Staying nimble in an evolving regulatory landscape

Anand Krishnan of Natixis Americas explains how regulatory pressures are changing the rules of the game and buy-side entities are changing with it

As the banking sector’s regulatory environment continues to tighten, financial resources are becoming increasingly scarce and costly. Constraints in many variables in both assets and liability have created a bigger need to optimise, make quick decisions, remain nimble, and be strategic. To adapt to the evolving market needs, Natixis believes that firms with infrastructure or platforms that can adapt to the new model will be able to provide better solutions and service to clients.

Solving counterparty risk diversification

To further complicate matters, and as a result of these trends, many institutions, particularly prime brokers, are reducing their balance sheets. And while prime brokers still offer valuable services, their ability to take on clients and new business is decreasing in conjunction with the size of their balance sheet, truncated by the ever-changing regulatory landscape.

As such, prime brokers are being forced to evaluate how they benchmark and score their clients, either because they can no longer offer space on their balance sheets, or because the individuals and entities seeking their business no longer meet their newer, elevated asset thresholds. This is in turn causing hedge funds, large asset managers, mutual funds and insurance companies to adjust the way they do business and extract the greatest value from their own collateral.

However, with change comes growth, and this latest evolution is no different. Natixis and other banks are working more closely with their counterparties and clients to offer balance sheet solutions in a way that allows counterparty risk diversification, where each counterparty still plays a meaningful role in the transaction. It’s important to take a solution-based approach with one’s clients, and that is how Natixis differentiates itself. We know all our clients’ needs are different, and not all structures and solutions fit everyone. This approach requires strong financial engineering and structuring capabilities that allow us to deliver an array of products and solutions. Whether it’s to hedge their risk or to provide collateralised financing, these solutions should be customised for each client.
Acheiving balance sheet flexibility

As we think about customisation and counterparty risk diversification, cross-asset solutions are a key driver facilitating this shift, allowing for balance sheet flexibility. Natixis recommends consolidating balance sheets between groups such as fixed income and equities. Doing so means that one can more effectively re-deploy capital, leverage and credit across a wider platform that reaches a larger audience, or one with multiple needs.

Providing high-quality liquid assets (HQLA) through collateral upgrades or downgrades, via innovative balance sheet optimal strategy, has been a key focus for lenders. As such, those who can take on those assets, either individually or through their counterparty network, are at a competitive advantage. And with demand for HQLA at an all-time high, asset managers are searching for more creative ways of extracting the maximum value from the collateral they hold, whether it’s through physical trade structures, synthetic trade structures, or other less utilised, more innovative vehicles.

In the case of hedge funds looking to add size, for instance, and given that today’s prime brokers offer less balance sheet, managers of these funds will be charged higher fees and other expenses to be able to utilise a prime broker’s balance sheet. At the same time, generating large enough returns to absorb these costs and still return acceptable capital to investors has been a challenge for many hedge funds.

And if one’s costs are increasing while returns are not keeping up, your business model risks becoming unsustainable. This becomes all the more pronounced amid the pressure that the traditional 2 percent and 20 percent model has come under from investors. Consequently, this shift is forcing hedge funds to reevaluate the types of funds and portfolios that they’re running. Some funds are taking a more proactive approach because of these headwinds, but others are shifting to nimbler, more agile mid-sized banks, and for good reason.

Size isn’t everything

Larger banks have historically leveraged their scale to more easily implement enterprise-wide enhancements and investments into their corporate infrastructure. This is particularly true from a regulatory perspective, where more stringent requirements have dramatically escalated compliance costs across the financial sector.

But while the ability to keep up with the cost of compliance can be an advantage in certain environments, today’s regulatory space is evolving at a pace that is less friendly towards larger, multi-year overhauls. Large banks have invested so much in this infrastructure over a longer time period, and many of the rules that caused them to make these investments are constantly evolving. These institutions are now too heavily invested to be able to pivot without incurring significant expenses, some of which may have to be dispersed across counterparties.

When you couple that with the aforementioned pressure facing hedge funds to generate better returns while cutting costs, these funds must critically evaluate their current relationships and think outside the box as to how to better balance their business model. For this reason, Natixis is seeing a proliferation of hedge funds strengthening their partnerships with nimble, mid-sized financial institutions that can more easily adapt to the current environment.

Enhanced technology is critical

With cost being a binding factor underlying compliance-related strategy, there isn’t any one regulatory shift or piece of legislation that has had a materially greater impact than any other. You must take all of them into account, and that’s what makes things difficult. As a result, counterparties, banks and their clients are working more closely now than ever before. With increased regulation, and a more data-driven securities finance business, the need for enhanced technology is critical.

Seeing this trend evolve, Natixis has recalibrated its technology to meet more modern and stringent reporting requirements, allowing for greater interconnectivity across its domestic and international platforms.

Centralise for success

With that in mind, a mid-sized bank that can successfully execute global campaigns is paramount. As the consolidated model becomes increasingly sought after in today’s business world, organisations that can increase touch points in a consolidated fashion by centralising their infrastructure are best positioned to succeed. While individual regions are held to their own local requirements, they can no longer be fully independent in how they operate, as clients become more global and operate in multiple markets.

The difference in capital ratio requirements for US versus European financial institutions is a prime example. While the requirements differ, a firm with a strong presence in both regions must take both standards into account and meld them into a broader, globally-compliant platform.

As such, it’s easier, from a collateral management standpoint, to have one central hub instead of having multiple regions trying to do everything on their own or, worse yet, leading an independent initiative and being forced to later merge it into a broader, incompatible intercontinental effort.

This centralised approach recommended by Natixis also opens the door for providing additional solutions across other areas of a bank’s platform beyond balance sheet lending, at both the product level as well as the intercontinental level. Multi collateral and currency structures are expected to be on the rise as groups will consolidate both locally and globally.

In sum, as regulatory pressure continues to escalate in the banking sector, it’s critical to diversify your balance sheet lending sources in ways that are cost effective while still providing the necessary flexibility and capacity. Counterparty diversification remains paramount as lenders work more closely with their constituents than ever before.

While the prime broker market is long-established and should generally withstand these evolving regulatory headwinds, there are other alternatives with which to diversify your assets, particularly if you’re having trouble meeting elevated asset/return thresholds. Whether that’s general financing, long-short financing, or other services, Natixis can help clients diversify and remain nimble, which will be critical in the current regulatory environment, which has placed a high premium on efficient balance sheet management.
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