As regulatory measures such as Basel III would impact network of market and counterparty relationship, hedge funds need to consider the critical drivers of change affecting their prime brokers to better adapt to the evolving business environment, notes a JPMorgan paper.

JPMorgan in its paper titled “Leveraging the Leverage Ratio” notes a more resilient banking and financial system will ultimately benefit hedge funds as counterparties will be better capitalized, with stronger balance sheets and will operate with more robust financing models than before the financial crisis.

Change drivers in prime brokerage funding model

According to the JP Morgan paper, the three elements of Basel III viz.: enhancing bank capitalization, reducing bank liquidity risk and constraining bank leverage will have potential impact to banks and indirectly to their hedge fund clients.

The paper highlights that the Basel Committee mandated an increase in common equity Tier 1 capital from 2% to 7%, with further buffers added to bring target common equity Tier 1 capital ratios to ~10% for so-called Systemically Important Financial Institutions (SIFIs). Hence banks have taken immediate action because as their capital buffers increase, in a flat to declining revenue environment, the return on capital falls.

Hence the paper points out that hedge fund managers should anticipate banks to become more discerning in their allocation of equity to support new and existing business.

Turning its focus on the liquidity risk, the paper highlights that to withstand periods of extreme funding stress, the BCBS introduced the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) with the aim to provide a framework for a more resilient liability structure.

The paper points out that NSFR will necessitate banks to hold long-term debt or equity capital against hard-to-finance assets. This would have a meaningful impact on prime broker financing because allocating a larger proportion of the cost of long-term debt to equity financing will increase funding costs significantly.

Leverage ratio

The JP Morgan paper points out that the BCBS first introduced a leverage ratio in 2010 to serve as a back-stop for risk– based capital ratios. Following consultation with the industry, the BCBS released its final standard on January 12, 2014.  The following table captures the comparison in the Exposure Measure between the two versions:

Hedge Funds Basel Leverage Ratio Framework 2010 and 2014

Less availability of balance sheet for hedge funds’ clients

The paper notes industry-wide, there will be less availability of 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.

Though the full implementation of the Basel III regulations is due only in 2018, banks will be reporting the new ratios to regulators from 2015. Moreover, banks will be under considerable pressure to conform to the new standards and have already initiated process to report on how they are positioned for compliance. The following table captures the implementation timeline for the Basel III measures:

Hedge Funds Implementation timeline for Basel III measures

The JP Morgan paper suggests hedge funds to address questions such as which prime brokerage legal entity they contract with currently and whether there are any benefits to switching, understand the prime broker’s funding model and when the prime broker plans to implement the Basel III regulations.

The paper believes the overall effect of initiating the above steps would help forge a stronger, more constructive and more mutually beneficial partnership between hedge fund managers and prime brokers.

See full whitepaper on Hedge Funds Impacted By Prime Brokerage Financing in PDF format here.