Basel III is aimed squarely at banks, but because the sell side’s raison d’être is helping the buy side access liquidity, institutional investment managers stand to feel a pinch from the sweeping ruleset.

“We are not directly affected by Basel III, but we are concerned about the impact it may have on the derivative markets,” said Jim Keohane, president and chief executive of the $52 billion Healthcare of Ontario Pension Plan. “The new capital rules will change the economics of certain transactions, particularly those which would be categorized as low-margin, high-balance-sheet-usage transactions.”

Basel III is a global standard that entails additional capital buffers and reporting ratios beyond the increased common equity and ‘Tier 1’ capital requirements set forth in Basel II. Agreed upon nearly five years ago by members of the Basel Committee on Banking Supervision, it is being implemented incrementally through 2019.

The rule set forces extra prudence on banks, which should bolster the stability of the financial system and markets in times of crisis. However, that bolstered stability is not free — because bank broker-dealers must keep more capital on ice, they have less capacity to make markets. For some derivative, fixed income and other securities for which banks have been the primary providers of liquidity, a diminished banking presence can result in inefficient and costly trades, and by extension a lower net investment return for the end investor.

Low-margin, high-balance-sheet-usage transactions represent the least desirable business for banks, which must look at their customers differently under Basel III. “Until Basel III started to be implemented, a $10 million client was always better than a $5 million client,” Robert Sloan, managing partner at S3 Partners, told Markets Media in October 2014. “In this world, that’s not true. A $5 million client that uses no balance sheet helps me create balance sheet, so that client is a better client than a $10 million client that uses a lot of balance sheet.”

To a certain extent, buy-side institutions see the market through the prism of the sell side, so any regs that constrain banks have a knock-on effect.

“With Basel III, more of risk management is becoming fully prescribed and examined by regulators,” said Ilaria Vigano, global head of regulatory and accounting products at Bloomberg LP’s Enterprise Solutions group. “Banks no longer can rely on internal credit and market analysis and must seek to use sophisticated market-based analysis that is comparable across firms. Stress testing, credit exposure calculations, single counterparty credit exposure limits, capital requirements and risk weighting are just a few of the overarching risk management tools that were introduced or refined by Basel III.”

“These requirements will help keep the financial system safer by increasing the capital and solvency of financial institutions globally and preventing systemic risk from building up,” Vigano continued. “On the other hand, the changes will also impair return on equity for the largest institutions. As a result, banks will continue to look for ways to streamline operations, shift the workforce and seek out new fee income streams. Basel III initiatives will also require firms to spend significant time and money on data integration for risk management and regulatory reporting processes.”

The buy side has taken notice of how Basel III stands to crimp market intermediaries. In a November 2014 letter to the Basel Committee on Banking Supervision, the Asset Management Group of the Securities Industry and Futures Markets Association expressed concern regarding a specific derivatives exposure measure contained in the Basel III Leverage Ratio Framework and Disclosure Requirements.

The measure “may substantially reduce our members’ ability to hedge risk and reduce volatility in the funds they manage through the use of cleared derivatives,” the Sifma group wrote.

Featured image via Elenarts/Dollar Photo Club