How will the next crisis look? We’re not talking about cause but effect. No one knows what will tip the balance, where that vulnerable inflection point lies. Examining some possible scenarios can help us to prepare and protect ourselves during the next financial crisis.
Regulators are always fighting the last war, trying to prevent what caused it from happening again. They usually do a decent job of this and the last crisis is no exception. Banks are better capitalized and less leveraged than 2008 and there is little argument about this. Will LCR and the matched funding requirement of NSFR enable banks to withstand a loss of access to the funding markets? That’s the theory.
But there are always blind spots (unaddressed issues) and unintended consequences (new problems created by the solutions).
The other variable that can’t be discounted is the effect of the anti-bank populist sentiment that remains strong seven years after the crisis. The politicians are committed to protecting the masses from effects of the next banking crisis. As usual they are long on rhetoric and short on fact but it plays well.
So how might the next financial crisis play out? Here’s one doomsday scenario:
- No or slow bailouts of troubled banks; congressional oversight slowing the Fed’s response to the crisis
- Government regulation forces the hording of liquid assets by the major banks. This combined with derivative CCP increases in margin requirements creates a shortage of treasury collateral that results in reduced liquidity in the credit markets
- Living Wills and the Orderly Liquidation Authority (OLA) prove to be a fiction as multiple banks fail quickly as the contagion spreads
- CCP participant failures threaten some depositories testing the LSOC customer protection model for the first time.
- Banks, constrained by Basel III, place limits on accepting additional financing business that leaves hedge funds with fewer options for transferring their assets away from troubled prime brokers.
- Banks turn inward and become more concerned with saving themselves at the expense of their customers. Term lending agreements are voided as primes look to significantly reduce customer financing.
- Large custodian banks, now integral to hedge fund asset protection, are under-resourced to deal with the magnitude of the crisis adding to the asset transfer gridlock.
The government talks big about letting banks fail but when they start to realize the consequences of an economy without credit they’ll rush to save the banks. But as we learned in 2008 responding quickly made the difference. Once the banks start to fail things may take on a life of their own and government action may not be able to stop it.
Now this doesn’t sound like fun. Could it happen this way? Probably not but who envisioned the carnage of 2008 and how close we came to a complete meltdown of the global financial system? Let’s assume for now that at least some of the scenario plays out this way. One of the more significant risks facing hedge funds in the next crisis is the breakdown of the multi-prime model.
Balance sheet constraints at the big banks are changing the risk mitigation benefits of the multi-prime model. The model is built on the premise that if one of your primes gets in trouble you can just move your financing balances to one of your other primes. Basel III, and more specifically the Supplementary Leverage Ratio, has changed all this. There is only so much balance sheet and only so much financing a prime broker can take on. This situation may be exacerbated in a crisis as bank balance sheets allocated to customer business are further reduced. Hedge funds transfer requests could be turned away or delayed in a crisis.
How can you be ready? What can you do to protect your firm and your assets? Here are some actions steps to consider:
- Identify which of your prime brokers will take your book in a crisis. This needs to be a part of the ongoing dialogue with your financing providers.
- Your prime brokers are dynamic organizations. You need to stay current on all aspects of the risk you are taking on with your counterparties.
- Develop a crisis management plan. Waiting until the crisis hits is too late. The hedge funds that have a plan, and keep it updated, will be more nimble and able to move quickly to protect their assets.
Readiness is all.
 For more on unintended consequences and blind spots see my post “What They Wished For” (10/27/15).
 “They want to make you scared of it and tell you who’s to blame for it. That’s how you win elections in this country” (Michael Douglas in the “American President”).
 U.S. Senators Elizabeth Warren (D-MA) and David Vitter (R-LA) recently introduced the “Bailout Prevention Act of 2015”. The bill would halt large bank bailouts during a financial crisis by limiting the lending authority of the Board of Governors of the Federal Reserve System.
 Large amounts of High Quality Liquid Assets (HQLA) are required to meet the Liquidity Coverage Ratio (LCR) to fund the banks’ operations for thirty days during a crisis.
 There is a great scene in the movie “Too Big To Fail” where Ben Bernanke, played by Paul Giamatti, explains this point to the congressional leadership.