Breaking up because of Basel III: It was good while it lasted

Across the global financial sector, Basel III’s capital and liquidity requirements are forcing banks to forgo low-return capital consumptive activities and, in the process, they are dumping some customers, including hedge funds. Where can hedge funds turn to find new and meaningful relationships? writes Jazeb Jones, the Managing Director of DMS Bank & Trust Ltd.

A hedge fund manager in Brazil recently received the equivalent of a “Dear John” letter from his bank (one of the global leaders in asset management and commercial banking), notifying him that as early as mid-July, the bank will no longer maintain the fund’s subscription/redemption account. It’s just not “feasible,” according to the bank.

Other hedge fund managers elsewhere are receiving similar letters. In the shadow of these relationship breakups lurks Basel III, a set of banking and financial sector regulations designed to address deficiencies in financial oversight that were exposed during the global financial crisis in 2008.

Basel III introduces new quantitative and qualitative capital requirements and minimum liquidity levels designed to ensure that banks have enough in reserve, in case of a crisis. Investment banks are required to increase their common equity Tier 1 capital from 2% to 7%.  Further buffers have been added to bring common equity Tier 1 capital ratios to 10% for systemically important financial institutions, or those considered “too big to fail.” To ensure that banks are able to withstand periods of funding stress, Basel III has also introduced a Liquidity Coverage Ratio and Net Stable Funding Ratio (NSFR), through which banks must hold long-term debt or equity capital against assets.

These liquidity constraints and capital buffers are causing banks to become more selective in how they support hedge fund businesses. Liquidity rules under Basel III require banks to demonstrate that they are able to withstand a 30-day market stress event.

By some estimates, because of the NSFR, banks will be forced to hold long-term debt against equity financing, and this may cause inflated costs for hedge fund clients. Credit valuation adjustment rules will also affect the costs of trades and, because hedge funds generally trade the most and in high volumes, they are likely to be the ones most impacted by these rules.

Financing for hedge funds is already one area that is being tightened considerably, as some banks begin the process of reshaping their hedge fund portfolio, or start to move away from that business entirely to concentrate on more core banking activities. This shaking out is expected to continue up to 2019, when Basel III’s six-year implementation process ends.

But it’s not just Basel III that is rewriting the rules for the international banking system. The U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act, which is also being implemented over several years, is also bringing in a new regime, aimed at ensuring the safety of the financial world and protecting consumers from systemic failure. Most pertinent to hedge funds is The Volcker Rule, which places limits on banks and their affiliates regarding the investments they make in hedge funds and private equity funds.

This convergence of new regulations is weighing heavily on many of the big, global banks, forcing them to shed clients or types of businesses they consider risky. Breakups can be painful so, as hedge funds and the administrators servicing them find themselves being squeezed out by their banks, where can they turn to find new and meaningful relationships?

A Guide to Finding New Partnerships

Stability and Security: As with any relationship, the importance of stability and security in your partner cannot be overstated. Hedge funds and their administrators forced to look around for new banking partners will want to ensure that their choices meet all the requirements for long-term stability as intended by regulations such as Basel III. They should therefore look for new partners that can readily demonstrate a commitment to these standards and that they adhere to practices that expose them to very minimal levels of market risks.

As far as security goes, a new banking partner should demonstrate investment in modern and comprehensive systems and controls that provide assurance of meeting and even exceeding both local and global regulatory standards. They should be among the most robust in terms of compliance procedures, with a proven track record of effective risk management and not engaged in any lending, proprietary trading or commingling of client assets that may place client assets at risk.

Meet the friends and family: It’s undeniable in global business that you are known by the company you keep, so one good measure of the appeal of a new banking partner should be seen in the kind of relationships that it keeps and with whom it does business. Correspondent banking relationships strengthen that appeal, and banking institutions that have multiple alliances and that are also highly recommended and referred by other leading industry firms are worth a first look when searching for a new partner.

Strength: It’s cliché, but sometimes size does matter. In this case, hedge funds may want to put their trust in a dominant banking partner that has a sizeable deposit of client assets maintained through top tier relationships established with the highest rated U.S. Federal Reserve banking institutions.  Market confidence is an important barometer and again, you are known by the company that you keep.

Experienced Custodians: This also belongs in the “plus” column. Recognition as an experienced custodian should be among the factors that help seal the deal, particularly where the bank maintains segregated custody accounts with stable, well-reputed institutions, which are themselves leaders in the global financial services industry.

A Partner Who Understands: Let’s face it, when it comes to relationships, few would debate the importance of having someone who truly understands them. It’s pretty much a given that the partner who understands what makes the other person tick is the one to keep for the long term. Hedge fund managers should therefore be looking for banking partners that understand how to work at their pace, with a track record of fast account opening and are recognized industry leaders in the banking services intrinsic to their businesses.

Accessibility: Being able to receive and process information about a partner is not only important in the building phase, but equally so once a genuine relationship has been established. Having a partner that understands the value of round-the-clock access to client information will no doubt strengthen the relationship in the long run. Most likely, this kind of access will be delivered through state-of-the art technology that perfectly blends security, speed and ever-improving client service.

Take Time to Know

In the search for a new partner, there is long-term value in a deliberate and thorough approach. Taking time to ensure that the potential partner ticks all the right boxes for regulatory compliance, institutional strength, stability and security, excellent correspondent relationships, ease of doing business, and access to information is not only smart, but a sound investment for the future. And yes, you can find love again.

Jazeb Jones is the Managing Director of DMS Bank & Trust Ltd., a Cayman Islands-based bank that provides offshore financial services to institutions and high net worth individuals.

Tags: commentary, hedge funds

Category: Finance, Financial Services