Repo financing will hit buy-side more than the sell-side as banks start switching focus from ROE to ROA, reports Citi Research.
Keith Horowitz and the team at Citi Research report that as banks move toward a leverage-based capital approach, banks will switch focus from maximizing ROE to ROA.
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Opportunities to enhance leverage ratios
The eight biggest U.S. banks will need to hold twice as much equity capital as required globally under a new rule launched by U.S. regulators in July, intended to protect taxpayers from any future costly bailouts. The rule would impose a so-called leverage ratio which requires the banks to hold equity capital equal to 6 percent of total assets.
Citi analysts point out that historically banks have optimized their balance sheets based on risk-based capital measures, while focusing less on non-risk-based leverage ratios, particularly European banks. However, Citi analysts highlight three primary opportunities which the banks can leverage to optimize their balance sheets to meet the supplementary leverage ratio viz.: (a) trade compression, (b) secured client financing, and (c) re-pricing unused commitments.
Keith Horowitz and team at Citi Research believe there is significant opportunity on the trade compression side to reduce gross derivative receivables via netting of trades between dealers. The analysts feel in the near term, this would likely to be the primary focus for the banks.
Citi’s report highlights how banks will address their secured financing businesses, for both clients and for their own balance sheet.
Deep dive into secured financing
Citi’s report elaborates secured financing transactions broadly consist of two instruments: repo and securities lending. Though both the instruments are economically similar, they are legally distinct. However, market participants broadly refer repo as secured financing.
While repo is primarily done on the cash financing desks within fixed income, securities lending is primarily done in prime brokerage within equities.
Banks’ repo business
The report highlights three wildcards which may put even more pressure on banks on their repo business: (a) adoption of international standards, (b) final definition of liquidity coverage ratio and (c) further potential regulatory reform as regulators remain much focused on this business.
Citi analysts feel since the ROA for the plain vanilla, commonly referred as General Collaterals, repo is about 10 bp, they don’t see any major hit to trading revenue. The analysts feel banks will likely re-price the business (estimated minimum +40 bps), but the analysts anticipate this will be offset by lower trading activity levels.
Opportunity for Barclays
Keith Horowitz and team at Citi Research anticipate, due to stricter U.S. leverage requirements, some fixed income players might lose share, such as the major European banks’ U.S. subsidiaries. However, based on the analysts’ cross-checking of repo exposure Vs trading market share, they observe significant opportunity exists for Barclays PLC (NYSE:BCS) (LON:BARC) to enhance its balance sheet efficiency.
Citi analysts feel reductions in repo financing could impact business models of one-sided leverage investors such as Mortgage REITS, as they do not provide any opposite or matched trade to offset their borrowing. Similarly, the analysts feel smaller tier clients could also be impacted as they rely on repo financing and do not generate enough fees when banks look at client profitability on an ROA basis.