The sudden decision by regulators to focus on bank leverage ratios will hobble the industry’s core trading businesses, dramatically slash the liquidity available in the capital markets, and bring about the most sweeping changes to investment banking seen in a generation.
After all the fretting over Dodd-Frank and levels of bank capital, and all the talk about reviving Glass-Steagall, at the end of the day the Basel Committee has put aside some three decades of oversight based on risk-weighted assets in favour of a blunt measure of total leverage – with all kinds of unintended consequences the likely result.
The shift in regulatory focus introduces an incentive to scale back on traditionally low-risk activities, while encouraging relatively greater appetite for higher-risk assets.
Curtailing traditional market-making in fixed-income products will limit the ability of banks to dampen bouts of volatility. The inevitable reduction in bank balance sheets, and the capital deployed for clients, will have a decidedly negative impact on economic activity. And some banks will abandon parts of their business altogether.
“For those banks that find they do not have the scale sufficient to make the economics work in low margin flow sectors, they’ll decide the return on capital is not there to sustain them,” said Chris Murphy, global head of rates and credit at UBS.
Caught off-guard
Pressure from the SNB to deleverage led UBS to wind down its fixed income operation last year. The bank cut the funded balance sheet at its investment bank from more than SFr500bn 12 months ago to less than SFr200bn now. The question is whether others, caught off-guard by this sudden shift, will have to follow suit.
Royal Bank of Canada last week abandoned a three-year-long effort to build a European government bond-trading business. The bank did not blame the new leverage ratio proposal, but still it decided there were better places to deploy its capital – and it is not alone.
The head of markets at a major investment bank, who had been considering building out his firm’s government bond business this year, also said that the leverage proposal had forced him to decide against doing so.
Under the new proposal, which is out for consultation until September, the new leverage ratio denominator looks at the funded balance sheet – including things such as government bonds and repos, plus add-ons for gross derivatives exposure and unfunded loan commitments. The new methodology forces banks to hold capital against all assets.
“If you’re looking at gross assets, then what were zero risk-weighted assets may be less compelling,” said Charlie Berman, vice-chairman of debt capital markets at Barclays. “There is the potential for this to have a significant impact on how investors view and manage their government bond holdings.”
Of course, many would argue that banks holding less inventory is a good thing, and that it could be positive for their credit profile. No longer would bouts of prolonged volatility be followed by hundreds of millions of mark-to-market losses from banks inventories.
“There are some businesses that are balance sheet-intensive but also very low margin,” said Bridget Gandy, head of financial institutions at Fitch. She said that liquidity portfolios and repos were two things that stood out on the large securities firms’ balance sheets in this regard.
“They have to hold minimum levels [of liquidity] and are finding it expensive to fund government bonds,” she said. “There is very little spread on these [and] applying a capital charge will further disincentivise holdings.”
Repo repositioned
Repos in fact may be one of the areas most affected by the proposed Basel changes. The sector features especially big numbers and very thin margins.
According to JP Morgan analysts, repos in the US, Europe and Japan make up a US$6.8trn market – or around 10% of the US$77trn reported assets of G4 commercial banks. But under current accounting rules, much of this US$6.8trn does not show up as assets in G4 banks.
The analysts argue that the new rules will mean that the LRD exposure measure (the denominator of the ratio) would increase by more than US$6trn, potentially creating an additional capital requirement of US$180bn for the G4 if a 3% minimum capital requirement was applied.
“I’m more concerned fundamentally with what this will mean for the repo market,” said Murphy at UBS. “It is going to be under real pressure.”
In fact, liquidity is already starting to dry up in the term repo markets. Traders wishing to fund positions in short-term dates still have liquidity, but there is little being quoted for repos out past three months – a highly unusual situation and one that is a function of dealers not wanting to tie up balance sheets for too long.
“I’m more concerned fundamentally with what this will mean for the repo market. It is going to be under real pressure”
A big fear in the market is that the same could happen to short-dated repo. That would mean participants could only trade from a long-only perspective and could result in a global squeeze.
“Given the importance of repo to the functioning of global liquidity in the financial system, that could create a major problem for the world economy,” Murphy said. “The inability to turn highly rated securities into cash is going to be a big issue for the global economy.”
How to cope
Banks have several ways of dealing with the potential impact on high-volume activities such as trading high-grade corporate credit as well as government securities. But there seems little doubt that the changes will affect their bottom lines.
“There is no question that this is a re-orientation of the fixed-income business to a new regulatory front,” said the chief operating officer of a European investment bank.
“Profitability could be reduced,” he said. “You can have more equity allocated to the business – therefore reducing the returns and profitability – or take another approach by reducing the size of the business [and] dealing with the denominator.”
Either way, that would mean dealers making less liquidity available to the markets – which in turn would make financing more expensive.
“Market liquidity is just one of the things being affected,” said Berman at Barclays.
“It’s generally agreed that several risks were not correctly priced in the run up to the crash. The whole thrust of Basel III and [the EU’s implementation of the Basel III rules] CRD IV is not just to recognise these risks, but for banks to actually levy the charges and users to pay them,” he said.
“An obvious area affected is long-dated cross-currency swaps, where many providers will simply stop providing this option. It will still be possible to do it, but it will in general cost a lot more than it did 10 years ago.”
Whither liquidity?
In June, the global markets got a taste of what can happen when liquidity disappears. The US new issue market shut after the benchmark US Treasury 10-year went from 2.2% to 2.60% in four trading sessions.
“Unless we’re going to move into a buy-and-hold world, market liquidity matters,” said Richie Prager, head of trading and liquidity strategies at BlackRock.
“I don’t think the market wants to commit to a buy-and-hold model. Asset managers and issuers alike need liquidity. Issuers need capital to be available, while investors want to be able to adjust their portfolios.”
Corporate bond investors are already concerned at the current inadequacies in secondary market liquidity, and fear what happens when interest rates spike and seemingly everyone in the world tries to push the sell button at the same time.
“These exogenous factors – regulations curtailing risk-taking, rules increasing capital at the banks – are all well and good, but the reality is they’re attacking the principal model in fixed income,” Prager said.
Most bankers will concede that the amount of outright capital committed to trading and holding risk is minimal compared with the market’s heyday.
Few are shedding any tears for the broker-dealers and the changes to their business model, but these moves worry investors and could hit sectors that matter to regulators – such as government bond auctions and trading.
There is some hope that other changes starting to sweep the industry, such as moving to central clearing and trading instruments at exchanges, could prove to be a lifeline for plain vanilla trading activity.
But overall the market structures needed are still nowhere near ready. And in the meantime, the proposals coming from the Basel Committee look set to dwarf any would-be improvements in market functioning elsewhere. According to the old adage, liquidity is never there when you need it. The shadow cast by the new regulations suggests that, in future, liquidity will hardly ever be there at all.
