(This article first appeared as Beyond Liquidity on Markets Media. Beyond Liquidity is sponsored by Liquidnet.)
The buy side may face even more pressure on their operating margins because US banks are likely to pass on higher capital costs from proposed regulations which could make it more expensive to trade, and also lead to more consolidation.
Consultancy Coalition Greenwich said in a report: “While there are recent examples of consolidation within the investment management industry, the potential for this trend to accelerate is real, as ambitious but resource-starved fund managers consider consolidating with established firms that have a recognized brand and a strong distribution network.”
The Basel Committee on Banking Supervision (BCBS) finalized revisions to its risk-based capital standards, known as the Basel III Endgame package, in 2019 in order to achieve greater global standardization of risk-based capital requirements. National regulators have been making proposals to implement the package with US regulators jointly publishing their proposals in July this year.
Minal Chotai, co-head of financial resources at Coalition Greenwich, examined the potential implications of the proposals that target “global systemically important banks” and said firms that are currently benefiting from artificially low GSIB scores at year-end would likely incur higher capital surcharges.
“Those higher costs would then prompt banks to more closely manage their balance sheets, likely causing them to decrease their market activity and/or pass along the increases to clients— neither of which is good for the buy side,” Chotai added. “And while this change will likely curb some Q4 market activity reductions, it remains to be seen how the elimination of “window dressing” will impact bank balance sheets and market liquidity over time.”
Banks will also assess the future profitability of existing client relationships on an overall basis and rationalize business with less profitable clients. He added: “In an economic environment where buy-side operating margins are tight, trade-level price competitiveness could be an important consideration of doing business.”
Therefore, Chotai recommended that the buy side should equally consider non-price factors, such as “on-demand” availability of funding, sell-side willingness to commit capital to facilitate trades, and coverage quality and, where applicable, highlight a history of providing their sell-side partners with ancillary income, e.g., fee business that has historically been capital light. Fund managers could also help reduce their capital burden, for example, by using central clearing and sponsored repo, and automating their operational processes so collateral is managed more efficiently.
“While it will take some time for these new costs to flow to the buy side, clients should initiate the dialogue with their sell side counterparts now to understand their position and explore mutually beneficial paths forward,” said Chotai.
Liquidity
Daniel Pinto, president and chief operating officer of JPMorgan Chase, warned that increased capital requirements for US banks will have a huge impact on market liquidity and lending. Pinto said at the Financial Times Global Banking Summit in November that the implementation of Basel III, as currently proposed, would have the biggest impact on the bank’s lending and markets businesses.
Jamie Dimon, chairman and chief executive of JPMorgan testified before the US Senate Committee on Banking, Housing, and Urban Affairs on 6 December and argued that the proposed Basel III Endgame Rule would unnecessarily increase capital requirements by 20-25% for the largest banks. Therefore, they will either stop offering certain products and services or charge more for them.
“Banks would be limited in their ability to deploy capital in the times we’re most needed, and the rule will have a harmful ripple effect on the economy, markets, businesses of all sizes and American households,” said Dimon.
David Solomon, chairman and chief executive of Goldman Sachs, also testified and warned that the proposal nearly doubles the capital requirement for market making activity.
“As of the third quarter, the institutions most impacted by this proposal accounted for two-thirds of both lending and capital markets activities in the U.S,” Solomon said. “In addition, since 2010, U.S. banks have underwritten 70% of equity financing and 60% of U.S. dollar public debt financing.”
James Gorman, chief executive of Morgan Stanley, also argued in his testimony that blanket capital increases for large U.S. banks is wholly unnecessary.
“It will make credit more expensive and less accessible to consumers and businesses while harming the competitiveness of the U.S. economy and driving more activity to the less regulated parts of the financial services industry,”
Gorman added. “As it stands, the proposal would increase the cost of capital and borrowing across the U.S. economy – not just to large corporations and small businesses, but also to pensions, municipalities, and endowments.”
