A series of conversations over the last two months have crystalized for us the idea of the Balance Sheet Haves versus the Balance Sheet Have-Nots. We now have enough evidence to break up the motivations and characteristics of each group and describe why their upcoming conflict will be a central theme in financial markets over the next couple of years.
The Balance Sheet Haves include the asset-rich big banks, some of which are in Europe, some in Canada and some in other parts of the world where their large deposit bases relative to their investment banking activities offer them flexibility. It is tempting to classify this group as the classic European Universal Bank, but that would be inaccurate; this is really a group that for various reasons has excess cash relative to trading needs. This is a small group but an influential one; this is the group that hedge funds have been turning to in the last couple of years when seeking better credit counterparties and an ability to do more kinds of bilateral trades. The Balance Sheet Haves are not particularly worried about Basel III, nor are they very concerned about Leverage Ratios or other constraints on repo or other low ROA businesses. Not only does Basel III not loom as a big threat, but CCPs are not necessarily that interesting to the Balance Sheet Haves. These banks can afford to do their business bilaterally because, really, they have the balance sheet to spare.
On the other side of the fence are the Balance Sheet Have-Nots. This group includes most investment banks (ie, Wall Street prime brokers) and regional banks that do big fixed income or OTC businesses without a big asset base. This group feels Basel III keenly; balance sheet constraints are real, in your face kinds of daily issues, and clients are charged for balance sheet usage pretty much directly. This group needs CCPs as a balance sheet saving mandate and can’t wait for everyone to join for every product that is feasible. As some points of evidence, the OCC’s securities lending program did an average daily notional of US$118 billion in transactions in May 2014, up from an average daily notional of US$32 billion in May 2012. That’s right, US$32 billion. That’s a nearly 4X increase over the two year period, and the OCC can’t even accept agent lenders or beneficial owners without a clearing member, which none of them want anyhow. LCH.Clearnet’s Repoclear is doing EUR 6.6 trillion per month in notional value, a huge sum. The business wouldn’t go to CCPs unless the Balance Sheet Have-Nots didn’t really need them. While there are many more data points that could be cited, we think that the grouping above sum up the main sides in the conversation.
We already see a real conflict between the Balance Sheet Haves and the Have-Nots, and that’s how fast each group wants to move to a new financial markets environment that is focused on Basel III and CCPs. The Haves benefit from the current way of doing business. Their balance sheets mean that they are unaffected by the incremental cost of capital for sensitive trades like repo. We estimate an increase in capital charges of 60-70 bps for repo under US Supplemental Leverage Ratio rules, but ONLY IF a bank has already reached its Leverage Ratio quotas already. Otherwise, there is no incremental cost because every transaction is already below the line. On the other hand, the Have-Nots need balance sheet relief in every way possible and can’t wait to get onto CCPs or take advantage of any other capital savings tool in their arsenal. Readers of Securities Finance Monitor know we are very interested in Single Treasury Futures (cleared on a CCP) and Collateralized Commercial Paper (not cleared but long dated) as funding substitutes. The Have-Nots would really like these products to succeed so they can do more business. Its not a casual preference; it is a dire need.
The question here is how does this conflict end. One possibility is that the Have-Nots, by virtue of outnumbering the Haves, shame their competitors into moving onto CCPs as regulators have requested and waste no time doing so. How happy would the Fed be if (bilateral) tri-party repo went to a third its current size and all those trades migrated onto CCPs? Point at CCPs and call them the next too-big-to-fails all you want; the fact is that they are the best solution for the Have-Nots to keep their businesses intact. Perhaps also this is what finally drives the next wave of big bank mergers. The Haves will buy the Have-Nots and combine their big balance sheets with the Have-Nots’ relatively bigger books of trading businesses.
However this shakes out, we see the conflict between the Balance Sheet Haves and the Balance Sheet Have-Nots as a central theme for the next couple of years in financial markets.