Category Archives: Counterparty Risk

What’s It All About, Treasury?

Well it looks like the day may have finally come. After years of more and more regulations being heaped on the U.S. banks the Treasury announced in June plans to ease, or a least revisit, a number of the Dodd Frank rules. Most of the proposed changes will not require the approval of Congress, which makes it even more likely that many of these changes will happen (unlike the Financial Choice Act which will likely not get passed by the Senate). The upshot is that the Treasury is putting the brakes on any new regulation and is taking a significant look at what needs to be changed in the existing regulations.

Now that Fed Governor Daniel Turrullo is gone and bank-friendly folks are at the reins in the Treasury department the road has been cleared for this kind of action. Many have been calling for a time-out to evaluate the effects of the now seven year old Dodd Frank regulations. It only makes sense to take some time to do a review to see what is and what is not working. This type of discussion has been difficult with the extreme partisanship in Washington and lingering populist anger with Wall Street. That said, there have been many unintended consequences from the financial regulations and some recalibration needs to be considered. The Treasury proposal should be encouraging for the major banks. It gives them some hope that they won’t have to deal with any new regulations and what they already have to deal with may get dialed back.  

What does all this mean for prime brokers and hedge funds?

The Treasury proposal contains changes to two regulations that will be a positive for prime brokers: the Supplementary Leverage Ratio (SLR) and High Quality Liquid Assets (HQLA). Specifically the proposal addresses some of the inefficiencies of the SLR and broadens the definition of HQLA to more closely align with that of the foreign banks.

The change to the SLR would provide the prime brokers with more balance sheet capacity. The U.S. banks are already well above the leverage thresholds and these changes will only increase this buffer. The SLR changes and their impact on prime broker balance sheets may also lessen the balance sheet scarcity especially in a crisis. The change to the HQLA definition won’t directly impact the primes but it may reduce the internal liquidity charges allocated to their business.

That said, in the end these changes are incremental and it will take a while for whatever changes are made to flow through the hedge fund financing food chain. Therefore status quo will probably be maintained for the foreseeable future. The primes and the hedge funds have reached a steady state in terms of managing the balance sheet and client returns. In the end the current counterparty risks brought on by regulation probably won’t be eased much for two reasons. First as mentioned earlier, these changes will take time. Second, the banks will be slow to make any big changes to their capital and liquidity management process knowing that a change in the political winds could reverse what the treasury is proposing to roll back.

In the end I will paraphrase the legendary Barton Biggs who once said in reference to tough times “…the news doesn’t have to be good it just needs to be less bad.” The Treasury proposal news is less bad for the banks.

Capital Idea

Financial regulation in the U.S. is turning out to be the gift that keeps on giving. Hopes of repealing Dodd Frank could turn out to be a cruel bait and switch for the major U.S. banks. The major players in this drama are Representative Jeb Hensarling (R/TX), FDIC Vice Chairman Thomas Hoenig and outgoing Fed Governor Daniel Turullo.

In late 2016 the house banking committee passed the Financial Choice Act, which is the their version of “repeal and replace” for Dodd Frank. The basic outline of the bill is as follows: If the banks keep 10% CET1 to total (leverage?) assets they will be exempted from some regulatory standards. The bill also repeals the Volker Rule. The bill is wildly unpopular with democrats and generally viewed as more of a messaging tool i.e., conversation-starter for negotiations on changing or repealing Dodd Frank.

FDIC Vice Chairman Hoenig recently put forth a proposal (“term sheet”) that would have the banks create two interim holding companies (IHC) below the parent financial holding company (FHC). One IHC would be for commercial banking activities and the other for non-traditional activities, mostly related to investment banking. Both IHC would be separately capitalized and inter-IHC transactions would be prohibited. In essence a 21st century Glass Steagel as our friends at Cadwaladar point out:

“The enhanced restriction on affiliate transactions and the separate capitalization requirements effectively mean that the banking and nonbanking arms of the FHC would be run as two largely standalone entities operating under a common brand.”

Both IHC would be required to meet a “10% leverage” test and in exchange would be exempted from many of the current regulatory metric standards (CET1, SLR, LCR, Living Wills, and certain Stress Test requirements). The banks would be given three years to migrate to the proposed structure. Again is this an opening gambit to future negotiations or end-state alternative regulatory structure?

Next we have the exit of the regulatory hawk Fed Governor Daniel Turullo. His departure probably means a significant foot off the gas pedal on bank regulation. Turullo’s reign, unofficial as it was, which makes it even more impressive, brought, among other things, ever-stricter CCAR and Living Will standards and capital surcharges for the major U.S. banks. His absence will create at least a temporary vacuum in the bank regulatory space, which may end up being the most significant regulatory relief for the banks in 2017.

Not everyone is jumping on the “capital is king” bandwagon. There was a recent op-ed in the Wall Street Journal that took the other side of this argument[1]. Tim Congden and Steve H. Hanke wrote that excessive capital requirements at banks would result in the economy sliding back into the conditions experienced during the great recession. Their thesis is that banks can meet ever increasing capital ratios two ways: raise capital or cut assets (which is exactly what J.P. Morgan did to reduce the Fed’s 2015 capital surcharge). The bank assets that would be reduced are comprised of loans to the industrial and commercial sectors of the economy. Lower lending activity equals reduced access to credit thus damaging the economy.

Clearly the view in DC is that capital is the key to bank stability. The more capital the banks have the more stable they will be[2]. There are unintended consequences flying off in all directions with these proposals.

First there would be a further widening of the differences in standards for US and International banks. This would result in making it harder for the US banks to compete with the foreign banks. Then there is the Congden/Hanke argument that increased capital requirements for the banks would plunge the economy into a deep recession. More capital also means the banks have to generate higher revenues to maintain, or increase, their ROE. Most of the banks are already struggling to make 10% ROE.

Finally there is the FDIC proposal, which really only affects about four of the major banks: JPM, Citigroup, BAML and Wells Fargo[3]. Morgan Stanley and Goldman Sachs aren’t really banks, though they would probably benefit from a leveling of the playing field with the big banks (who have been making inroads into their prime brokerage market share). The FDIC proposal seeks to ring-fence a separately capitalized investment banking entity so that it can fail without impacting commercial and retail bank customers. However one has to ask, even with separately capitalized investment bank would the government not bail them out in a crisis? It doesn’t take a bank failure to destabilize the world economy (e.g., Lehman Brothers). It seems like a lot of effort that does nothing to solve for Too Big To Fail.

Admittedly it is early days for both these proposals, so how much should we worry about this? Congress isn’t looking too effective right now at getting anything passed. Dodd Frank reform, or repeal, is way back in the line behind tax reform, infrastructure spending, etc. The FDIC idea would also take an act of Congress and cooperation from the banking industry. Not such a high probability at the moment. Still the “capital is king” movement bears watching. Bank regulation, in the form of Dodd Frank but more importantly Basel III, has had a significant impact on banks’ financing of hedge funds. These proposals by the Congress and the FDIC would ratchet up the capital requirements at the major U.S. banks. Higher bank capital requirement will result in a further reduction in balance sheet and financing available to hedge funds. Not such a capital idea.

[1] “More Bank Capital Could Kill the Economy” by Tim Congdon and Steve H. Hanke, The Wall Street Journal, March 13, 2017

[2] We haven’t even discussed Minnesota Fed President Neel Kashkari’s call for bank capital levels of more than 20%. Yikes!

[3] It’s probably a good idea to keep the retail guys separate from those risky IB folks.

The Art of Counterparty Risk Management

The kerfuffle last fall around the fortunes of Deutsche Bank resurrected the question among hedge funds about how to react to increased insolvency risk at one of their counterparties. Call it Lehman Brothers redux. The potential $14B mortgage settlement with the DOJ created panic among the bank’s clients (the flames being ably fanned by the media coverage). The Deutsche Bank situation forced their hedge fund clients consider whether to reduce exposure and by how much. One would think with what hedge funds learned in 2008 that they would move decisively in this type of situation. I would suggest that in 2017, more than eight years after the fall of Lehman, that this is still a difficult decision. Counterparty risk management remains both science and art.

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Will The Donald Trump Dodd-Frank?

Since the populist fervor swept Donald Trump into the presidency last week financials have been rallying based on the feeling that his dovish views on financial regulation will lesson the constraints on the banks. In particular Trump has talked about repealing or significantly rolling back parts of Dodd-Frank the landmark banking regulation that was put in place after the financial crisis. The House Republicans have also recently passed the Financial Choice Act that is aimed at paving the way for changes to Dodd-Frank.

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Blame It On Cain

One thing that has caught my attention recently is how both political parties in the race for the 2016 presidency have amped up the vitriol again on how they are going to “get tough on Wall Street”[1].  I wrote about this a while ago in my piece on Elizabeth Warren. (Who by the way was recently mentioned as a potential running mate for Bernie Sanders. Just so you know I will be doing an Alec Baldwin and leaving the country.) How can they say something like this with a straight face after Dodd Frank and Basel III? Either they’re being dishonest or aren’t very bright. Based on past performance I would lean towards the former with a decent dose of the latter.

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When The Levee Breaks

“If it keeps on raining the levee’s going to break”[1]

In our case the levee is the prime broker industry and the rain is government regulation of the banking industry. The levee’s not looking too good these days. Recent news from some of the major foreign banks show we have moved, and are accelerating, into the next phase of re-structuring the prime brokerage business.  The script is playing out with the major prime brokers “focusing on our core client base” which is code for “we’re re-pricing or throwing everyone over the side that makes sub-optimal use of our balance sheet”.

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The Known and the Unknown

“There are known knowns… there are known unknowns… and there are unknown unknowns…”  Donald Rumsfeld

In this age of uncertainty over the regulatory impact on the banking industry we turn to former Secretary of Defense, Don Rumsfeld[1] for some guidance on how to think about managing counterparty risk. Let’s break down this quote and see where it leads us.

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