Just a few days after finding out that Goldman Sachs Group Inc (NYSE:GS) is scaling back its prime brokerage services to hedge funds, JPMorgan has released a white paper breaking down the impact of Basel III regulation on the prime brokerage business and why hedge fund managers should expect serious changes in their business relationships over the next couple of years, the report is titled “Leveraging the Leverage Ratio – Basel III, Leverage and the Hedge Fund-Prime Broker  Relationship through 2014 and Beyond”.

“Although the reforms will change the way banks operate, those changes indirectly impact the traditional hedge fund financing model which has relied, almost exclusively, on their prime broker’s ability to finance their portfolios as financial intermediary,” says the JPMorgan report. “Structural challenges to the prime brokerage financing model are, in effect, structural challenges to the hedge fund financing model.”

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Basel III: Capital requirements

Capital requirements have gotten the most press so far simply because they were the first part of the Basel III regulations to come online, scaling from 4.5% minimum tier 1 capital and 8% minimum total capital in 2013 to 6% and 8% respectively in 2015.

As banks’ capital buffer increases, especially when fixed income yields are so low, the return on equity can easily fall below the long-term cost of capital in the 10% – 12% range, which investors won’t put up with for very long. The drive to keep ROE above the cost of capital will force banks to reallocate balance sheet away from business lines with low returns on equity, and hedge fund managers should understand that their accounts will be measured against this new standard.

Basel III: Liquidity coverage ratio

Basel III minimum liquidity coverage ratio (LCR) requirements won’t take effect until 2015, but banks have already started preparing for a longer average tenure short-term funding has to have a weighted average of 30-days or longer, compared to the overnight – one week funding that has been the norm for so long.

“As shorter-term funding is extended past the 30-day LCR threshold, the investor base changes, capacity

Another major change is that internalization, using the assets of one client to cover shorts within another, can only be counted at 50% for LCR purposes under Basel III. Since certain types of assets only have half as much internalization value to prime brokers, hedge fund managers should expect pricing to change accordingly. Some hedge funds many even need to change their trading strategies to account for the new internalization rules and the costs that come with them.

The net stable funding ratio (NSFR) isn’t slated to take effect until 2018, but when it does banks will maintain access to enough stable funding to finance long-term (illiquid) obligations for at least the next year.

“Hedge funds with less liquid strategies that require funding of assets that do not qualify as HQLA will likely be most impacted,” says the report.