Some time ago we posted Now Everyone Can Be a SIFI, a look at new FSB proposals expanding the definition of a Significant Financial Institution. That’s the regulatory part. Now we take a look at the reality of who should be funding who and why.
Our observation is that financial markets our moving fast in the direction where each individual financial services firm needs to think of itself as its own funding desk. This is a very different perspective than the old model, where hedge funds, insurance companies and others could look to banks as the source of their principal funding. The new model relies on each end-user to take responsibility for their own selves using banks as agents to execute transactions. This is a fairly fundamental shift and one that we now see occurring at the largest firms. It will take some time to filter downwards however and we think that the transition to understanding what being a self-funding entity means will create further shifts in the institutional investor, asset manager and hedge fund landscapes.
A recent set of interviews we conducted for an upcoming report on collateral management vendors for large financial institutions cemented this idea for us. It had been in the backs of our minds but now its front and center. We heard various comments about greater interest in collateral management, but more importantly we heard direct and indirect references to clients wanting one cohesive system in collateral that reached from the front office through to operations and compliance. For firms with securities lending and repo as well as OTC derivatives transactions, the need to manage and optimize collateral is obvious; what is less obvious is looking at these transactions as if they were originating on the investor’s trading desk with no principal backing from a bank. This is the next point on the horizon.
Banks themselves are driving this change through higher pricing. As one example, lines of credit that used to come with very low fees for no utilization now carry a 3.5% charge, enough to deter a casual investor looking for a feel-good backstop. Why? Look no further than the Leverage Ratio, which tallies up all on and off balance sheet liabilities and guarantees (the off balance sheet part of the Leverage Ratio includes “include commitments (including liquidity facilities), unconditionally cancellable commitments, direct credit substitutes, acceptances, standby letters of credit, trade letters of credit, failed transactions and unsettled securities,” says the Basel Committee here. We’ve discussed frequently on this site and in our reports that this extends to principal transactions and is expected to make a sizable impact on bank funding behavior, even with new revisions to Basel III that should allow repo netting (the question of whether this has to be on a CCP notwithstanding).
There are a bunch more examples that could be made here: agent lenders eliminating indemnification; Direct Repo; LCH.Clearnet and Euroclear’s new repo CCP; Eurex’s Securities Lending CCP, etc. All involve banks stepping out of the risk transfer business and acting as agent or even getting sidelined altogether (although more realistically we don’t see the sidelining happen – banks have too much reach and too many relationships).
The upshot is that banks will become advisors for the funding decisions that their clients make while utilizing the bank’s facilities and CCP memberships (for a fee). Clients will ultimately take more of the costs, risks and benefits of their decisions on their own books. It’s a small conceptual leap to see where technology fits into this, not to mention a former bank funding manager now moved to the buy-side.
This is how we see things going. We think that the sooner investors adopt this model, even if bank principal funding is available, the better off they will be.
For more on Now Everyone Can Be a SIFI, see our January 15, 2014 post here or the Financial Stability Board’s publication “Proposed Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions.”