Regulatory Impact on Prime Brokerage Financing

Regulatory measures such as Basel III will change the way banks operate and impact the traditional hedge fund financing model – which has largely relied on a prime broker’s ability to finance portfolios. Structural challenges to the prime brokerage financing model are, in effect, structural challenges to the hedge fund financing model. Banks are becoming more selective, increasingly evaluating relationships with hedge funds based on the impact on their (i) balance sheet, (ii) return on client assets and (iii) pricing opportunity. The impact may not be shared equally across all hedge funds and strategies.

Basel III will impact banks in three major ways:

1. Enhancing Bank Capitalization:Hedge fund managers should anticipate that banks will become more selective in their allocation of bank equity to support new and existing business, redirecting resources away from businesses that are expected to earn low returns on bank equity.
2. Reducing Bank Liquidity Risk: To withstand periods of extreme funding stress, the Basel Committee on Banking Supervision (BCBS) introduced the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) with the goal of providing a framework for a more resilient, longer term liability structure.The regulation is designed to shift a bank’s funding dependency from overnight to term so that Banks match their funding commitments. Term financing comes at a higher cost which is likely to be passed on to hedge fund clients.
3. Constraining Bank Leverage:The leverage ratio is expected to reduce availability of bank balance sheet for hedge fund clients.Clients who may be particularly at risk are those whose strategies are significant consumers of balance sheet such as highly levered, directional portfolios with little or no internalization value. Banks and their hedge fund clients will need to work closely together to optimize the usage and availability of financing.

The calendar for implementation of the Basel III regulations, reporting and ratio testing begins early 2015 and continues in earnest to full implementation in 2018.In addition to Basel III, local country variations of these ratios have already commenced and in some cases add a further layer of requirements.Finally, limits on prime brokerage capacity and risk appetite as well as pricing adjustments are already apparent in the financing marketplace.

Michael Katz is the Founder and Managing Partner of Quadrangle Consulting LP. Michael has spent his career building world-class investment management firms. Prior to Quadrangle, Michael was the Managing Director and Co-General Counsel at Paloma Partners. Michael was responsible for legal, regulatory and compliance as well as various business and transaction matters between the investment partnerships, funds and management company. He helped develop the fund’s operational banking arrangements and built best practice models for each of the fund’s trading strategies. Michael also was instrumental in building the infrastructure for Paloma’s seeding platform.