What They Wished For… The (Unintended) Impact of Financial Regulation: Part 1

“The war is over. They won”. [1]

The impact of Basel III and Dodd-Frank on the banking industry is becoming clearer and it appears the government is getting what it wanted:  a smaller, less risky and less leveraged banking system.  Capital ratios, leverage and liquidity rules are all combining to constrain the size of the major banks. Throw in the Volker rule so banks can’t risk their own capital through prop trading and the picture is complete. However in the world of unintended consequences, to paraphrase the Rolling Stones, you can’t always get just what you want.

On a macro level, the large banks will generally be less able to provide capital markets services because of regulations limiting the size of their balance sheets. We are already seeing large banks exiting low return lines of business. The universal bank model will become less prevalent as the players stake out their higher return niches.  In the prime brokerage business, here’s what is happening, and what I think will happen:

  • Prime brokers are already seeing their business constrained by limits on margin lending and stock loan. This will result in them restricting the amount of balance sheet available to clients at a time when the hedge fund industry is growing to record levels.
  • The prime brokers’ new focus on not just revenue but return, will lead to price increases and clients being asked to exit the platform. There there is evidence this is already starting to happen.
  • More complex strategies e.g., distressed debt, that require leverage will have fewer financing options as more primes back away from these low optimization, low return lines of business.
  • Balance sheet constraints will then lead to mid-tier banks gaining share of the prime brokerage business as hedge funds seek out alternative financing sources.  Hedge funds with four primes will need six, six will need eight and so on.
  • This over-diversification of the multi-prime model will ultimately result in increased counterparty risk as lower capitalized institutions take on more hedge fund financing.  There is also the possibility of increasing operational risks as hedge fund demands outstrip these emerging primes’ capabilities. It may also put a strain on hedge fund operations as they are challenged by managing additional, less efficient financing relationships.

This will take awhile to shake out but it will. These new regulations will probably prevent the big banks from getting into the kind of trouble they did in 2008. However that doesn’t mean this new world order will be less risky for hedge funds. Be careful what you wish for. [1] Extra credit is you can identify the movie from which this quote comes.

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