It is no secret that we think many in the investment management industry are asleep at the switch when it comes to the issue of prudential regulation, including its impact on capital and leverage. With the NFA asking for public comments on the possibility of imposing capital requirements on commodity pool operators and commodity trading advisors (see here) and the AIFMD already imposing capital requirements for advisers in the E.U., is it fair to detect a general push for capital requirements on advisers — or on some of their clients? The spade work for the latter may have already begun at the OFR. Also noteworthy is the recent Senate testimony by U.S. Federal Reserve Governor Daniel Tarullo, noting that “…we have yet to address head-on the financial stability risks from…[short term] funding that lie at the heart of shadow banking” and highlighting the prospects for uniform excess margin requirements.
With all this in mind, we asked Peter Smedresman, a banking partner at Satterlee Stephens Burke & Burke, to provide his insights on what is going on with the U.S. financial regulators and how this will impact funds and managers that employ leverage. His comments follow.
With the Federal Reserve and the SEC in a turf war about the extent to which asset managers pose systemic risks (see here), asset management firms may believe that the only issue at stake is whether the “big guys” will be designated as systemically significant (and thus subject to a more intensive regulatory regime). This is understandable, but wrong. In recent months, senior officials of the Federal Reserve and the SEC have staked out divergent positions on another (but related) area – regulatory capital rules.
First, a bit of background. Banking groups (which after the 2008 meltdown include most large broker-dealers) are subject to a complex capital regime. Advisory firms in the U.S. are not (unless they are owned by a financial services firm). However, advisers operating in the E.U. may be subject to limited capital requirements, for example, under the AIFMD. Worldwide regulators, collaborating on a voluntary standard for bank capital for many years, are now implementing a third overhaul—called Basel III.
Fed Governor Daniel Tarullo – the Fed’s point man on regulatory issues – sees much unfinished business in bringing Basel III into full effect. He is particularly focused on the risks posed by short-term “securities financing transactions.” These include repos, reverse repos, securities borrowing and lending transactions, and securities-collateralized loans. In a speech given on November 22, Governor Tarullo suggests that both banks and firms that fall outside the current regulatory structure need stronger regulatory requirements when undertaking such transactions.
With respect to regulated banks, Governor Tarullo notes that, under pressure from bank regulators, the volume of intraday credit extensions has decreased. For example, clearing banks have worked with the Fed to reduce the intraday credit provided in the tri-party repo market by nearly 70 percent (with another 20 percent drop expected soon). The bank regulators have other tools in their arsenal. Two components of Basel III, the Liquidity Coverage Ratio and the Net Stable Funding Ratio, impose additional capital requirements on certain liquidity deficiencies. Although Governor Tarullo finds even these inadequate, they provide regulators with the leverage to increase capital requirements on (and thus the cost of) some transactions.
With respect to transactions with counterparties not currently regulated by the Fed, Governor Tarullo calls for rules focused on the type of transactions undertaken, rather than the “nature of the firm engaging in the transactions.” These transaction-based rules would apply to all counterparties. Any alternative fund that employs leverage should take note; these also would increase funding costs.
Transaction-based, rather than entity-based, regulation is not a new concept. Governor Tarullo points to the recent mandate for central clearance of derivatives as an example. He might have also mentioned the margin regulations that are administered by the Fed but enforced by the SEC. Of course both of these rules have a statutory basis, which appears not to exist for the new proposal.
What are the prospects for the SEC cooperating in a legislative effort?
Not too bright, judging from a speech by SEC Commissioner Daniel Gallagher on January 15. His comments, which include a spirited defense of the SEC net capital rules for broker dealers, are primarily directed against employing bank rules for bank-affiliated broker-dealers and against proposals for prudential regulation of money market funds.
No one should underestimate Governor Tarullo’s determination to reform funding mechanisms. With respect to counterparties reliant on banking institutions, he has plenty of authority to take action. With respect to those whose counterparties are systemically important non-bank firms, a broad (if not specific) statutory basis exists in Section 165 of the Dodd-Frank Act. Regulating credit extensions through these two means provides the Fed with plenty of room to reduce intra-day leverage, which could impact returns generated by highly-leveraged funds. This impact could be felt regardless of whether or when a broader market-based authority is given to the Fed.
Alternative funds and investors employing leverage should not be complacent that the status quo will be maintained.
Peter S. Smedresman