Complacency about prime broker risk could kill hedge funds
A SUMMARY AND FULL REVIEW OF THE DISCUSSION AT THE WEBINAR ON 29 JUNE 2020 Part I
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The impact of the Covid-19 crisis on hedge fund managers is different from that of the financial crisis of 2008. Then, the concerns were revolved around funding and asset safety.
Segregation of assets, restrictions on rights of rehypothecation, a better understanding of legal entity risk and less unbalanced documentation mean these concerns are not acute in 2020.
The 2020 crisis has also inverted the 2008 preference for banks over broker-dealers as counterparties. Managers are now more concerned about bank exposure to Main Street risk.
The clearest guide to the evolution of Main Street risk is the Q1 and especially the Q2 – the first full quarter since lockdowns began – loan loss provisions made by banks.
Loan loss provisions taken by American banks are already at levels last seen in 2010, and the less drastic measures taken by European banks reflect their weakness, not their strength.
Credit consensus data collected on a fortnightly basis by Credit Benchmark indicates deterioration in the creditworthiness of some banks in some regions already.
Prime broker risk cannot be managed in isolation but must be understood in the context of the supply chain (CCPs, CSDs and custodians) to which the prime brokerage firm exposes a hedge fund.
Established measures, such spreading balances between multiple prime brokers and monitoring the CDS spreads of banks, are not adequate to the complexity of the current threat.
Instead, managers must get close to their counterparties, filter analyst calls and conferences for data, and understand their value to each prime broker and the value of prime brokerage to each bank.
Capital and liquidity ratios determine the size of bank balance sheets, and hedge fund managers will find themselves competing with real economy clients for a share of them.
The need to maintain lending to speed economic recovery from the pandemic is likely to see bank balance sheets inflate, but managers will still need to compete for access to them.
Differences between the Covid-19 crisis of 2020 and the great financial crisis of 2007-09?
In 2008 hedge fund managers were concerned primarily about asset safety. They wanted to move their balances from stand-alone investment banks thought to be at risk of failing in the manner of Bear Stearns or Lehman Brothers to commercial or universal banks with large balance sheets funded by retail depositors or global custodian banks which hold client assets (for the most part) off their balance sheets. The concern of managers, in short, was primarily about counterparty risk.
Although the volatility in the markets in February, March and April did lead to significant margin calls across both cleared and non-cleared markets, managers encountered no repeat of the precipitate alteration of margin terms and withdrawal of funding by prime brokers that took place in 2007-08. Indeed, managers report constructive engagement with their prime and clearing brokers despite falling net asset values (NAVs). As to concern about the counterparty risk of stand-alone investment banks, this was noticeable only by its absence.
In fact, if there was any concern at all about counterparty risk, it focused on commercial and universal banks. They are not only exposed to corporate and retail customers likely to default on mortgages, credit card bills and other loans during the lockdown but bound to come under pressure from governments not to tighten credit precipitately in the recovery. Banks did increase their loan provisions significantly in the first quarter of 2020, and the second quarter data will be watched closely for signs of deterioration when it is published in mid to late July.
A better understanding of banks as counterparties is one reason why hedge funds are more sanguine this time, but there are others. A re-regulated banking industry, with healthier capital and liquidity ratios, is less stressed than it was in 2007-08. Fund assets, especially of the unencumbered kind, tend to be segregated these days. And the documentation of prime brokerage and swap agreements reflects what managers learned from their experience in the earlier crisis, especially in terms of legal entity exposures and the rights of prime brokers to seize and re-hypothecate assets.
How a real economy crisis might turn into a financial market crisis
That said, markets recovered quickly, not just in terms of value but in terms of issuance and trading volume as well. The massive deleveraging of March was also reversed, albeit slowly. This incurs the risk of complacency, not least because the monetary measures taken by central banks and the fiscal measures taken by governments have buoyed up the financial economy. Unlike 2007-08, however, 2020 is primarily a crisis of the real economy – so far.
This crisis has assigned to banks a role different to the one they played 12 years ago. This time, they are not blocking the flow of liquidity and funding to the financial economy but intermediating the flow of liquidity and funding to the real economy. That exposes banks to distress in the real economy, which is why their loan loss provisions for the second quarter – the first full quarter since the lockdowns began – will be scrutinised carefully.
Loan loss provisions made by the largest banks in the United States in the first quarter took them to levels last seen in 2010, and provisions in the second quarter may take them to the 21st century peaks of 2009. The major European universal banks also made sizeable provisions in the first quarter, with the heaviest concentrated among banks in the United Kingdom, Italy and Spain, though the scale did not match that of their American counterparts – partly because European regulators do not believe European banks are robust enough to both absorb massive provisions and keep lending.
It may turn out that large banks with investment banking arms can offset losses in their commercial lending businesses with gains in their securities business, with revenues up from both trading and new issues. That possibility is also worth scrutinising in the second quarter results. But whether or not the provisions made so far prove conservative, the fact they are being made at all is an early indicator of the scale of the damage to the real economy that might be inflicted by the pandemic. It could turn a health problem into a financial crisis.
Not all banks are the same and not all bank credits deteriorate at the same rate in the same way
The credit consensus data – fortnightly changes in how banks view the creditworthiness of other banks – collected by Credit Benchmark is already picking up deteriorations in the credit quality of banks. It shows that in recent weeks deteriorations have outweighed improvements across every type of bank and in every region, with North America and Latin America deteriorating fastest.
The Credit Benchmark data identifies 37 banks, mainly in North America and Europe, that have already migrated from investment grade to high yield status. It also shows that two out of 30 Globally Systemically Important Banks (GSIBs) are now rated BBB by their counterparties, and 21 single A. In Europe, two thirds of the 1,057 banks tracked by Credit Benchmark are now rated as BBB or worse by their counterparties.
The detail of this geographic difference matters to hedge funds because the Credit Benchmark data is unequivocal on one point: there are more higher credit quality GSIB prime brokers in North America than in Europe (where a AA- prime broker recently acquired a BBB prime broker). As hedge fund managers found to their cost in 2007-09, no one prime broker is equivalent to any other prime broker in terms of credit risk. In addition, no prime broker represents a single credit risk. The risk fluctuates not only by bank but by the legal entity with which a manager is contracted.
Credit risk is complicated by supply chains, networks and networks of networks
Nor does credit risk halt at the edge of the corporate organogram. Every prime broker is part of a network of counterparties of their own, including sub-custodian banks and central securities depositories (CSDs) that hold client assets and central counterparty clearing houses (CCPs) that increase margin calls mechanistically as asset values fall and credit quality deteriorates. Clearing brokers obviously transmit those margin calls to their buy-side clients. Collateralisation of non-cleared derivatives means similar effects are observable in bi-lateral markets.
Understanding and measuring risks as complex as these – clearing trades through a CCP, for example, exposes clearing members to the risk of every other member of the CCP – is beyond the capacity of the vast majority of hedge fund managers. And it is this complexity and interconnectedness, coupled with the evolving nature of prime brokerage counterparty and interconnectedness risks, that makes it impossible for hedge fund managers to navigate this episode purely by the usual rules-of-thumb.
That said, the application of broad prudential principles continues to make sense. It is a good idea for managers to multiply their prime brokerage relationships, weight balances towards bank-owned rather than non-bank prime brokers – the Credit Benchmark data does show that bank-owned prime brokers do enjoy a slight credit advantage – and measure the commitment to and investment in the prime brokerage business of each prime broker they use.
It is also important to strike a balance between these considerations. It manifestly helps not to spread balances across so many prime brokerage relationships that not one of them is making enough money. Likewise, it makes sense to reward prime brokers that have sustained their commitment to the industry. Even a cursory review of the list of top prime brokers in 2008 shows that most of the European leaders then have since shrunk their commitment to the business, and one has withdrawn altogether. The stand-alone investment banks that dominated the business before 2008 now seem at least as interested in asset and wealth management as equity trading and finance.
These are all factors that every hedge fund manager needs to bear in mind. So are conventional measures of the financial soundness of a bank, such as issuer-paid credit ratings and credit default swap (CDS) spreads. But they do have to be treated with caution. Credit ratings are too stable to incorporate the latest information. CDS rates, on the other hand, fluctuate a lot. That, however, is a better measure of their use as trading and hedging instruments than their value as a counterparty risk management tool.
The prudent hedge fund manager is the informed hedge fund manager
Ultimately, prudent hedge fund managers owe it to their investors not to rely on these measures alone. Instead, they must get as much up-to-date information about their prime brokers as they can obtain. They need to be as informed as they can be about their counterparties and stay informed about them as the problems of the real economy unfold in the financial markets. This is not easy, when audited financial data is published by banks on a quarterly basis and is invariably backward-looking anyway.
However, opportunities to gather intelligence do exist between quarterly releases. Analyst calls and intra-quarter statements at investment bank conferences offer insights, such as likely increases in loan loss provisions, and changing expectations about the depth and duration of the economic recovery from the pandemic. Managers are also advised to get closer to their counterparties, so they know exactly which individuals can help them in a crisis. They should also make contact with the funding desks and treasurers of all their counterparties.
This is rarely a realistic option for smaller or emerging managers. The treasurer simply will not take their call. Nor do they have the resources to digest large quantities of information. Nevertheless, they should do something, such as review all documentation; arrange monthly or quarterly meetings with each of their prime brokers and perform an annual due diligence exercise on each of them too; understand the profitability of their business to each of those prime brokers; assess the profitability of prime brokerage to the parent bank; and comprehend the exposures of the supply chains and networks that a prime brokerage relationship entails. After all, hedge fund managers, especially of the smaller kind, are dependent on a host of third parties to fulfil tasks as basic as raising money, clearing and settling trades and keeping customer assets safe.
Larger hedge fund managers can do more – though not much more, for even the largest hedge fund manager is still a small company relative to a bank – and they can also expect the treasurer to accommodate their call. It will help their allocation and risk management decisions to know how credit sentiment is running within a bank, and how hard real economy problems are hitting the balance sheet. But even for the largest managers the reasons for starting a conversation with a prime broker are more specific.
Capital and liquidity ratios put hedge fund shares of bank balance sheets at risk
They are three-fold. First, to find out how valuable the business of the manager is to the bank, since a highly profitable client can expect to be treated more generously in a crisis than a less profitable one. Secondly, and more importantly, to find out how profitable the prime brokerage business as whole actually is. Thirdly, to establish whether the prime brokerage business is self-funding, or close to self-funding, through the re-use of client assets, or reliant on the wider bank for funding.
These last two considerations will be major determinants of how developments in the real economy impact the ability of a bank to support its hedge fund clients. If those real economy developments turn seriously ugly, the Common Equity Tier 1 (CET1) ratio will come under pressure because that is where equity capital is taken from first when losses need to be covered. If loan loss provisions eat CET1 at such a rate that the minimum level of Tier 1 capital looks like being breached, banks will have to shrink their balance sheets.
Prime brokerage competes with other businesses for room on the balance sheet of a bank and, in current political circumstances, the banks will find it easier to cut lending to financial counterparties such as hedge funds than industrial and commercial companies in the real economy. That cut will be harder to implement if prime brokerage is still extremely profitable.
But if the cut is made, it could start a self-fulfilling process. Prime brokerage remains a profitable business, whether it is measured by return on assets or return on equity. But what makes prime brokerage profitable to banks is not just the lending itself but the fact that lending to hedge funds against cash and securities as collateral makes the use of the balance sheet efficient.
In other words, the cash and securities of the client can be used to offset long and short positions, reducing the amount of balance sheet the business actually devours. As leverage shrinks, so does balance sheet efficiency, exacerbating the shrinkage. In short, managers need to be alert to the risk of losing access to bank balance sheets as capital ratios start to bite.
Managers have already experienced some of the unintended consequences of the capital regulations introduced since 2007-09. In the United States, the GSIB surcharge, which can result in increases in capital requirements imposed on banks, is calculated on 31 December every year. This already causes banks to shrink their balance sheets in the fourth quarter, with direct effects on hedge funds, which find their prime brokers trying to shift their cash market positions into swaps and make other adjustments to reduce the size of the balance sheet of the bank at 31 December. That effect might be particularly pronounced this year, with banks under political pressure not to squeeze Main Street.
Liquidity ratio calculations have also caused banks to change their behaviour in ways that are unhelpful to hedge funds. Although central banks have blamed leveraged hedge fund trades for the turmoil in the repo market in September 2019 – the overnight rate on 17 September jumped from its usual range of 10-20 basis points to 700 basis points – and for the dislocation in the US Treasury market in March 2020, there is an alternative explanation of both episodes.
This is that the tougher liquidity constraints imposed on banks since the financial crisis of 2007-09 have made it impossible for the banks which dominate the US repo market to provide funding to participants in stressed markets, even if that market means they will end up holding US Treasuries. In March, a similar dislocation was evident in emerging market sovereign debt, and the banks again withdrew support from managers active in those instruments.
The pandemic provides an opportunity to adjust counter-productive capital and liquidity ratios
Which is why there is a growing conviction in the hedge fund industry that, while the capital and liquidity regulations and other measures introduced since the crisis in 2007-09 have made the overall financial system more robust, certain of the changes introduced over the last decade need to be revised. In fact, there is an expectation that the need to recover rapidly from the effects of the pandemic will prompt central banks to address some of the unhelpful (though unintended) consequences of capital and liquidity ratios.
On that front, an encouraging signal was issued by the Basel Committee on Banking Supervision at the end of March. It announced that the implementation of the Basel III capital standards, risk framework and disclosure requirements would be deferred by a year from 1 January 2022 to 1 January 2023. This is helpful for hedge funds, because it means prime brokers can continue to calculate their own risk-weighted capital allocations for another year and delays the introduction of a 100 per cent capital weighting for unrated buy-side counterparts such as hedge funds.
Another helpful move was made by the Federal Reserve in May. The American central bank made a temporary change to the Supplementary Leverage Ratio (SLR), which requires banks with more than $250 billion in assets to hold capital equivalent to 3 per cent of their total leverage exposure. The change, which expires in March 2021, allows banks to exclude US Treasuries and central bank reserves from the SLR calculation.
This will, as intended, encourage banks to increase the size of their balance sheets. The question for hedge fund managers, however, remains the same: how can they best maintain their share of that expanded balance sheet?
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Questions to be addressed for the next Prime Brokerage discussion
What will the Q2 loan loss provisions by the major banks of North America and Europe tell hedge fund managers about the outlook for continuing support from their prime brokers?
What are the transmission mechanisms by which a real economy crisis turns into a financial markets crisis?
How can hedge fund managers mitigate and manage the risks posed by extended chains of intermediaries such as custodian banks, clearing houses and depositories?
Is relief from the balance sheet shrinkage caused by capital and liquidity ratios likely to become permanent or remain temporary?
How can hedge funds persuade central banks that they are not amplifiers of risk in stressed markets but important absorbers of risk in a healthy financial system?
The Future of Finance is always open to hold further meetings to answer these and other questions and to continue the conversation. If you would like to sponsor such a meeting please contact Wendy Gallagher at the number or email address below. Also view our upcoming meetings elsewhere on http://www.futureoffinance.
Tel: 07725 160903