on short term finance that drove the global financial system to the edge of the precipice. This is why one of the central pillars of the Basel III regulatory principle is the liquidity coverage ratio (LCR). This calls for banks to hold an adequate stock of unencumbered high-quality liquid assets that can be converted easily and immediately in private markets into cash to meet banks’ liquidity needs within a 30 calendar day liquidity stress scenario. As the Bank for International Settlements (BIS) explains, the LCR was designed to “improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill-over from the financial sector to the real economyi.”The LCR, which was introduced at the start of 2015 and should be fully implemented by 2019, is to be supplemented by the net stable funding ratio (NSFR), which is due to take effect in 2018. This has been developed to ensure that lenders maintain a 'sustainable funding structure', in order to reduce the likelihood that disruptions to a bank’s regular sources of funding will erode its liquidity position in a way that would increase the risk of its failure and potentially trigger broader systemic stress. “The NSFR limits overreliance on short-term wholesale funding, encourages better assessment of funding risk across all on- and off-balance sheet items, and promotes funding stability,” according to the BISii.
These two key liquidity ratios have been complemented by the leverage ratio. Aimed to contain the build-up of excessive leverage within the global financial system, the ratio is a measure of a bank’s leverage exposure to its tier 1 capital, and ranges between 3 per cent and 6 per cent.
Karl von Buren, Managing Director and Global Head of Equity Finance Delta One at HSBC, says that in aggregate, these regulations represent an effective set of tools for de-risking the system. But he adds that for the prime brokers which have traditionally been the principal source of financing for hedge funds and other institutional investors, the ramifications of the evolving regulatory regime have been complex and far-reaching. In many instances they are forcing banks to reappraise their financing strategies.
This is because a common objection to the leverage ratio, for example, is that it does not take account of the risk-weighting of assets in its calculation. “One of the effects of the leverage ratio is that it can tend to reduce the incentive for banks to lend against high quality assets,” says Vinay Raj, Managing Director, Head of Financing Solutions at HSBC. “Higher quality assets attract a lower margin, but use up the same amount of balance sheet and hence capital, which makes it more challenging for banks to strike the right balance between balance sheet consumption and riskiness of lending.”
Funding: What has changed?
More generally, the primary consequences of the cascade of new regulation for banks has been the increase in costs and complexity of bank funding. Because the LCR requires banks to hold sufficient cash to meet their commitments in times of stress, it is incentivising banks to rethink the structure of their deposit bases, which have traditionally been their most efficient and cheapest form of financing.“Today, we have to look very carefully not just at where our deposits are coming from but also the forms those deposits take,” says Raj. “Much of our funding focus is now on corporates which could be more beneficial for NSFR. This can be in a number of different formats ranging from simple triparty corporate repo to SPV-related notes, both of which are a strength for HSBC given the depth of our corporate relationships.” HSBC was named ‘World's Best Bank for Corporates 2016’ in the Euromoney awards for excellence in June.Jean-Michel Meyer, Managing Director and Global Head of Repo at HSBC, says that in the UK, another driver of rising funding costs for banks is ring-fencing of retail banking operations. “At HSBC, we are fortunate in the sense that we have multiple balance sheets all over the world,” he says. “But we will still be affected because our UK retail bank - an important source of NSFR-compliant liquidity - will be ring-fenced.”
Clients’ funding pressure and collateral transformation
As Meyer explains, in the new regulatory environment it is not just bank lenders that are facing a barrage of new cost pressures which is in turn increasing clients’ costs of access. Additionally the same regulatory pressure is changing the shape of the business clients are engaging in or need to engage in, with implications for financing and collateral transformation. For example, pension funds, although currently exempted from mandatory central clearing of over-the-counter derivatives contracts, are expected to become subject to initial margin requirements.Margin requirements will also require collateral to be liquid, which could effectively mean that this would need to be in cash or government bonds. This is why collateral optimisation or collateral transformation is likely to become increasingly important for asset owners. As Von Buren explains, this is especially relevant in the case of equities. “While the main equity indices are regarded as liquid, price volatility over stressed periods is such that it takes out a large proportion of individual stocks,” he says. “So our challenge is to transform what is fundamentally an illiquid book into a liquid one.”
“We can make that transformation through a whole variety of transactions,” Von Buren adds. “Some are as straightforward as borrowing government debt and lending out equity as collateral, which we call a collateral upgrade. Then there are various bespoke derivatives trades based effectively on the forward sales of illiquid assets.”
Reshaping prime broking relationshipsAt the most extreme level, pressure on funding costs and banks’ intensified scrutiny on the efficient use of their balance sheets is leading some to withdraw from prime brokerage entirely. Increasingly, this is creating opportunities for non-bank financial institutions to step into the gap, providing an alternative source of financing for hedge funds, but probably injecting an added element of counterparty risk into the system.
The banks that remain committed to prime brokerage – such as HSBC – are revisiting their business model in a number of ways. Most obviously, it is leading them to re-evaluate the viability of their relationships with institutional clients. This is because to date, many of the rising costs of prime brokerage have been absorbed by the banks themselves.
Increasingly, however, it is inevitable that these costs could end up being passed in part or in whole to the end clients. This could add to the pressures on smaller funds, which are already having to adjust to a world of steeper compliance costs. Those hedge funds specialising in less liquid asset classes, and those with investment strategies that are highly dependent on leverage, are likely to be most negatively affected by mounting costs across the industry. “A long/short market neutral equity strategy which turns over its portfolio frequently and is prepared to trade synthetically is more likely to be attractive to service providers than a passive stock-picker,” says Von Buren.
“Balance sheet constraints mean that there is now a finite amount of leverage available on the Street for clients, so banks have to be much more selective,” adds Loic Lebrun, Managing Director, Head of Prime Finance EMEA at HSBC.
The result, he says, is that while tier one institutions with sizeable financing needs and a range of other financial service requirements may be better prepared to navigate the regulatory blizzard sweeping across the industry, tier two or tier three institutions lacking critical mass may be more negatively impacted. “In the past, banks may have been happy to maintain pure financing relationships with clients,” says Lebrun. “Today, for that relationship to be sustainable, banks also need execution off the back of the balance sheet commitment. So there is now much more of a focus on how we bring together our financing and execution capabilities as a holistic offering for the client.”
The impetus for the change in the relationship between banks and their clients will not come solely from prime brokers weighing up the size and attractiveness of institutions’ wallets or their potential as a source of so-called execution dollars. As Von Buren points out, asset owners themselves are now increasingly rationalising the number of prime brokers they use.”
Either way, it is likely that providers as well as consumers of liquidity will need to work together to explore creative solutions in response to balance sheet constraints. “The challenge for everybody is to find the most efficient way of delivering scarce balance sheet resources to clients in a way that generates an acceptable return for the bank while complying with the new regulations,” says Raj.
Creative financing solutionsThe challenge of maximising efficiencies in apportioning scarce balance sheet resources is already forcing banks to be more creative about how they provide financing for institutional clients. This is underpinning a notable rise in synthetic prime brokerage. “This is certainly an area where we are pushing for more growth, because if clients are trading synthetically it gives us a lot more control over the management of our balance sheet,” says Von Buren. “Our ideal scenario is one in which a client wants to short a given stock on a synthetic basis and we can match the other half of the transaction from a client who wants a long exposure to the same stock. This is highly balance sheet-efficient, but depends on matching clients with opposite trading requirements.”
For many of the larger and more creative asset owners, which are able to channel resources into their treasury functions, the demand for a bridge between suppliers and consumers of liquidity dynamic is creating a new potential source of alpha. Hedge funds, in particular, are exploring ways of lending unencumbered assets to other investors. “A lot of the conversations we’re having with some of our larger and more sophisticated investor clients is about the opportunities that the new regulatory environment is giving them to act as liquidity providers,” says Von Buren. “If we had suggested 10 years ago that hedge funds could provide the banks with financing, liquidity and balance sheet, people would have thought we were mad. But that is exactly where we are today.”
A bank such as HSBC, meanwhile, is ideally positioned to leverage the combination of the strength of its balance sheet, the breadth of its global network and its credit rating to act as an intermediary. “Our global client reach means we are able to provide a bridge connecting different pools of liquidity be it by geography, client type or currency,” says Raj.
This mirrors HSBC’s broader ability to address the thorny issue of liquidity mismatches that have been the driver of so much regulatory change over the last few years. “The regulators are asking consumers of liquidity to go longer-dated, and suppliers of liquidity to go shorter-dated,” is how Von Buren summarises the financing dilemma facing the industry today. “The winners will be those that can navigate a market that is being pulled in two different directions and create solutions that can satisfy both sides of the market.”
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i Basel Committee on Banking Supervision - Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013
ii Basel Committee on Banking Supervision - Basel III: The Net Stable Funding Ratio, October 2014